Proposed Treasury Rule May Hit Tax-Credit Scholarship Programs

Published October 12, 2018

The U.S. Department of the Treasury and the Internal Revenue Service (IRS) have closed the comment and testimony period for a potential revision to how federal income taxes treat payments to local and state tax credit programs, including charities intended to help low-income families send their children to better schools.

The Tax Cuts and Jobs Act of 2017, signed by President Donald Trump in January, limits the amount of state and local taxes individuals may deduct from their federal income taxes. In 2018, 12 state governments created tax-credit programs intended to circumvent the federal deduction cap.

IRS heard public testimony for and against the proposed rule on November 5, after accepting public comments from August 27 until October 11.

‘Allowed Fake Charities’

Lennie Jarratt, education project manager at The Heartland Institute, which publishes Budget & Tax News, says some state governments were trying to circumvent provisions of TCJA by effectively creating fraudulent charities.

“States allowed taxpayers to pay their taxes into a state-run fund, and then they could deduct these payments as a charitable contribution,” Jarratt said. “The states essentially allowed fake charities to get around federal tax law.”

Jarratt says the Treasury proposal does not differentiate between these state-run gimmicks and legitimate charities such as tax-credit scholarship (TCS) programs and other nonprofit organizations.

“The proposed rule treats donations to these fake charities the same as donations to real charities, and limits their deductibility on federal taxes,” Jarratt said. “The ability to utilize a federal tax deduction on top of a state tax credit encouraged larger donations. Without this benefit, the incentive to donate, especially for small donors, will be reduced. This potentially reduces the amount of donations to tax-credit scholarship programs as well as other charitable organizations.

“If there is a large enough reduction in TCS donations, fewer scholarships will be available for students who need them,” Jarratt said.

Intended to Stop Gimmicks

Leslie Hiner, vice president of legal affairs at EdChoice, a nonpartisan nonprofit organization promoting educational freedom, says the Treasury rule is intended to prevent state governments from avoiding the consequences of their tax policies.

“In a nutshell, the rule was proposed after a few high-tax states passed laws to help wealthy donors dodge higher federal taxes,” Hiner said. “The new federal tax law limits federal deductibility of state and local taxes greater than $10,000. Many individuals in high-tax states pay state and local taxes that are well in excess of $10,000. In response, states with the most oppressive state and local taxes, with New York leading the way, created tax shelters to help high-income individuals avoid paying higher federal taxes. Sadly, they developed a scheme that shamelessly used charitable-giving laws, and now legitimate charities are also swept in by the proposed rule.”

Saving Taxpayer Dollars

Jarratt says TCS programs provide a net benefit to taxpayers by facilitating families’ use of privately funded education.

“These programs effectively save the state money since fewer students are now served by state tax dollars,” Jarratt said. “Programs like this allow individuals the ability to direct money to education, instead of money going to the state and then hoping the state directs that money back to education. States creating TCS programs allow more students access to the education services they need.”

In addition to creating TCS programs, state lawmakers should use educational savings accounts (ESAs) to expand education freedom and maximize the effectiveness of taxpayers’ money, Jarratt says.

“Creating and increasing the limits on TCS programs is a great start,” Jarratt said. “These TCS programs can do more than just provide scholarships in that they could fund education savings accounts, which would allow more flexibility for students. An ESA allows students to pick courses at different schools, instead of just a single school.”

Predicts Fall-Off in Donations

As currently proposed, the Treasury rule would punish TCS programs, reducing educational freedom, Hiner says.

“Scholarships awarded through state tax-credit scholarship programs, operated by public charities, could be negatively impacted by the proposed rule,” Hiner said. “A donor’s cost of making a charitable contribution that funds scholarships will increase. This will make charitable giving less attractive for donors, especially those who need advice of a tax accountant, and even if donations continue, they may be diminished to offset the donor’s increased cost of giving.”

‘We Can Do Better’

Elected officials at every level of government should use every tool available to them, including tax policy, to promote localism and education freedom, Hiner says.

“Lawmakers would be wise to promote the virtues of state-based education policy, directing attention to the value of developing education without being led by the heavy hand of national government agencies, national teacher unions, and national politics,” Hiner said. “Keep it local; let independent teachers and parents lead the way.

“Legislators could use their bully pulpit to promote the virtues of charitable giving, the kind of community support that is driven first and foremost as a way to improve the quality of life in a community,” Hiner said.

Hiner says parents and communities working together can be trusted to succeed where big government may fail.

“Reliance on government produces unreliable results,” Hiner said. “We can do better.”