Federal Scholarship Tax Credits: State Implications and Resource Considerations

The Federal Scholarship Tax Credit (FSTC) program represents a significant new source of educational funding for families across the country. Beginning in 2027, taxpayers can receive a dollar-for-dollar federal tax credit of up to $1,700 for contributions to certified Scholarship Granting Organizations (SGOs), which in turn provide scholarships for tuition and other qualified educational expenses.

On October 1, Treasury and the IRS issued two sets of rules: temporary regulations governing state elections, SGO lists, and SGO registration, and proposed regulations covering student eligibility, SGO operations, and audits.

The potential scale of the program is massive. Treasury and the IRS estimate that by 2030, more than 11 million taxpayers could donate up to $26 billion through hundreds of SGOs.

For families, that could mean greater educational choice and help with costs like tutoring and school supplies. For state governments, it could mean overseeing hundreds of thousands of donors and potentially billions of dollars flowing through the organizations they certify.

At first glance, the state’s responsibilities seem limited: elect to participate, certify qualified SGOs, and submit a list to the federal government. In reality, certification is only the beginning of an ongoing oversight function that includes audit reviews, data monitoring, compliance testing, investigations, and enforcement.

States will never directly manage the funds, but their decisions determine which organizations participate and whether donations qualify for the credit. Their residents will donate expecting tax credits in return, and families and schools will plan around the resulting scholarships. If oversight falls short and those expectations don’t match reality, states could face significant legal and political consequences.

Certification is Only the Beginning

FSTC contributions are private donations, not state or federal funds. However, participating states must still substantiate that SGOs managing those dollars meet program requirements, both initially and annually, and remove organizations that no longer qualify.

This model closely mirrors the processes states are already familiar with in subrecipient monitoring for federal grants: assessing risk, monitoring performance, reviewing audits, resolving findings, and imposing corrective actions.  States may be able to build on processes and controls they already use rather than starting from scratch.

States should expect to establish:

• SGO application, certification and recertification processes
• Financial and programmatic audit review standards
• Reporting and data requirements
• Risk assessment and compliance monitoring structures, and
• Investigation, corrective action, and removal procedures
• Documentation linking certification decisions to reports, audits, complaints, risk assessments, and corrective actions

School Choice Comes with an Important Implementation Challenge

The IRS has described the FSTC as “America’s first nationwide school choice program,” and advocates have echoed that framing. The narrative is simple: parents or other family members can claim a tax credit of up to $1,700, or $3,400 for a couple, for contributions to SGOs that then fund scholarships for their children.

However, there’s an important distinction in how the program works. Families cannot contribute  with the expectation of receiving the same money back as a scholarship for their own child. Contributions cannot be earmarked for particular students, and awards must be made independently of donor status. States will need to make that clear to SGOs, schools, donors, and families, and enforce it.

This restriction also shapes how SGOs are structured. Fundraising and donation management must be materially separated from scholarship administration, so award decisions remain independent of donor activity.

Consistent patterns of parents contributing to an SGO and their children receiving scholarships of similar amounts could indicate noncompliance and may be grounds for decertification.

Documentation Will Determine the Quality of Oversight

Annual applications and audit reviews alone will not give states enough information. They will need enough data to test transactions and identify potential compliance issues. That includes student eligibility, allowable expenses, duplicate funding, earmarking, account segregation, and audit findings.

Duplicate payments are a key example. An SGO can show it did not pay an expense twice, but it cannot see whether another SGO or a state education program already covered it. Only the state can.

The program’s technology also needs to do more than just support SGO applications and reporting. States need systems that can:

• Bring together donor, student, scholarship and transaction-level data across SGOs
• Identify duplicate payments, quid pro quo patterns and other compliance concerns
• Protect sensitive information through appropriate privacy, security and access controls
• Support data governance and records retention requirements

Monitoring Should Be Scaled Based on Risk

As with subrecipients, every SGO should receive a baseline review. States should also monitor SGOs more closely when they show signs of higher-risk, including: 

• Rapid growth
• Inconsistent reporting
• Material audit findings
• Complaints
• Unclear transaction data
• Unresolved corrective actions

Technology platforms can flag those risks but are no substitute for testing. States should periodically sample contributions, awards, and disbursements against reported data to confirm organizations are operating as represented.

States should also establish a clear process for responding to issues. Serious findings may require expanded testing, forensic investigation, corrective action plans, or decertification.

Oversight Decisions Will Have Lasting Consequences

That taxpayer and family reliance on the program is what makes oversight failures so costly. If a required independent audit shows that an SGO mismanaged funds and should be decertified, donors may worry about their tax credits, families may lose scholarships they were counting on, and the state could face scrutiny.

States should also expect legal challenges. SGOs that are denied certification or decertified may contest those decisions, so clearly documented criteria and appeal processes need to be in place from the outset.

Once a state opts in, it also takes on responsibility for how the program operates for its residents. An SGO failure, data breach, or questions about the appropriate use of scholarship funds could quickly draw attention to the state’s role in administering the program. Strong documentation and oversight will be important in demonstrating how the state fulfilled its responsibilities.

Federal scrutiny may also become more significant in the next few years as the program scales and the approach to its goals and enforcement evolves. Decisions made during the program’s initial implementation may be examined later under shifted priorities, making a strong administrative record especially important.

Third-party reviews can help states demonstrate appropriate due diligence in their oversight of SGOs. An objective, independent monitoring process would show that states took appropriate steps before certifying or recertifying SGOs, helping to guard against possible future legislative, court, and federal reviews.

The February 15 Deadline Increases the Pressure

Under the temporary regulations, states must elect to participate by January 1, 2027, and submit their list of qualifying SGOs to the IRS by February 15, 2027. If a state misses either deadline, resident donations to organizations in that state will not qualify for the tax credit, and its students will not be eligible for FSTC-funded scholarships.

With both sets of rules released October 1, states have roughly four months to build an application process, set eligibility standards, review submissions, and certify SGOs. As of early October, fewer than half of participating states had announced how their processes would work.

That timeline creates two risks. Move too slowly, and in-state SGOs and families risk missing the first year. Move too fast, and states may set up weak certification processes that could create problems during recertification or future independent audits.

States Need to Adequately Fund Program Administration

Oversight costs will vary from state to state, but the core requirements will be similar: program administration, SGO certification, technology and cybersecurity, audit and compliance review, analytics, investigations, and enforcement.

States need to decide how to fund those functions, including staff, technology, legal support, and outside expertise, before the February 15 deadline rather than assuming an existing agency can absorb them.

One option is a scalable recertification fee based on the volume of funds and scholarships SGOs administer. SGOs can use up to 10% of donations for administrative costs, and states should consider whether a portion could fund their oversight.

That would let oversight resources grow with participation and contribution levels instead of straining the state’s existing budget.

Build for the Now and the Future

The initial administrative burden may look minimal, but states should plan beyond the first certification cycle.

The question is not if an agency can review a handful of SGO applications at launch, but whether the state is building a structure that can oversee hundreds of thousands of taxpayers and billions in donations as the program grows.

Electing to participate is a political and policy decision. Administering the program requires a sustained commitment to operational, financial, technology, compliance, and governance support.

States that recognize that distinction early on can build infrastructure that grows with the program and protects the taxpayers and families relying on it.  Without that foundation, oversight gaps could allow noncompliance to go undetected, disrupt scholarships, and erode public trust. A program that depends on voluntary contributions also relies upon taxpayers having confidence in how it is administered.