The IRS issued a proposed rule on August, 23, 2018 that may unintentionally eliminate much of the funding for school voucher programs. The new rule is intended to block attempts to circumvent a cap on federal income tax deductions for state and local taxes.
The Tax Cuts and Jobs Act of 2017 limited the state and local tax (SALT) deduction to $10,000. Democrats have alleged that this was a partisan attack on states like California and New York, which have high income and property taxes and tend to vote Democratic
Some states have introduced state legislation to bypass the $10,000 cap by converting SALT into charitable contributions, which are fully deductible.
For example, pending legislation in California would allow taxpayers to make charitable contributions to colleges and universities and certain other non-profit organizations and get Golden State Credits in return. Each dollar of Golden State Credits will cost the colleges 90 cents and yield an 80 cent state tax credit to the taxpayer. Taxpayers get to deduct the full amount of the charitable contribution from their federal income taxes. The colleges and universities net 10 cents for every Golden State Credit.
A similar scheme is already in use for funding state school voucher programs and scholarship programs. Donors get most of the value of donations to the school voucher programs back in the form of state income tax credits. They get additional value back from a federal income tax deduction for the charitable contribution. In some states, donors to school voucher programs get more than a dollar back for each dollar contributed.
The IRS issued a proposed rule to block the SALT cap avoidance effort by requiring taxpayers to reduce the charitable tax deduction on their federal income tax returns by the amount of any credits received on state and local taxes, if the tax credits are worth more than 15% of the contribution amount.
The IRS is accepting public comments on the proposed rule through October 11, 2018. After the 45-day public comment period closes, a public hearing on the proposed rule will be held on November 5, 2018.
If the IRS rule becomes final, it will not only block workarounds for the SALT deduction limit, but also similar loopholes for school voucher and state scholarship programs.
This could cause big drops in funding for school voucher programs, since the financial value to the taxpayer would be reduced.
If the IRS does not apply this rule to school voucher programs but does apply it to the SALT deduction cap workarounds, the states can argue that this is a violation of the U.S. Constitution’s equal protection clause. Lawsuits are likely.
To comment on the proposed rule, visit regulations.gov and search for REG-112176-18 to find the docket, Contributions in Exchange for State or Local Tax Credits. Then click on the Comment Now button in the upper right corner.