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New York, New Jersey, and Connecticut filed a joint lawsuit against the IRS on July 17, 2019, setting up the next chapter and newest battlefront in the dispute between certain states and the federal government in response to the Tax Cuts and Jobs Act’s $10,000 cap on the state and local tax (SALT) deduction.
SALT deduction cap leads to chain of events
The loss of the full SALT deduction has been controversial, leading several states to enact workarounds in the hopes of providing a benefit to their residents by allowing individual taxpayers to make certain contributions to state and local governments that were otherwise fully deductible charitable contributions under federal income tax. The workarounds were intended to promote charitable giving through the use of SALT credits.
The Treasury published final regulations (T.D. 9864) on June 11, 2019, and they are set to take effect on Aug. 12, 2019. The final regulations aim to prevent these state workarounds by further limiting deductibility for federal tax purposes and are being challenged by this lawsuit.
Lawsuit seeks to set aside final regulations
The lawsuit, filed in the U.S. District Court for the Southern District of New York, seeks declaratory and injunctive relief, vacating or setting aside the final regulations.
In the complaint, the states contend the following:
1. The final regulations undermine state and local programs designed to promote charitable giving through the use of tax credits and hence deprive school districts, municipalities, and counties of important funding.
2. The final regulations violate the Administrative Procedure Act because they are contrary to the plain meaning of Section 170 by treating the receipt of SALT credits as a quid pro quo that reduces the value of a federal charitable deduction. Moreover, the final regulations are “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” and “in excess of statutory jurisdiction, authority, or limitations, or short of statutory right.” That is because they are inconsistent with a long line of case law and IRS administrative guidance that treated tax benefits from a charitable deduction as a simple reduction in tax liability – and not as a consideration reflecting a bargained-for exchange. Indeed, the complaint alleges, courts had consistently held that the expectation of a tax benefit does not give rise to a quid pro quo that would diminish the donor’s charitable intent or the donor’s right to reduce the amount of a charitable deduction under Section 170 of the Internal Revenue Code. See, e.g., Transamerica Corp. v. United States, 15 Cl. Ct. 420, 465 (1988) (stating that “[e]ven where the donation is made solely for the purpose of obtaining a tax benefit, the taxpayer is entitled to the deduction”); Skripak v. Comm’r, 84 T.C. 285, 319 (1985) (noting that “a taxpayer’s desire to avoid or eliminate taxes … cannot be used as a basis for disallowing the deduction for that charitable contribution”).
Similarly, the complaint alleges, the final regulations’ 15% safe harbor is (1) contrary to the text of Section 170 and (2) arbitrary and capricious. Essentially, taxpayers who make contributions that yield SALT credits worth 15% or less of the donation may claim a deduction for the full contribution, whereas taxpayers who make a contribution above the 15% threshold must subtract the value of the credit from the deduction. This exception is arbitrary and unsupported by any plausible interpretation of the plain text of Section 170.
3. The final regulations violate the Regulatory Flexibility Act (RFA) because the IRS did not prepare and make available for public comment a full regulatory flexibility analysis examining the fiscal ramifications of the rule for local governments as required under the RFA.
This case is the second lawsuit the states have filed in an attempt to mitigate the effects of the SALT deduction cap. The first lawsuit, filed last year by New York, Connecticut, Maryland, and New Jersey, sought to have the cap declared unconstitutional and removed from the federal tax laws. This new lawsuit challenges the validity of the new IRS rule intended by the IRS to thwart the states’ effort in using workarounds like the charitable deduction to circumvent the SALT cap. The first case is still moving through the federal courts, and it is uncertain whether either case will succeed.
What does CohnReznick think?
These are complex issues, and the outcome of any litigation is often unpredictable. We will continue to monitor the case for noteworthy developments.
One outcome is certain: The loss of the full SALT deduction could have a significant impact on taxpayers, especially wealthy taxpayers, in high-tax states such as New York, New Jersey, and Connecticut. As a consequence, individual taxpayers may be considering various tax planning strategies to mitigate the potential effects. High-net-worth taxpayers, for example, are often mobile and may consider changing their tax residence to lower-tax states. Residency planning, though, requires careful preparation and strict attention to detail. Residency audit defense, too, requires a nuanced understanding of the applicable rules. Accordingly, taxpayers should proceed with caution and seek professional advice when facing a question regarding residency planning or, worse, a residency audit.
Subject matter expertise
Corey Rosenthal
JD, Principal, Practice Leader, State and Local Tax (SALT) Services
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