As the IRS works to put tax reform into practice through regulatory language, there have been ripple effects for several popular strategies, including the federal treatment of charitable contributions made through Pennsylvania’s Educational Improvement Tax Credit (EITC) program. The EITC program has long benefitted scholarship and education improvement organizations by offering tax credits to businesses and their owners in exchange for contributions. Recent guidance from the IRS limits the deductibility of charitable contributions when made in exchange for tax credits. It also provides an alternative presentation of the payment that can be beneficial for some taxpayers.
Let’s take a look at this update to the federal treatment of state and local tax credit programs and sort through its impact on donor businesses.
PA EITC benefits
The EITC program awards tax credits to businesses that donate to eligible education-related organizations, which must be registered with the PA Department of Community and Economic Development (DCED). Both of the credits offered through EITC (Education Tax Credits and Opportunity Scholarship Tax Credits) can equal 75 percent of the contribution value for a one-year commitment and 90 percent of the contribution value for a two-year commitment. For contributions to registered Pre-K organizations, these tax credits are 100 percent of the first $10,000 and 90 percent of the remaining amount, with an annual cap of $200,000.
New federal tax treatment for contributions in exchange for state, local tax credits
In its most recent guidance on the topic, the IRS stated that it will disallow a federal charitable deduction to the extent any state or local tax credit was awarded as a result of a charitable contribution. In Pennsylvania, these proposed regulations end the previous practice of businesses and their owners deducting the full EITC related contribution amount as separately stated charitable deduction on the Schedule K-1, flowing to the individual Schedule A. Starting with contributions made on August 27, 2018 or after, businesses must reduce the charitable contribution amount by the state tax credit awarded. The remaining amount may be claimed as a separately stated charitable contribution and reported on Schedule A.
Here’s a demonstration of the change:
A business makes a two-year commitment to the PA EITC program, donates $100,000 to an eligible organization and receives a $90,000 state tax credit. Previously, the business owners could have claimed the entire $100,000 contribution as an itemized deduction. Now, the $90,000 tax credit must be subtracted from the $100,000 contribution amount, leaving the remaining $10,000 as eligible to be claimed by the business owners on Schedule A.
The IRS later clarified that these types of charitable contributions may be deductible as an ordinary business expense. This change has different implications for C Corporations versus pass-through entities, which is explained in the next section.
Federal tax impact for donor businesses
The new federal treatment of these types of contributions will not be a problem for C Corporations that use the PA EITC or similar programs. A move of the expense from the charitable contribution line to an ordinary and necessary business expense line (if it qualifies as ordinary and necessary) will either decrease the net federal taxable income or keep it the same.
This classification change could have a significant impact on owners of pass-through entities, depending on the character of the income:
- If the income is active, the change from charitable contribution to ordinary business expense has the same net effect on the ultimate shareholder. The dollar-for-dollar reduction in taxable income is not changed.
- If the income is passive, moving a payment from being a charitable contribution reported on Schedule A to ordinary business income which flows through Schedule E will trigger passive activity income limitation rules. This means if the entity overall has a passive loss and the taxpayer has no passive income to offset the loss, there will be no current year federal benefit from making the contribution to a scholarship organization. Keep in mind, the contribution amount is not lost, it is just suspended, which means it will carry forward until the full amount of the loss is offset by passive income or you end ownership in the pass-through entity.
Special Purposes Entities most affected
These passive activity income rules are significant for the PA EITC program and “Special Purpose Entities” (SPE). SPEs are formed specifically for the purposes of receiving capital from its members, disbursing funds to EITC/OSTC organizations and applying for the tax credits, which are distributed to SPE members to offset individual state income tax liabilities. By definition, SPEs are passive activities. An example:
Same facts as before, if the business adjusts the presentation of the $100,000 contribution to a business expense, and has no other activity, a passive loss of $100,000 will flow through to the owners on the federal level, state income will be $0 and the state tax credit will be $90,000. If the owners do not have $100,000 of passive income to offset this loss, the benefit of the loss will be suspended until there is sufficient passive income to offset the loss or ownership of the entity ceases. The benefit of the $100,000 contribution, even if not received in the current year, does not go away, but carries forward until it can be used.
Alternatively, if presentation remains a contribution, the $90,000 credit must be subtracted from the $100,000. As a result, a $10,000 charitable contribution will flow through to owners on the federal level, state income will be $0 and the state tax credit will be $90,000. Presumably the owners will have sufficient other itemized deductions to receive the benefit of the $10,000 contribution in the year of the contribution. However, if the owners do not have enough itemized deductions and use the standard deduction, there will be $0 federal benefit to the contribution in the current or any future years.
IRS rules allow the entity to make this classification change of the charitable contribution at their discretion. For this reason, members should discuss their unique tax situation with their RKL advisor to determine the best course of action on their individual returns.
PA tax treatment unchanged
In response to this federal regulatory update, the PA Department of Revenue (DOR) recently reiterated that it does not allow deduction of charitable contributions on state income tax returns. Contributions to EITC-registered organizations, no matter how they are presented for federal purposes, are still considered a charitable nondeductible expense by DOR and should be added back to taxable income.
Your RKL tax advisor is available to contextualize these regulations for your personal financial situation and advise on strategies to gain the most benefit from this tax credit program at both the state and federal level. Contact us today for more information or guidance.