Arizona Tuition Credit Practices may Break Federal Tax Laws

PHOENIX (Wire Services) December 27, 2009 —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 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 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 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?

What the law does say

There are few absolutes in the federal tax code that guide tax-exempt charities. The code is complex and often applied on a case-by-case basis.

Tax specialists, however, agree on one thing: Federal law makes swapping donations a violation if a taxpayer claims the donated gift as a charitable deduction - the gift is being made to benefit oneself.

"The IRS could say there is collusion involved to get around the tax laws through this sleight of hand," said Tucson accountant Jeff Hill, a former state legislator who has testified before lawmakers about tuition groups.

Even when donations are not involved in a swap, there are still questions about donations intended to aid specific students.

The absolutes begin to get gray over the practice of "recommending" a donation go to a specific child, perhaps a grandchild or an employer's son.

Hill says tuition groups may be operating within the law if they are careful not to guarantee donations will go to a recommended student.

"When you donate to the school tuition organization, it's a 'suggested recommendation,' and they have all kinds of caveats that say the school may or may not do this, which they use to make sure there is no linkage," Hill said.

Phoenix tax attorney Chuck Whetstine believes the practice violates tax law.

"There is no way under the federal law you can make a deductible contribution to a 501(c)(3) charity and designate or tell the charity where the money should be spent, whether it's on your own child or another child," Whetstine said. That applies whether it's called a recommendation or a designation. Donations must be made with what attorneys call "a disinterested motive."

Whetstine said he contributes to a tuition organization and has no children at the private schools it supports; he would not donate if the tuition group allowed him to recommend a specific child.

"It's against public policy, it's against IRS rules, and I'm really surprised the IRS hasn't jumped on this one," Whetstine said.

Stefanie Campbell, president of the Arizona Society of Enrolled Agents, a tax-specialist industry association, said some tuition groups are tap-dancing around the law by saying donations come only with "recommendations." That approach will do little to protect an organization once an IRS auditor links enough contributions to the "recommended" students, she said.

Campbell and her mother, Ellen Campbell, are partners in a Phoenix tax and financial business. Campbell said it's hard to convince clients who donate to tuition groups that having grandmother and uncle make a tax-credit donation in the name of a family member endangers the tuition organization and is not deductible on their federal return.

"I understand why people want to do it," she said, but it's not really charity.

The Campbells say their clients often present them with a receipt for their donation, but those receipts don't reveal whether the gift was made with a recommendation for a specific student.

"We say to everyone who hands us one of those, 'Don't forget you can't be giving this for an individual child,' " Ellen Campbell said.

Many tax preparers never ask or don't know enough to ask, she said.

Mixed messages

Many parents receive confusing messages from tuition organizations and private schools about the tax-credit program.

Seven of the 12 largest tuition organizations and others allow donors to recommend students. They warn taxpayers on their Web sites to ask their tax preparers before taking a federal deduction on a tax-credit donation. Some warn parents swapping contributions is against tax law. Others say they cannot guarantee a donation will go to the recommended student.

But the caveats become muddled by practices that encourage targeting donations to students:

• Some tuition groups assign families or children identification numbers. That makes it easier for relatives and friends to make an online credit-card contribution for a specific student.

• Online donation forms contain a space where donors can recommend a particular student.

• Tuition groups and schools offer parents sample letters to send to relatives and friends to solicit donations for the parents' child.

• Schools, often the main contact for parents on tax credits, hold talks and put out materials that promote targeting the gifts to students.

As an example, this notice appeared in an October newsletter from Thunderbird Adventist Academy in Scottsdale: "You don't have a Tax Credit Buddy? I have a family that is interested in being a Tax Credit Buddy. They will pay their 2009 donation to your student if you will pay yours to their student. Contact the TAA Development Office to get connected to this family."

Xenia Capote, business manager for the Scottsdale school, said it's necessary to connect parents because contributing a tax-credit donation in the name of your own child is against the law.

Capote said the receipt donors get for a tax-credit donation also allows the donors to take a charitable donation off their federal returns.

"I'm telling you that because my own personal accountant does that," Capote said.

Lack of inquiries

Some tax experts say they are surprised the IRS has not taken a closer look at the tax-credit issues through audits or investigations.

One federal tax-code ruling states, in part, when an organization "pays 'scholarships' to pre-selected, specifically named individuals designated by subscribers, the organization is serving private interests rather than public charitable and educational interests. . . . Therefore, it does not qualify for exemption from federal income tax under that section."

The IRS does not reveal if it is investigating or auditing a person or an organization. It also may keep the matter confidential, choosing to send only a warning letter or not to act. The IRS does disclose cases in which it revokes a non-profit organization's tax-exempt status.

The IRS, which has limited resources, audits only about 1 percent of non-profit tax returns nationally. Private-school tax credits are offered in limited states, so audits of groups involved in the programs would likely yield little in taxes, penalties and interest.

Even so, "I'm surprised IRS haven't picked it up" because of media coverage of the issue, Whetstine said. "Maybe they already are."

In August, Rep. David Lujan, D-Phoenix, wrote to the IRS asking for a review of tuition organizations, citing the earmarking of donations for specific students. The IRS told him it could not comment on actions it may or may not be taking.

Lawrence Mohrweis, a Northern Arizona University accounting professor who also runs a school tuition organization, said the IRS would need to examine a tuition group in depth to find a violation. If a tuition group essentially lets many donors direct their money to specific students, it likely doesn't publicize the practice; instead, it emphasizes donors can recommend, not earmark, recipients.

"In terms of what I call window dressing, they clearly state these are recommendations and not designations," Mohrweis said. "It's the substance that becomes critical."

Investigating would be time-consuming for the IRS. Tuition organizations know this and continue violating tax law because it generates so much revenue, Mohrweis said. Parents, acting out of self-interest, end up becoming the sales force for some tuition organizations by recruiting others to donate for their children.

ChamBria Henderson, executive director of Arizona Scholarship Fund, a school tuition organization in Mesa, says her group allows recommendations but has worked closely with the IRS to follow tax law.

"We do not allow, nor did we ever allow, designations or earmarking," she said.

To get a scholarship, students must, among other things, register with the tuition group and already be enrolled in a private school. Their parents also must submit tax returns. A committee decides who get the scholarships.

"No child just gets money just because a donor says they want the money to go to that specific child," Henderson said.