Tax credits and deductions are often referred to as matters of legislative grace. In 2013 the South Carolina Legislature exercised that grace by passing a budget proviso1 that allows taxpayers to receive a dollar-for-dollar tax credit of up to 60 percent of their tax liability for donations made to organizations set up to provide private school scholarships to students with extraordinary needs. The South Carolina Department of Revenue recently announced donations to those organizations will also qualify for a charitable contribution deduction under section 170 of the Internal Revenue Code.
That dual benefit tax credit would allow taxpayers to receive a tax benefit greater than their charitable contribution, and thus make a profit from their charitable giving. Should taxpayers be able to take advantage of that "runaway legislative grace"? David Cay Johnston recently wrote about five Arizona tax credits, including a private school tax credit similar to South Carolina's, that allows taxpayers to make a profit through their charitable donations.2 According to Johnston, taxpayers can turn a quick, no-risk profit by making charitable gifts without so much as a charitable thought. That raises the questions whether the IRS should allow the deduction at all, and whether the Service should treat South Carolina's 100 percent state tax credit as a quid pro quo that eliminates the otherwise allowable charitable deduction.
I. South Carolina's 2013 Private School Tax Credit Proviso
Proviso 1.85 authorizes approved nonprofit scholarship funding organizations (SFOs) to award scholarships of up to $10,000 or the total cost of tuition, whichever is less, to students with exceptional needs to attend independent schools. Although the bill has limitations -- its limited time of effectiveness, the $8 million cap on tax credits, and restrictions on eligible students and schools -- the tax credit it allows could have a significant impact on taxpayers who choose to donate to an SFO. Donating individuals and corporations can receive a dollar-for-dollar state tax credit of up to 60 percent of the taxpayer's total tax liability for the tax year the contribution is made. That means that a taxpayer who owes $1,000 in state taxes could reduce his tax liability to $400 by donating $600 to an SFO.
In addition to a tax credit, the DOR has announced that donations to SFOs also qualify for state and federal tax deductions allowed for charitable contributions.3 A state senator who helped draft the bill said that when deciding whether to adopt the budget, lawmakers did not discuss the possibility of tax deductions for donations to SFOs.4 Because of that lack of discussion about a potential dual tax benefit and because of the approval process of the state budget -- which can include proposals that have not been fully vetted in committees -- the possible additional benefit of a tax deduction could come as a surprise to lawmakers and taxpayers alike.
II. Tax Deductions Versus Tax Credits
A tax deduction and a tax credit are not the same thing. A tax deduction reduces the amount of a taxpayer's taxable income. The value of the deduction depends on that individual's income tax bracket.5 Therefore, if a taxpayer is in the 28 percent bracket, a $1,000 deduction lowers his tax liability by $280. But if instead he was in the 15 percent bracket, a $1,000 deduction would only lower his tax liability by $150. Because tax deductions are based on the individual taxpayer's tax bracket, they are worth more to people in higher tax brackets.
A tax credit reduces the taxes owed. If a taxpayer donated $1,000 and received a 100 percent tax credit, his tax liability would decrease by $1,000 regardless of his tax bracket. Therefore, a tax credit is more beneficial to taxpayers than a tax deduction of the same amount.
A. Charitable Deductions
IRC section 170 allows a deduction for any charitable contribution made during the tax year. The code defines a charitable contribution as "a contribution or gift to or for the use of . . . a corporation, trust, or community chest, fund or foundation . . . organized and operated exclusively for religious, charitable, scientific, literary, or education purposes. . . ." A tax-exempt organization under IRC section 501(c)(3) is an organization qualified under section 170(c)(2) to receive charitable contributions deductible under section 170(a). Under Proviso 1.85, to become a qualified SFO, an SFO must be an exempt organization under section 501(c)(3).6 Therefore, SFOs will be qualified organizations under section 170(c)(2), and contributions made to them that meet the requirements of a charitable contribution may be deductible under section 170(a).7
Generally, the IRC allows deductions for "bona fide gifts notwithstanding the motivations of a taxpayer."8 However, not every contribution to a qualifying organization is deductible under section 170.9 To be deductible as a charitable contribution, "the transfer must be a gift which is completed, made voluntarily . . . with donative intent . . . and without consideration or benefit (other than 'mere satisfaction') to the donor."10 If the donor receives or expects to receive an "economic or financial benefit" equal to the amount of the donation (whether money or property), no charitable deduction is allowed.11
Consistent with the idea that deductions are a matter of legislative grace and are therefore narrowly construed, "economic and financial benefit" is given a very broad meaning in determining whether a charitable deduction is allowed. The term includes "medical, educational, scientific, literary, and religious benefits." When a taxpayer receives or expects to receive a benefit in exchange for his charitable contribution, the benefit is a quid pro quo, and as such, the contribution is not deductible under section 170(a).12 If the quid pro quo is worth less than the amount of the taxpayer's transfer, the transfer is deductible to the extent the amount of the contribution exceeds the fair market value of the benefit received, as long as the excess amount was transferred with the requisite donative intent.13 To determine whether a contribution was made with the expectation of a quid pro quo, and thereby nondeductible, the IRS examines the external features of the transaction to avoid delving into the motivations of the individual.14
In Hernandez v. Commissioner of Internal Revenue, the U.S. Supreme Court held that the taxpayer petitioner's payments to the Church of Scientology for auditing and training were not deductible as charitable contributions because they were part of a "quintessential quid pro quo exchange."15 In exchange for his donation, the petitioner received auditing and training sessions, for which the church had established a set of price schedules based on the length of the session and the levels of sophistication of the participants. Also, the church refunded any amount if the auditing and training services were not performed, distributed account cards so churchgoers could keep track of which services they used, and prohibited free sessions.
The Court concluded that those practices "reveal[ed] the inherently reciprocal nature of the exchange." The Court also rejected the petitioner's argument that a quid pro quo analysis was improper because he received only a purely religious benefit. The Court concluded that the IRC allows a deduction only if a payment to a charitable organization is a "contribution or a gift." Because the taxpayer received a benefit in return for his donation, it was not a gift and was not deductible under section 170(c). The Court's holding makes clear that if a taxpayer receives any benefit in exchange for his payment to a charitable organization, no deduction is allowed.
Further, the return benefit does not have to come directly from the charitable organization itself to be considered a quid pro quo. In Ottawa Silica Co. v. United States, the Federal Circuit Court of Appeals disallowed a charitable contribution when the taxpayer received a benefit from the actions of third parties.16 In the case, a family-owned corporation claimed a charitable deduction for the value of land it transferred to a school district so a high school could be built, but the IRS disallowed the deduction on the grounds that it was not a charitable contribution within the meaning of section 170 because the corporation received a substantial benefit in increased property value.
In concluding that the taxpayer corporation was not entitled to a charitable deduction, the Ottawa Silica court looked to Singer Co. v. United States,17 when the court of claims held that Singer, a company that sold sewing machines to schools, was not entitled to a charitable deduction because "the expected receipt of increased profits by Singer, either immediately or in the future, was incompatible with its claim for a charitable contribution."18 Singer sold discounted sewing machines to schools and other charitable organizations, and the court had to decide whether the discounted sales qualified Singer for a charitable deduction. The court determined that Singer's predominate purpose for making the discounted sales to the schools was to encourage the students to use the sewing machines and in the future to buy them, thereby increasing Singer's future sales. Holding that that purpose made the sales to schools more like business transactions than charitable contributions, the court therefore upheld the IRS's decision to disallow the deduction for the sales to the schools. However, the court of claims in Singer held that the company could take a charitable deduction for the bargain sales of sewing machines to charitable organizations because from those sales the company had no expectation of increasing its sales and benefited only incidentally.
In Ottawa Silica, the plaintiff argued that the benefit it received in return for its contribution of property to the school district was only incidental. However, the court held that no charitable deduction was allowed because the plaintiff received a substantial benefit from the transfer that constituted a quid pro quo and destroyed the transfer's charitable nature. The court highlighted evidence that before agreeing to transfer its land to the school district, the plaintiff knew that doing so would result in the development of the area. The court concluded that "the plaintiff knew that the construction of a school and the attendant roads on its property would substantially benefit the surrounding land, that it made the conveyance expecting its remaining property to increase in value, and that the expected receipt of those benefits at least partially prompted plaintiff to make the conveyance." The court held that under Singer, that gave the IRS more than sufficient justification for disallowing the charitable deduction. Therefore, even when the benefit comes from a source other than the charitable organization that receives the donation, any return benefit precludes the taxpayer from taking a charitable deduction under section 170(c), regardless of where the benefit comes from.
III. Tax Benefits as a Quid Pro Quo
The issue that arises when a state tax credit also qualifies for a state and federal charitable deduction is whether the tax credit is a quid pro quo that destroys the charitable nature of the transfer and makes the charitable deduction improper. Under Proviso 1.85, the taxpayer does not receive a benefit from the SFO to which it donates; it is the state government that gives the taxpayer a dollar-for-dollar credit for any amount donated -- up to 60 percent of the taxpayer's tax liability -- in exchange for its donation. However, as the court explained in Ottawa Silica, a benefit that comes from an entity other than the charitable organization can still constitute a quid pro quo that reduces or eliminates the allowable deduction. Therefore, under Ottawa Silica, Proviso 1.85's tax credit could be a quid pro quo that would reduce the allowable charitable deduction. However, if the tax credit is not a quid pro quo, a taxpayer can make money from his charitable donations by receiving a tax benefit greater than his contribution to the SFO.
A hypothetical helps to illuminate the potential issue. Suppose Sally makes a $1,000 donation to an SFO. The payment would qualify for a federal tax deduction under section 170(c). As long as she itemizes her deductions, she would be able to take a $1,000 federal tax deduction. Section 1130 of Title 12 of South Carolina Code Annotated states that South Carolina taxable income is computed by first starting with the taxpayer's federal taxable income with a few modifications.19 Therefore, if Sally receives a federal charitable deduction under section 170(c), she will also receive a state tax deduction, because her state taxable income is based on her federal taxable income and will start at the already reduced amount. From the tax computed on that reduced taxable income, she would also receive a dollar-for-dollar state tax credit for the donation she made to the SFO.
Thus, in exchange for her donation to the SFO, Sally would receive a $1,000 federal tax deduction, a $1,000 state tax deduction, and a $1,000 (100 percent) state tax credit. Although it seems that the federal and state tax deductions would both be a profit to Sally, that is not the case. The federal deduction for state taxes she would have been able to take under section 164 would be reduced by the amount of her state tax credit. Therefore, the deduction she would no longer be able to take under section 164 would be offset by her section 170 federal tax deduction. However, Sally will still make a profit from her state charitable deduction. Any profit is problematic because it contradicts the idea of disallowing deductions for quid pro quos.20
A. Tax Deductions -- A Quid Pro Quo?
The Court of Federal Claims has held that the tax benefit of a federal or state charitable deduction under section 170 is not a quid pro quo negating the charitable intent and therefore reducing or eliminating the allowable deduction. In McLennan v. United States, the court of claims concluded that the McLennans, a husband and wife filing jointly, were entitled to a charitable deduction for granting a scenic easement to the Western Pennsylvania Conservancy over a part of their property.21 The IRS claimed that the McLennans lacked the requisite donative intent and disallowed the deduction. The IRS asserted that the McLennans donated their property to the Conservancy to maintain their property values, to achieve a desired zoning restriction for the property, and to receive a tax deduction. The IRS argued that correspondence between the McLennans and a Conservancy official, which stated the estimated tax advantages of the scenic easement conveyance, proved that the McLennans granted the scenic easement solely to receive the resulting tax benefit.
However, the court rejected the IRS's argument, and instead held that the evidence demonstrated the McLennans had the requisite donative intent. The court held that the McLennans had acted as "prudent landowners" by investigating all of the potential effects of granting the scenic easement, which they knew could diminish the overall value of their property. The court held that the evidence did not show that the McLennans were primarily motivated by the Conservancy's assurances regarding the resulting tax benefits. The court concluded that the McLennans granted the easement with the requisite donative intent -- to help ensure the "pristine quality of their locality" -- and therefore, any benefit they received as a result of the conveyance "was merely incidental to an important, public spirited, charitable purpose." After that analysis, the court mentions in a footnote that a donation made exclusively to receive a tax deduction "does not vitiate the charitable nature of the contribution." That footnote suggests that even if the McLennans' primary reason for granting the scenic easement was to receive a tax benefit, the deduction still would have been allowed.
Similarly, in Skripak v. Commissioner of Internal Revenue, plaintiffs were involved in a tax shelter book contribution program, when they purchased scholarly reprint books through Reprints Inc. at one-third the publisher's catalog retail list price, then contributed the books to small rural public libraries qualified to receive charitable deductions.22 The plaintiffs then claimed deductions for their contributions for the full amount of the publisher's catalog retail list price -- three times what they had paid for the books. The Tax Court held that the plaintiffs were entitled to a charitable deduction for the FMV of the donated books regardless of what they paid for them. In so holding, the court noted that the purpose of charitable deductions was to give taxpayers an incentive to contribute to charities, and therefore the IRS could not use a taxpayer's desire to avoid taxes by contributing to charities as a basis for disallowing a deduction. The court noted that the IRS did not allege that the plaintiffs received "some economic benefit or consideration, other than the expected tax deduction, as the quid pro quo for their charitable contributions."23 That language indicates that the resulting tax deduction was a quid pro quo, but that it did not negate the donative intent to justify the IRS disallowing the deduction. Therefore, despite the plaintiffs making their charitable contributions for the purpose and with the expectation of receiving a tax deduction, the court held the plaintiffs were still entitled to the charitable deduction.
B. Tax Credits -- A Quid Pro Quo?
Together, the holdings in McLennan and Skripak indicate that although a tax deduction technically constitutes a quid pro quo, it is not a quid pro quo that reduces or eliminates the allowable charitable deduction because a taxpayer's expectation of a tax benefit does not negate the requisite donative intent. The courts in both cases were focused solely on tax deductions, when the total tax benefit the plaintiffs received was still smaller than the amount of their charitable donations. The question arises whether the benefit received from a 100 percent state tax credit should be treated in the same way.
In 2011 the IRS Office of Chief Counsel released a memorandum regarding the deductibility of donations that qualify for a state tax credit.24 In the memorandum, the chief counsel's office discussed whether a transfer of cash or property to either a state agency or a charitable organization that entitles a taxpayer to a state tax credit could be considered a charitable contribution under IRC section 170 or a payment of state tax deductible under section 164. After discussing the holding in McLennan and other similar cases regarding tax deductions, the memorandum acknowledged that the IRS has not resolved the issue of whether the analysis applied to tax deductions would also apply to tax credits, and noted that the IRS was not contemplating publishing any official guidance on the issue. The chief counsel memorandum concluded that the rule established in McLennan should also be applied to tax credits, since it saw no reason to "distinguish between the value of a state tax deduction, and the value of a state tax credit, or to draw a bright-line distinction based on the amount of the tax benefit in question."
The memorandum explained that for federal tax purposes, the IRS generally treats a state or local tax deduction as a reduction in tax liability -- meaning it reduces the deduction for payment of state or local tax allowed under section 164.25 The tax benefit, which includes tax deductions as well as tax credits since the chief counsel decided the same rule applies to both, is thus not a quid pro quo reducing the charitable deduction allowed under section 170. Therefore, taxpayers could deduct the full amount of their charitable contributions under section 170 but would not be entitled to a deduction under section 164 for the amount the state tax credit offset their state tax liability. Despite that seemingly strong conclusion, the memorandum does provide a caveat that there may be "unusual circumstances" when it would be appropriate to recharacterize what was a charitable contribution in form as a satisfaction of tax liability in substance; however, it provides no further explanation of when those circumstances may occur.26
Overall, the memorandum provides little explanation of why a 100 percent tax credit should be analyzed under the same test as a tax deduction. It does cite authority that supports the conclusion that a tax credit should not be income or deductible under section 164.27 However, the memorandum cites no authority other than McLennan and similar cases to back up its conclusion that a section 170 charitable deduction should also be allowed. Specifically, the memorandum refuses "to draw a bright-line distinction based on the amount of the tax benefit" received, whether from a state tax credit or a state tax deduction.
Taken literally, that statement arguably makes sense, especially in the context of tax deductions. If the IRS limited the availability of a tax deduction to a specific dollar amount, taxpayers would be affected differently. Those in the lower tax brackets would get the full benefit of their charitable donations since their tax benefits would be lower, and they would be able to take the full deduction for their charitable contributions. However, taxpayers in higher tax brackets would not get the full benefit of their charitable donations because their tax benefits would be higher and their allowable deductions would be limited. That progressive result would likely have a negative effect on charitable contributions. Those in lower tax brackets would not have any greater incentive to donate to charities, and those in higher tax brackets -- who likely have more income to donate -- would have less incentive to donate because at a specific point they would not be able to receive the reciprocal tax benefit. Thus, it seems prudent to avoid a distinction based on the dollar amount of the tax benefit received in exchange for tax deductions.
However, because the disparate effect on taxpayers in different tax brackets is not an issue for tax credits that result in the same tax benefit for all taxpayers, the logic does not support the same treatment for tax credits. Tax credits can have a much more significant impact on a taxpayer's tax liability, especially if it's a 100 percent tax credit -- such as in Proviso 1.85. As Blackman and Stark point out, the memorandum's statement suggests that a state tax deduction for a taxpayer in a 10 percent bracket would be treated the same as a state income tax credit, regardless of the statutory credit percentage. Thus, under that interpretation, regardless of whether a state statute provides a 50 percent credit or a 100 percent credit, the donation would be deductible as a charitable contribution under section 170.28 That is where deductions and credits differ, and where the reasoning applied to each should also differ.
Although in dicta, courts have noted that a taxpayer is entitled to a deduction even if the donation is made for the exclusive purpose of receiving a tax benefit,29 and a tax benefit is not regarded as a quid pro quo that negates charitable intent, it is unlikely that in so holding courts imagined a tax benefit that exceeded the charitable contribution. That is a quintessential example of a quid pro quo, and it is unlikely that legislative grace was meant to extend that far.
IV. The Dual Benefit of Proviso 1.85
To prevent taxpayers from benefiting in that way with regard to 100 percent state tax credits such as the one provided in Proviso 1.85, the IRS should apply a different rule to tax credits than it does to tax deductions. The IRS could treat any state credit that a taxpayer receives as a quid pro quo reducing the allowable deduction under section 170(c). That would prevent taxpayers from making a profit from their charitable contributions and bring 100 percent tax credits that also qualify for tax deductions back in line with the quid pro quo requirements. Regardless of how the IRS chooses to address the issue, it is time to rein in that runaway legislative grace.
1 Proviso 1.85, H 3710 (S.C. 2013).
2 David Cay Johnston, "Give to Charity, Turn a Profit," State Tax Notes, Jan. 27, 2014, p. 225.
3 Jamie Self, "More Than One Tax Benefit for S.C.'s School-Choice Credit," The State, Sept. 1, 2013.
4 See id. (quoting South Carolina Sen. Joel Lourie (D)).
5 See id.; see also IRC section 63 (2006) (defining taxable income) and IRC section 1 (setting out the percentage of tax imposed on taxable income).
6 S.C. Information Letter #13-15 (Sept. 2013).
7 See id.; IRC section 170.
8 McLennan v. United States, 24 Ct. Cl. 102, 106 (1991) (citing Sheppard v. United States, 176 Ct. Cl. 224 (1966)).
9 Dejong v. Comm'r of Internal Revenue, 36 T.C. 896 (1961); Petit v. Comm'r of Internal Revenue, 61 T.C. 634 (1974); Short v. Comm'r of Internal Revenue, T.C. Memo. 1997-225 (1997).
10 Petti v. Comm'r of Internal Revenue, 61 T.C. 634 (1974).
11 Rev. Rul. 76-185 (IRS RRU), 1976 WL 36937 (1976).
12 McLennan v. United States, 24 Ct. Cl. 102 (Ct. Cl. 1991).
13 United States v. Am. Bar Endowment, 477 U.S. 105, 116-118 (1986).
14 Hernandez v. Comm. of Internal Revenue, 490 U.S. 680, 690-691 (1989).
15 Id. at 683-684, 691.
16 699 F.2d 1124, 1135 (Fed. Cir. 1983).
17 Singer Co. v. United States, 449 F.2d 413 (Ct. Cl. 1971).
18 Ottawa Silica Co., 699 F.2d at 1131-32 (citing Singer, 449 F.2d at 413, 423).
19 S.C. Code Ann. section 12-6-1130 (2012).
20 See Ottawa Silica Co., 699 F.2d 1135.
21 McLennan v. United States, 24 Ct. Cl. 102, 107 (1991) (McLennan II).
22 Skripak v. Comm. of Internal Revenue, 84 T.C. 285, 304-305 (1985).
23 Id. (emphasis added).
24 ILM 201105010 (Feb. 2, 2011). Although the memorandum is informative in providing the office's current position on the issue, the memorandum states that it "cannot be used or cited as precedent." Id. See also Phillip Blackman and Kirk Stark, "Capturing Federal Dollars With State Charitable Tax Credits," Tax Notes, Apr. 1, 2013, p. 53 at p. 58 (discussing the memorandum and the issue it presented).
25 See Blackman and Stark, id. at 59 (discussing ILM 201105010).
26 ILM 201105010, supra note 24; see also Blackman and Stark, supra note 24, at 59. It is possible that a tax credit that with a deduction would reduce state taxes by a greater amount than the contribution could fall into that category. However, the memorandum suggests that that would not be the case, since it draws no distinction based on the amount of benefit received.
27 ILM 201105010, supra note 24, at 4-5 (citing Rev. Rul. 79-315, 1979-2 C.B. 27; Synder v. Comm'r of Internal Revenue, 894 F.2d 1337 (6th Cir. 1990) (unpublished opinion)).
28 The percentage of the tax credit is important. A 100 percent tax credit would result in all taxpayers who itemize being able to make a profit from their charitable giving. But with lower percentage credits, it will depend on the taxpayer's tax bracket as to at what point and to what extent the credit causes that likely unintended result.
29 McLennan II, at 106 n.8.
END OF FOOTNOTES
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