Last year’s federal tax overhaul has cast a bright light on a corner of the tax code that long has needed scrutiny.
With the passage of the Tax Cuts and Jobs Act (TCJA) in December, Congress inadvertently encouraged more state governments to embrace a little-known tax strategy to help their residents avoid federal taxes. But Thursday, the IRS and Treasury Department responded with proposed regulations that just might, if given a chance, shut down both the new schemes and the ones that predated the new federal tax law.
This tax shelter has been brought to the fore by a provision in the new federal tax law capping state and local tax (SALT) deductions at $10,000 per year. In response, New York, New Jersey, Connecticut and Oregon passed legislation designed to help their residents “work around” the cap. In theory, taxpayers using these workarounds can make charitable gifts, which are still fully deductible on federal tax returns, instead of SALT payments, to support state or local services.
This relabeling doesn’t matter much at the state and local levels, but at the federal level it means that taxpayers potentially could pay significantly less income tax than they would otherwise. The new federal tax law places a strict cap on SALT deductions, but it places no such cap on deductions for charitable contributions.
To pull off this tax-to-donation transformation, taxpayers who make a voluntary donation to support public services will, within a few months to a year, have most of their donation reimbursed with a state or local tax credit. In New York, for example, the credit can offset 85 percent of the amount donated. These states hoped that their residents then would be able to fully deduct these so-called charitable donations on their federal tax returns, thereby avoiding the cap that would apply if these payments were characterized as state or local taxes.
What does this have to do with private-school donors? New York’s tax credit design is ripped from the playbooks of mostly “red” states such as Alabama, Arizona, Georgia and South Carolina, where taxpayers receive whopping 100 percent tax credits in return for donations they make to support private K-12 schools.
Wealthy taxpayers in these states long have used these credits to dodge a looser limit on the SALT deduction (the Alternative Minimum Tax, or AMT) that existed before last year’s tax overhaul. In Georgia, for example, Whitefield Academy used to tell its donors that “you actually stand to make money on this program” — meaning that donors subject to the AMT’s limits on the SALT deduction could receive combined state and federal tax cuts larger than their so-called “charitable donation.”
But with the new $10,000 cap on the SALT deduction, these red-state tax credits are being exploited on a whole other level, driving record amounts of funding to private K-12 schools and lining the pockets of super-wealthy donors who may not have been able to use the old loophole.
In Alabama, for example, financial advisers told their clients that the state’s private-school credit could be used to “avoid losing” the SALT deduction, despite the new tax law’s cap. While public response to the credit in prior years often was lukewarm (millions in state tax credits frequently went unclaimed), this year taxpayers snatched up the entire allotment of $30 million in available tax credits more quickly than ever before. One prominent tax lawyer called SALT cap-avoidance a “driving force” behind the surge in interest.
Even more telling is Arizona’s experience, where taxpayers claimed a record $89 million in tax credits in just two minutes after private-school backers took to the airwaves to share the “really big news” that the state’s 100 percent private-school credit could be used to dodge the SALT cap.
Rather than distance themselves from this profiteering, private schools have incorporated it into their pitch to prospective donors. And national advocates for private schools such as Education Secretary Betsy DeVosBetsy DeVosMcAuliffe rolls out new ad hitting back at Youngkin on education Biden DOJ tries to shield DeVos from deposition in lawsuit over student loans The long con targeting student survivors of sexual assault MORE, the American Federation for Children, and EdChoice have been fighting against any effort to refine the federal tax treatment of these questionable “donations.” It turns out that it’s a lot easier to raise money for private K-12 schools if you don’t have to track down donors who care about the cause and instead can rely on any high-income taxpayer who’s looking to make a buck.
On Thursday, the IRS proposed regulations that crack down on all types of so-called “donors” who claim charitable deductions for “donations” that actually were reimbursed with state tax credits. Anyone who wants a fair and transparent tax system should be cautiously optimistic that these rules will put an end to the tax shelters for donations to private education as well as the workaround provisions enacted by states more recently.
The IRS deserves praise for resisting efforts to carve out exceptions for donors to private schools that would allow them to continue profiting from their role in the movement of public dollars into private schools. Sen. Johnny IsaksonJohnny IsaksonHerschel Walker calls off fundraiser with woman who had swastika in Twitter profile Georgia reporter says state will 'continue to be a premier battleground' Critical race theory becomes focus of midterms MORE (R-Ga.) had disclosed that officials at the Treasury Department were “sympathetic” to his appeal for such a carve-out, but we know now that they ultimately opted for a fairer route.
Supporters of private schools no doubt will attack this rule and attempt to weaken or overturn it. The IRS and Treasury should reject any such efforts. Any rule that shuts down workaround provisions enacted by blue states while allowing the same type of tax dodge to persist in red states that use them to divert funds to private education would be transparently political and unfair.
Carl Davis is the research director at the Institute on Taxation and Economic Policy, where he works on a range of issues related to state and federal tax policy.