Tim:

Hi, I'm Tim Christmann

Melaney:

I'm Melaney Partner. We work for the IRS Exempt Organizations Office

We're going to talk about State Tuition Organizations. A relatively new development in tuition aid for students and the tax implications for the states that create them and the parents who use them.

Several states have created what are called State Tuition Organizations. These are set up as tax-exempt organizations. Their purpose is to help reduce the tuition cost to students attending private schools by providing scholarships.

Each state legislature that creates STOs set their own law and regulations for receiving contributions and distributing its funds. So there are no national requirements.

Tim:

The general idea behind STOs we are talking about here lets individuals or corporations make contributions to a state-registered STO. In return the donor may get a state tax credit. Because the STOs are tax-exempt organizations, the donor can deduct the donation as a charitable contribution deductible on federal tax returns.

Just like any tax-exempt organization, state tuition organizations can create federal tax issues if they are not careful how they set up and operate.

Tax-exempt 501(c)(3) organizations must avoid activities that substantially benefit the private interest of any individual.

Some states allow contributors to STOs to recommend that certain students receive a donation. They avoid the private benefit prohibition by not allowing donations that are made on condition that a particular student receive it, or disallowing a tax credit if the donor designates the contribution for the benefit of any of the donor's direct dependents.

Melaney:

For the purposes of federal taxes, an STO can distribute donations to students that donors recommend as long as the student is not a dependent of the donor and there is no problematic behavior such as swapping. Swapping is when parents try to avoid the direct dependent prohibition by agreeing to designate each others children as recipients for donated funds.

Swapping and similar methods raise the problem of pre-selected, designated beneficiaries and quid-pro-quo arrangements; both prohibited for 501(c)(3) organizations. Because of this the parents who do this may be improperly claiming the charitable contribution deduction.

And if the state tuition organization distributes these funds to students that the donors designate, or that improperly benefit the organization's principals, that could jeopardize the organizations' tax-exempt status.

Tim:

Whether you are setting up or operating a state tuition organization, it's best to carefully review the standards for 501(c)(3) tax-exempt organizations. You can find a lot of information at the IRS Charities and Non-profits web page at www.irs.gov/charities. We also have a website called StayExempt, with online courses about the basics of starting and maintaining a 501(c)(3) organizations at www.stayexempt.irs.gov.