Red state charities could be collateral damage from the GOP’s war on California’s high taxes

Reporting from Washington —  The Alabama Opportunity Scholarship Fund has helped 5,000 low-income children since starting in 2013, but its days could be numbered because of a partisan fight over state and local tax deductions prompted by the GOP tax overhaul.

Money for the fund, which provides annual scholarships averaging $6,000 to attend a private K-through-12th-grade school or a public one outside of a student’s district, is raised through a tax incentive.

Contributions receive a dollar-for-dollar state tax credit and are fully deductible from the donor’s federal income taxes. Now, the future of that federal deduction is at risk.

The program is among more than 100 charitable tax-credit programs in dozens of states — including red ones such as Alabama, Georgia, South Carolina and Louisiana — that could be collateral damage in a dispute between Republicans in the nation’s capital and leaders of Democratic-controlled states, including California.

“We’ve got thousands of kids here whose educations are being jeopardized potentially,” said Lesley Searcy, executive director of the Alabama scholarship fund.

The Internal Revenue Service is preparing to block attempts by lawmakers in California and other high-tax states to help residents avoid a new $10,000 limit on the deductibility of state and local taxes that was included in the tax overhaul enacted late last year.

Republicans complained that the deduction is an indirect subsidy to some state and local governments and shifts money from lower-income people in low-tax states to higher-income earners in high-tax states.

But Democrats contended that the limit was a politically motivated move designed to reduce the cost of the tax overhaul’s deep cuts in rates for businesses and individuals by targeting high-tax states where the Democratic Party is strong.

Californians received one-fifth of the total value of the deduction nationwide in 2014, according to the Tax Foundation, a conservative-leaning research organization. And of the top 10 states for the deduction, including New York, New Jersey, Illinois and Texas, President Trump carried only three in the 2016 election.

To circumvent the cap, legislation is pending in California and has been adopted in New York, New Jersey and Connecticut that would allow taxpayers to claim a charitable deduction to help offset state and local tax payments above the new limit.

The problem, according to some tax law experts, is that it will be very difficult for the IRS to prohibit efforts designed to circumvent the state and local tax-deduction limit without also disallowing the federal tax deduction for contributions to programs such as the Alabama Opportunity Scholarship Fund.

“There’s really no difference between what these existing programs do and what the new ... programs do,” said Kirk Stark, a UCLA law professor who has studied the issue.

He and seven other tax experts released a 44-page research paper in January arguing that states would be allowed to turn state and local tax payments into charitable contributions based on previous IRS rulings and court opinions.

“It’s not just a kooky, crazy idea,” Stark said. “It’s something these states have been doing for many years and it’s been benefiting their taxpayers.”

So any attempts to change regulations or alter the law could ensnare existing charitable tax credit programs. And that has Searcy, of the Alabama fund, and others worried.

“There is great concern,” she said, which has prompted officials from the program to reach out to members of Alabama’s congressional delegation.

Last month, John Schilling, president of the American Federation for Children, which advocates for school-choice programs, wrote to Treasury Secretary Steven T. Mnuchin and Education Secretary Betsy DeVos, urging them to ensure the IRS preserves the charitable tax deduction for scholarship contributions.

“They should issue rules that distinguish between state charities designed to get around the [state and local tax deduction] caps from all other legitimate private charities established to support education,” Schilling said last week.

Schilling said he heard that the IRS would not issue its new rules until California finalizes its legislation, which is expected this summer. An IRS spokesman had no comment.

A bill from state Sen. Kevin de León (D-Los Angeles) would allow state residents to circumvent the new $10,000 limit on state and local tax deductions through a complicated process involving an 85% state tax credit for contributions to school districts, charter schools, child-care centers operated by local educational agencies, and community college districts.

Taxpayers would also be able to deduct 100% of the contributions on their federal tax returns because there are no limits on charitable deductions.

The bill is pending in the state Legislature, where it needs a two-thirds majority to pass and requires voters to approve a constitutional amendment on the November ballot. Two other bills that require only majority votes and no constitutional amendments would expand an existing tax credit and create a new one for educational contributions.

Rep. Kevin Brady (R-Texas), who was a key player in drafting the federal tax overhaul, is “confident these gimmicks can be addressed without disrupting the legitimate programs that have been in place for years for scholarships and other charitable purposes,” a spokesman said.

Leslie Davis Hiner, vice president of legal affairs for EdChoice, which advocates for school choice, said there is a clear distinction between existing scholarship programs and attempts to circumvent the new tax law’s deduction limit.

“If a state creates and operates its own nonprofit for the purpose of creating a tax dodge for high-income taxpayers, it’s tough to call anything about that situation ‘charitable,’ ” Hiner said. “On the other hand, there is no question that contributions to the tax scholarship programs are charitable.”

But UCLA’s Stark said that it would be difficult for the IRS to make such distinctions because of a longstanding feature of tax law known as the full-deduction rule.

Normally, the amount a taxpayer can claim for a charitable contribution must take into account the value of anything received in exchange for the contribution. So, for instance, a contribution to a public radio station that includes a free tote bag requires the taxpayer to reduce the contribution by the value of the bag in calculating the deduction.

But the IRS has never required taxpayers to deduct the value of the charitable deduction in lowering tax liability.

In the paper he co-wrote, Stark and the other experts noted that a $100 charitable contribution by a person paying the new top tax rate of 37% gets a full $100 deduction even though the contribution reduces the tax liability on that money by $37.

“Those tax benefits, just like the tote bag, have the effect of reducing the net cost of the gift to the donor,” he said.

The full-deduction rule makes it challenging, if not impossible, for the IRS to prohibit state workarounds for the new deduction limit by arguing that taxpayers would be receiving the benefit of reducing their tax liability, Stark said.

“They may try to do that, but that’s going to be incredibly difficult to both pull off and probably even more difficult to defend as a matter of law,” he said of the IRS.

Stark and the other experts detailed a slew of charitable tax credit programs that could be affected by new IRS rules, including initiatives for education, economic development and environmental preservation.

The tax law change has led people in Alabama to scramble to contribute to the scholarship fund, Searcy said.

The annual cap of $30 million in state tax credits through the program was reached on March 1, the earliest in its five-year history, she said. Part of the reason was accountants were concerned that efforts by California and other states to avoid the new deduction limit would lead the IRS to step in and endanger the program, she said.

“We certainly do not want programs like ours, which have been around for five years, to get swept up in a review of this,” Searcy said.

jim.puzzanghera@latimes.com

Twitter: @JimPuzzanghera