A special-purpose entity (SPE) is a legal entity created to fulfill a specific or a temporary objective. SPEs are typically used by companies to isolate the firm from financial risk. One of the most notorious examples is Enron’s use of thousands of SPEs to hide risk prior to its bankruptcy filing in 2001. Normally, an SPE is set up to manage a single asset that has complex financial implications. The SPE is dedicated to the acquisition and financing of the asset, and the parent corporation is protected in case of bankruptcy, loan default, or other loss on that asset.
EITC Program Overview
SPEs can also be used to allow individuals to participate in tax credits that are normally only available to businesses. In Pennsylvania, the state’s Educational Improvement Tax Credit (EITC) program provides tax credits to eligible businesses that contribute to approved scholarship and educational improvement organizations. Businesses support approved organizations with charitable donations and receive tax credits to offset certain Pennsylvania business and individual tax liabilities. Without the SPEs, the EITC program would not be available to individual taxpayers.
The EITC program consists of: Scholarship (OSTC), Educational Improvement (EITC), and Pre-Kindergarten Scholarship. OSTC and EITC tax credits can equal 75% of the donation amount up to a maximum of $750,000 per tax year (90% of the donation with a two-year commitment). The Pre-K Educational Improvement Tax Credit is made available to eligible businesses contributing to a pre-kindergarten scholarship organization. This tax credit is 100% of the first $10,000 contributed and 90% on any additional amount, up to a maximum contribution of $200,000 annually.
Organizations can qualify to participate in these programs if they are a nonprofit entity that is exempt from payment of federal income tax. OSTC requires at least 80% of annual receipts be designated to a scholarship program, qualified under the requirements of Article XVII-F of the Tax Reform Code. EITC requires that at least 80% of its annual receipts be used as grants to a public school, charter school, or private school for innovative educational programs. Pre-K EITC requires that at least 80% of its annual receipts be used for a qualified Pre-K Scholarship Program.
Individual Participation in EITC
Pennsylvania has approved SPEs that allow a new group of individual donors to participate and receive EITC and OSTC tax credits. The sole purpose of the SPE can be to receive capital from its members, apply for the tax credits, and disburse funds to approved organizations. Credits earned by an SPE can be passed through to an individual’s joint or single PA tax liability. The individual can direct the SPE to contribute to the school of their choice as tuition scholarships, provided they qualify for the program.
Private schools and scholarship organizations can set up an SPE to access donor’s funds. Using an SPE is simple for donors and their tax preparers. However, running an SPE properly requires the entity to meet several compliance and administrative burdens. This type of SPE would be a business where individuals make an investment that is donated to a charity. The business entity might operate as a limited liability company (LLC) and would require an operating agreement and a managing member. An LLC with 10 or more investors triggers security law requirements for federal and state registration, as well as compliance requirements related to these registrations. Security regulations may limit participation to only accredited investors, which means not every individual can participate in the SPE.
EITC Tax Credits
Tax credits awarded to the SPE are passed through to investors through K1s. These are usually distributed by March 15 each year. New EITC tax credits are difficult to obtain. Existing EITC donors have preference and can apply for credits between May 15 and June 30. New EITC credits cannot be applied for until July 1.
Due to the popularity of the program, July 1 applications were not always successful, as tax credits had already been fully utilized by existing donors. A new SPE may take several years to be awarded tax credits. Schools and scholarship organizations should be aware of the possible long delay between setup of the SPE and when PA EITC tax credits may be awarded to a new SPE.
EITC programs have always been popular, but they have become even more attractive since the Tax Cuts and Jobs Act of 2017 (TCJA) placed limits on the ability to deduct state and local taxes on federal income tax returns. State and local taxes are now limited to a maximum federal deduction of $10,000. Participating in EITC converts this deduction to a charitable contribution. Charitable deductions do not have a $10,000 cap.
Potential investors in SPEs should be aware that the Department of the Treasury released temporary regulations in August 2018 addressing state credit programs as a way of circumventing TCJA. If adopted as proposed, these regulations could limit federal tax benefits. It is believed that programs existing before TCJA, such as the PA EITC program, will get a reprieve in the final regulations. However, even if PA EITC is not grandfathered, most taxpayers will still benefit if they contribute via the EITC program rather than directly to the charities.
- SPEs in PA allow individuals to participate in tax credits that were previously only available to businesses.
- EITC tax credits can equal 75% of the donation for a one-year commitment or 90% of the donation with a two-year commitment.
- TCJA’s limit on the ability to deduct state and local taxes on federal income tax returns has made EITC programs even more popular.
1. Authorized by Act 194 of 2014
2. Meeting requirements under IRC 501(C)(3)
3. PA Notice 2015-01