Explaining the IRS Proposed Rule on Charitable Contribution Deductions

On August 23, the IRS issued a long-awaited proposed rule on federal charitable contribution deductions under state tax credit programs. The rule was originally intended to address schemes in high-tax states to circumvent new federal restrictions on the deductibility of state and local taxes (SALT). So, how did it come to affect private school choice programs? And what happens next?

The Tax Cuts and Jobs Act, passed in late 2017, limited the amount of state and local taxes taxpayers can deduct each year to $10,000. Unsurprisingly, this new cap caused a fair amount of consternation among high-wealth individuals who could no longer deduct the full amount of their state and local taxes from their federal tax bill.

In response, several states—New York, Connecticut, and New Jersey—set up government-run “charities” that allowed taxpayers to make payments in lieu of taxes. These taxpayers received state tax credits for their gifts in addition to a federal charitable contribution deduction, effectively allowing them to preserve their tax breaks despite the SALT cap.

Meanwhile, it became clear that the imposition of the SALT cap messed with tax formulas in way that allowed some donors to receive tax benefits in excess of their contributions when those donors claimed both a state tax credit and a federal deduction for the same gift. Opponents of school choice wasted no time capitalizing on the issue, writing letters (and even full-length white papers) arguing that the IRS should write any rule addressing SALT cap workaround schemes broadly enough to also include scholarship tax credit programs.

Unfortunately, that is exactly what the agency did. U.S. Secretary of the Treasury Steve Mnuchin issued a (very) carefully worded statement implying that the rule was designed not to impact state school choice programs. But while technically accurate in its statistics, that statement was misleading; the rule does indeed affect scholarship tax credit programs like the ones in which ACE participates in Kansas and Louisiana.

With only a few exceptions, the IRS rule means that donors will no longer be able to claim a state tax credit and a federal deduction for the same gift. This restriction applies across the board, impacting conservation, historical preservation, medical, and other credits in addition to school choice programs.

So, what happens now? First comes a 45-day public comment period, which closes on October 11, followed by a public hearing on November 5. Additional rounds of review by federal agencies will follow. If approved in its current form, the rule’s new restrictions would retroactively apply to donations made on or after August 28, 2018.

National school choice groups have taken different positions on the rule, with some arguing that full federal deductions should be preserved and others supporting the substance of the rule while asking for a delayed effective date.

ACE Scholarships is following this issue closely and will be participating in the public comment process on behalf of our Louisiana and Kansas scholarship families. Stay tuned for more on that front.