Tax Credits for Private School Scholarships

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What CPAs Should Know

In an April 2009 decision, the Ninth Circuit Court ruled that taxpayer donations to faith-based scholarship organizatioas raised serious questions as to whether private school tax credits are constitutional. As shown in Exhibit I, six states now have tax credit scholarship programs in place for private elementary and secondary schools: Pennsylvania, Rhode Island, Florida, Georgia. Iowa, and Arizona.

The ruling by the Ninth Circuit Court refocuses the nation's spotlight on how Arizona's scholarship organizations are using taxpayer money to fund private school scholarships. It was over a decade ago, in 1998. that Arizona established school tuition organizations (STO). These are nonprofit entities that allocate at least 90% of their revenues for scholarships, with up to 10% used for administrative and marketing expenses. Each STO is required to award scholarships to children at two or more private schools. Some STOs support only religious private schools (e.g., Catholic, Jewish, Islamic), while others reach out to all private schools. Exhibit 2 shows a list of Arizona STOs and the funds collected in 2008.

The state tax credit gives STOs a significant marketing advantage in soliciting donations compared to other nonprofit organizations, such as the United Way and Salvation Army. Married taxpayers receive a state tax credit of up to $1.000 and single taxpayers receive a credit up to $500 for contributing to STOs. When contributing to a scholarship fund, residents of Arizona receive the full amount of their donations as dollar-for-dollar tax credits when they file their state taxes. In January 1999, the Arizona State Supreme Court ruled, in a 3-2 decision, that the state's tax credit program was constitutional. Exhibit 3 shows the explosive growth of STOs over the past 10 years.

Separation of Church and State

The Ninth Circuit Court ruling revisited the continuing debate over the separation of church and state. The court's pronouncement states that Arizona's private school scholarship tax credit program, as applied, violates the Establishment Clause of the U.S. Constitution. The key words are "as applied." The tax credit program itself was not disputed. The challenge was directed only to those STOs that restricted scholarships to religious schools. The court stated that Arizona's tax credit program

channels a disproportionate amount of government aid to sectarian STOs, which in torn limit their scholarships to use at religious schools. The scholarship program thus skews aid in favor of religious schools, requiring parents who would prefer a secular private school but who cannot obtain aid from the few available nonsectarian STOs. to choose a religious school to obtain the perceived benefits of a private school education. (Winn v. Garriott [No. 05-15754], p. 4606. filed April 21, 2009)

In the landmark U.S. Supreme Court case in June 2002 involving school vouchers in Cleveland, Ohio (Ze Iman v. Simmons-Harris), the vast majority of funds were, in fact, flowing to religious schools. Nevertheless, the Supreme Court ruled that these vouchers were constitutional because funds were transmitted to religiously affiliated schools only through the independent decisions that parents made for their children. In contrast, the Ninth Circuit Court mied that Arizona's program was not one of true private choice for parents. The court noted that parents who wished to place their children in private secular schools, but who could not otherwise afford to do so. were at a disadvantage compared to parents who were willing to accept scholarships for private religious schooling. Arizona's program, as applied in practice, created incentives that pressured these parents into accepting scholarships that were readily available under the program for use at religious schools.

New Corporate Tax Credit

In 2006, Arizona's STOs started to collect additional funds through a corporate tax credit program, modeling its legislation after similar programs in Pennsylvania and Florida. …