The Personal Income Tax Law, in modified conformity with federal income tax laws, allows various deductions from gross income in computing adjusted gross income under that law, including deductions for payments to individual retirement accounts, alimony payments, and interest on educational loans.

This bill, for taxable years beginning on or after January 1, 2016, and before January 1, 2021, would allow a deduction in computing adjusted gross income for those amounts contributed to a Coverdell education savings account, up to $750 per taxable year, as provided. The bill, for taxable years beginning on or after January 1, 2016, and before January 1, 2021, would also allow a deduction in computing adjusted gross income, not to exceed $2,500, for the cost of education-related expenses of the taxpayers dependent child or children attending public or private school, as specified.

This bill would take effect immediately as a tax levy.

SENATE COMMITTEE ON GOVERNANCE AND FINANCE

Senator Robert M. Hertzberg, Chair

2015 - 2016 Regular

Personal income taxes: deductions: education expenses: education savings accounts

Allows an “above-the-line” deduction for contributions to Coverdell Education Savings Accounts and a deduction for qualified education related expenses.

Background

Coverdell Education Savings Account. Established by federal law, a Coverdell Education Savings Account (ESA) is a trust or custodial account created exclusively for the purpose of paying qualified education expenses of a named beneficiary. Annual contributions to a Coverdell account may not exceed $2,000 per designated beneficiary and generally may not be made after the designated beneficiary reaches age 18. The contribution limit is phased out for taxpayers with a modified AGI between $95,000 and $110,000 ($190,000 and $220,000 for married taxpayers filing a joint return); the AGI of the contributor, and not that of the designated beneficiary, controls whether a contribution is permitted by the taxpayer.

Distributions from an ESA are excluded from the gross income of the student to the extent that the distribution does not exceed the qualified education expenses incurred by the beneficiary the year the distribution is made. The earnings portion of an ESA distribution not used to pay qualified education expenses is includible in the gross income of the student and generally subject to an additional 10% tax. Tax-free transfers or rollovers of account balances from one ESA to another ESA are permitted, provided that the new beneficiary is a member of the family of the prior beneficiary and is under age 30 (except in the case of a special needs beneficiary).

In general, any balance remaining in an ESA is deemed to be distributed within 30 days after the date that the beneficiary reaches age 30 (or, if the beneficiary dies before attaining age 30, within 30 days of the date that the beneficiary dies).

Qualified education expenses include “qualified higher education expenses” and “qualified elementary and secondary education expenses,” and are defined as follows:

• “Qualified higher education expenses” means expenses for undergraduate or graduate-level courses, and includes expenses for tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible educational institution, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time, half-time, or less than half-time basis, certain room and board expenses for any period during which the beneficiary is at least a half-time student, and amounts paid or incurred to purchase tuition credits, or to make contributions to an account, under a qualified tuition program for the benefit of the beneficiary of an ESA.
• “Qualified elementary and secondary education expenses” means expenses for enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12), and include tuition, fees, academic tutoring, special needs services, books, supplies, room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the designated beneficiary, and the purchase of any computer technology or equipment or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school. Computer software primarily involving sports, games, or hobbies is not considered a qualified elementary and secondary education expense unless the software is predominantly educational in nature.

California law generally conforms to federal law for ESAs, modified to provide that the federal additional 10% tax on excess distributions is instead an additional tax of 2.5% for state purposes.

Deduction for certain education-related expenses. California law allows various income tax credits, deductions, and sales and use tax exemptions to provide incentives to compensate taxpayers that incur certain expenses, such as child adoption, or to influence behavior, including business practices and decisions, such as research and development credits. The Legislature typically enacts such tax incentives to encourage taxpayers to do something that but for the tax credit, they would not do. The Department of Finance is required to annually publish a list of tax expenditures. Currently, tax expenditures exceed $57 billion dollars. Federal law lacks an education deduction for K-12 education expenses.

Proposed Law

Senate Bill 1437 provides an above-the-line deduction for contributions to an ESA, not to exceed $750 per taxable year.

SB 1437 also provides an above-the-line deduction for qualified education related expenses incurred for the benefit of a dependent child paid by a qualified taxpayer. The bill defines the following terms:

• “Dependent child” means one or more children who are dependents for federal tax purposes, attend grades K-12 full-time, and are under the age of 21.
• “Qualified amount” would mean the amount paid or incurred for qualified education related expenses.
• “Qualified education-related expenses” would mean the kindergarten or any of grades 1 to 12, inclusive, costs of any of the following:
  • The rental or purchase of educational equipment required for classes during the regular school day; computers, computer hardware, and educational computer software used to learn academic subjects.
  • Fees for college courses at public institutions or independent nonprofit colleges, or for summer school courses that satisfy high school graduation requirements.
  • Psychoeducational diagnostic evaluations to assess the cognitive and academic abilities of dependent children; special education and related services for dependent children who have an individualized education program or its equivalent.
  • Out-of-school enrichment programs, tutoring, and summer programs that are academic in nature.
  • Public transportation or third-party transportation expenses for traveling directly to and from school.
  • Excludes any expenses for items as provided in this provision that also are used in a trade or business.
• “Qualified taxpayer” would mean a parent or legal guardian of one or more dependent children who meets all of the following requirements:
  • Both the dependent children and the parent or guardians reside in California when the qualified education-related expenses are paid or incurred.
  • Household adjusted gross income does not exceed 250% of the federal Income Eligibility Guidelines published by the Food and Nutrition Service of the United States Department of Agriculture for use in determining eligibility for reduced price meals.

The deduction is limited to $2,500 per year. SB 1437 applies to taxable years beginning on or after January 1, 2016 and before January 1, 2021.

State Revenue Impact

According to the Franchise Tax Board (FTB), SB 1437 results in revenue losses of $20.4 million in fiscal year (FY) 2016-17, $20.45 million in FY 2017-18, and $21.45 million in FY 2018-19.

Comments

1. Purpose of the bill. According to the author, “SB 1437 would combine a state tax incentive, along with a new measure of tax relief, to support families in personally saving and caring for their children’s learning needs from kindergarten through college. As a tax incentive this bill will encourage, through a $750 state tax deduction, contributions made to a federal Coverdell Education Savings Account (ESA) to save for qualified educational expenses at public and private schools, colleges, and universities. As tax relief this bill would allow working and middle-class families, with incomes at or below 250 percent of federal reduced lunch guidelines, a $2,500 deduction, for K-12 education-related expenses incurred on behalf of their dependent children attending California schools. SB 1437 will encourage families to put away more money for college to ease future student debt burdens, while also saving for college preparedness should K-12 educational needs arise. SB 1437 will additionally aid families in providing resources and services that are paramount to K-12 learning to help close learning gaps, promote prevention and recovery, and lessen the number of high school graduates who enter college needing remedial assistance.”

2. Tax expenditures. Existing law provides various credits, deductions, exclusions, and exemptions for particular taxpayer groups. In the late 1960s, U.S. Treasury officials began arguing that these features of the tax law should be referred to as "expenditures," since they are generally enacted to accomplish some governmental purpose and there is a determinable cost associated with each (in the form of foregone revenues). This bill would increase an existing tax expenditure. The tradeoff for increasing the tax expenditure, resulting in revenue losses, is higher taxes or reductions to other services or programs.

3. How is tax expenditure different from a direct expenditure? As the Department of Finance notes in its annual Tax Expenditure Report, there are several key differences between tax expenditures and direct expenditures. First, tax expenditures are reviewed less frequently than direct expenditures once they are put in place. This can offer taxpayers greater certainty, but it can also result in tax expenditures remaining a part of the tax code without demonstrating any public benefit. Second, there is generally no control over the amount of revenue losses associated with any given tax expenditure. Finally, once enacted, it takes a two-thirds vote to rescind an existing tax expenditure absent a sunset date. SB1437 contains a 5 year sunset.

4. 529 versus ESA. Although similar, there are key differences between utilizing an ESA versus a 529 account (also known as a as a ScholarShare College Savings Plan) tool for saving for education. An ESA has both a yearly contribution limit and income limits, a 529 has no yearly contribution limit or an income limit, but there is a maximum account balance limit of $475,000. Balances in an ESA must be disbursed on qualified education expenses by the time the beneficiary is 30 years old or given to another family member below the age of 30 in order to avoid taxes and penalties; there is no age limit for 529 plans. An ESAs allows withdrawing the money tax free for qualified elementary and secondary school expenses, whereas a 529 plan does not.

Earnings from both types of accounts are not subject to federal and state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board. Contributions to both accounts are not deductible.

5. Favoring Higher Income Earners. According to a report by the Government Accountability Office (GAO), less than 3% of families have 529 or ESA plans and those who do tend to be wealthier. (Higher Education: A Small Percentage of Families Save in 529 Plans, GAO, Dec. 2012.) Specifically, families with 529 and ESA plans had a median income of $142,000 per year and a median financial asset value of about $413,500. It was also said that families with 529 and ESA plans tend to have higher levels of education, which may increase the likelihood that their children will attend college. The report outlined several reasons why low-income families participate far less in 529 and ESA plans, such as a lack of awareness, confusion as to how the plan works, and differences among the various plans. However, 68% of those surveyed stated a lack of money as the major reason for not participating. In the end, it is difficult to encourage families to save for college when they have little or no disposable income.

6. Private School Subsidy. Unlike a 529 College Savings plan, an ESA allow taxpayers to withdraw and make payments for K-12 educational expenses. K-12 educational expenses, however, are not limited to public schools. Funds can be used to pay for private school tuition. The Committee may wish consider whether subsidizing private education is an appropriate use of public funds.

7. Above and below the line deductions. An above-the-line deduction is a deduction that allows a taxpayer to subtract amounts from gross income when calculating their AGI. If the deduction is taken above the line, it is used to determine the taxpayer’s AGI. An above-the-line deduction can be taken by any taxpayer regardless of whether the taxpayer itemizes. Moreover, an above-the-line deduction reduces AGI, and having a smaller AGI can lower many subsequent calculations which will further reduce taxes. As a result, above-the-line deductions are more advantageous than those taken below the line. Once AGI is determined, a taxpayer can either itemize deductions or take the standard deduction, whichever is greater. Once itemized deductions exceed the standard deduction, other smaller below-the-line deductions, such as miscellaneous expenses, can be applied to increase tax savings. However, in order to take advantage of a miscellaneous below-the-line deduction, total expenses must exceed 2% of AGI and all deductions in total must exceed the standard deduction. Currently, less than one-half of California individuals itemize their deductions.

8. Reverse nonconformity. California law does not automatically conform to changes to federal tax law, except under specified circumstances. Instead, the Legislature must affirmatively conform to federal changes. Generally, when the federal government changes its tax laws, California catches up by enacting its own legislation the following year to reduce differences between the two codes, thereby easing the tax preparation burden on taxpayers, tax preparers, and the Franchise Tax Board. Currently, under federal tax law there is no above-the-line deduction for contributions to an ESA, or for K-12 education expenses. Thus, if SB 1437 is enacted taxpayers would be entitled to a deduction for state tax purposes, but not for federal tax purposes.

9. Let’s get clear. Several terms in the bill may need to be clarified. For example, it is unclear if “household income,” as defined in this provision, would include the AGI of each member of the household or only the AGI of the qualified taxpayer. The Committee may wish to consider amending the bill to reduce potential disagreements between taxpayers and FTB.

Support and Opposition

(5/5/16)

Support: California Association of Private School Organizations; California Catholic Conference.

Opposition: California Federation of Teachers; California Tax Reform Association; California Teachers Association.

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