The Illinois Private School Scholarship Tax Shelter (UPDATED)

A program aimed at helping students from low- and middle-income families will pad the pockets of high-income Illinois taxpayers

[UPDATE (8/28/2017 6:30pm CT): The Illinois House on Monday afternoon voted down the education funding bill that would have created the tax credit program — so for now, no tax shelter for AMT payers (and, rather more importantly, no state funding plan in place for the Chicago Public Schools and more than 800 other Illinois school districts). The version of the bill posted on the House site Monday also would have withheld credits to taxpayers who claimed federal income tax deductions for contributions to scholarship organizations, thereby limiting the shelter opportunity as well.]

The Illinois state legislature is on the brink of passing an education funding bill that includes $75 million for tax credits to incentivize contributions to private school scholarship funds. Details are still sketchy, but the basic idea seems to be that Illinois taxpayers who donate to organizations that give private school tuition scholarships to students from low- and middle-income families will be eligible for state tax credits worth 75 cents for every dollar donated. The proposed credit would sunset after 5 years unless renewed. At least 17 other states have similar programs already.

Intentionally or not, state lawmakers appear to be creating an attractive tax shelter for Illinois households subject to the alternative minimum tax. (Hat tip to Eric Citron for helping me puzzle through this on Twitter.) The IRS has opened the door to this shelter by taking the position that contributions to state tax credit programs are deductible as charitable contributions under section 170. So if I donate $1 to a scholarship organization, I get a state tax credit worth $0.75 and I get the ability to deduct $1 from my federal taxable income. (Assuming Illinois follows the IRS’s position for purposes of the state charitable contribution deduction, I probably get to deduct $1 from my state taxable income as well.)

The state tax credit also means that I pay $0.25 to Illinois where I otherwise would have paid $1. Thus, my deduction for state taxes under section 164 declines by $0.75. For a taxpayer in the 39.6% bracket, this means that the $1 donation results in a state tax benefit worth $0.75, a $1 deduction under section 170 (worth $0.396), and the loss of a $0.75 deduction under section 164 (which would have been worth $0.297). $0.75 + $0.396 — $0.297 = $0.849. So a $1 donation leads to net tax benefits (federal plus state) of roughly 85 cents. [NOTE: This paragraph has been updated to reflect the fact that, as Carl Davis points out, Illinois does not allow a charitable contribution deduction for state tax purposes. The initial version assumed a state charitable contribution deduction in addition to a state tax credit.]

So where’s the shelter? How might taxpayers actually make money from donating to private school scholarship funds?

The answer lies with the alternative minimum tax (AMT). More than 4% of Illinois taxpayers are subject to the AMT, and these tend to be relatively high income households (in the $200,000 to $1 million range). State taxes aren’t deductible for AMT purposes, but charitable contributions are. By transforming a state tax liability into a charitable contribution, taxpayers subject to the AMT can transform a nondeductible expense into a deductible one.

The top marginal income tax rate under the AMT (accounting for the exemption phaseout) is 35%. For an Illinois taxpayer facing a 35% AMT rate, giving $1 to a private school scholarship organization leads to a state tax benefit worth $0.75 plus a federal tax benefit worth $0.35. (There is no need to subtract the lost deduction under section 164 because the AMT already takes that deduction away.) Contributions become a money-making opportunity: Give $1, get $1.10 back from the federal government and the state.

Is there any plausible policy rationale for this? From Illinois’s self-interested perspective, maybe: This is a way for the Land of Lincoln to essentially take money from the federal government and reallocate it to low- and middle-income Illinois students and high-income Illinois taxpayers. As Sarah Johnson argued in Tax Notes a couple of years ago with respect to a similar South Carolina provision, though, the IRS need not interpret section 170 to allow this. It could quite plausibly say that the 75 cent tax credit should be considered a “return benefit” that reduces the deductible charitable contribution from $1.00 to $0.25.

In the meantime, expect your friends who are Chicago tax lawyers and law professors to take a sudden philanthropic interest in private and parochial schools.