Tax Law Blog | IRS Tax Attorneys

This month, as the tax year nears an end, thousands of Arizonans are expected to donate money to private-school tuition groups and claim a tax credit
that reduces what they owe the state.

Many taxpayers will recommend that their money go to specific students as scholarships; many tuition groups will honor those wishes.

But these taxpayers, and the school tuition organizations that give out the scholarships, may be running afoul of federal tax law
.

The legal do’s and don’ts are not entirely clear because the IRS has not ruled specifically on tax-credit donations targeted to particular students. But disputes run deep among private-school and tuition-group operators and tax experts over the legality of recommending that specific students get the scholarships.

A typical scenario illustrates how such legal concerns arise:

• A married couple decide to make a maximum $1,000 donation using the tax credit. They send a check to a tuition group and indicate they want the money to go to the husband’s nephew.

• The tuition organization honors the recommendation and allocates a roughly $1,000 tuition scholarship to the nephew.

• Come tax time, the couple file an Arizona income-tax return claiming the $1,000 tax credit. Their tax bill is reduced by that amount. At the same time, they claim a $1,000 charitable deduction on their federal tax return because the donation went to a non-profit, tax-exempt tuition group. Their taxable income is reduced by $1,000. Without that deduction, the couple’s federal tax bill would increase because the donated $1,000 would still be considered taxable income.

• In a common variation, the couple also have a child in private school. State law bars them from making a donation to a tuition organization to directly benefit their own child. But the couple have friends whose child attends the same school. The two couples strike a deal to make $1,000 tax-credit donations for each other’s children, a practice called “swapping.” Both claim the state tax credit and the federal deduction.

Tax preparers and attorneys say this scenario raises three key legal questions: Are taxpayers allowed to claim a charitable deduction on their federal tax forms for a donation intended for a specific student? Is it legal for taxpayers to claim that same deduction when they swap donations with other parents? Are non-profit tuition organizations, which are 501(c)(3) charities under tax law, allowed to accept and honor requests from donors that the money go to particular students?

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The state’s high court on Tuesday upheld a 3-year-old law that lets corporations divert some of their state income taxes to help students attend private and parochial schools.

Without comment, the Arizona Supreme Court rejected arguments by the Arizona Education Association and other foes of the law that the law amounts to the state providing illegal aid to these schools. The justices also apparently were unswayed by arguments that the law amounts to the state advancing religion, as most of the dollars collected end up in the coffers of parochial schools.

Tuesday’s ruling is the second time the high court has ruled that the system of credits does not run afoul of state constitutional provisions which bar state funds from being used in aid of private schools. The justices previously upheld a similar tax credit for individuals.

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House Speaker Kirk Adams said Friday he fully expects legislation to come forward in the next session that will address Arizona’s Private School Tuition Tax Credits.House Speaker Kirk Adams said Friday he fully expects legislation to come forward in the next session that will address Arizona’s Private School Tuition Tax Credits.

Last week, Adams, R-Mesa, announced the creation of the official House task force to examine the tax credit law. The committee is made up of Republicans and Democrats from the Ways and Means committee. Rep. Rick Murphy, R-Glendale, is chairman.

Arizona law allows individual taxpayers to receive a state tax credit of up to $1,000 a year for a donation to a school tuition organization (STO), a 501(c)3 charity under federal tax law. STOs then give scholarships to students attending private schools or to students with special needs attending preschool programs.

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The failure of Arizona lawmakers and the governor to reach an agreement on a state budget — and permanently eliminate the state property tax, which was suspended in 2006 — means the tax automatically returns as planned in 2009.

For all intents and purposes, the time for lawmakers to repeal the levy has run out. State law requires county supervisors to set the tax rates Monday. That includes the state property tax, which is technically called a “county equalization tax.”

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The Arizona Senate defeated a tax bill Wednesday that would have put Gov. Jan Brewer’s proposed sales tax hike on the ballot for voters to decide.

The 14-11 vote was two votes short of what’s needed for passage, and an effort to resurrect the proposed sales tax failed on a 15-10 vote.

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Democratic leaders in the Arizona House of Representatives on Tuesday called for state and federal investigations into Arizona’s Private School Tuition Tax Credits program and the scholarship charities that operate the tax subsidy.

Some Republican lawmakers joined in the requests to review tax credits and, if there’s cause, to reform them.

The Democratic caucus in the House also announced the creation of a task force to examine possible changes for the tax credits. The lawmakers sent a letter to the Internal Revenue Service and U.S. Attorney’s Office in Phoenix requesting federal inquiries; they sent a similar appeal to the Arizona Attorney General’s Office.

Legislative changes might include reducing the amount of donations scholarship charities can spend on administration, as well as a new provision making it a violation of state law for private school parents to trade tax credit donations - such transactions already break federal tax law.

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