Several northeastern states are finally in agreement with regard to the imposition of state and local taxes (SALT). To this end, Connecticut, New Jersey, and New York filed a joint lawsuit against the IRS on July 17, 2019, opening a new front in the dispute between the states and the federal government over the Tax Cuts and Jobs Act of 2017’s (TCJA) $10,000 cap on the SALT deduction. This article will provide CPAs with an overview of the latest chapter in this saga.
The SALT Deduction Cap and Workarounds
As CPAs are aware, the cap on the SALT deduction has been controversial, leading several states to enact workarounds aimed at allowing individual taxpayers to make certain contributions to state and local governments that were otherwise fully deductible charitable contributions under federal income tax law. The workarounds were intended to promote charitable giving through the use of SALT credits.
The Treasury Department published final regulations (TD 9864) that took effect on August 12, 2019, which aim to prevent these state workarounds by further limiting deductibility for federal tax purposes. The joint lawsuit challenges these 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:
- The final regulations undermine state and local programs designed to promote charitable giving through the use of tax credits and thus deprive school districts, municipalities, and counties of important funding.
- The final regulations violate the Administrative Procedure Act because they are contrary to the plain meaning of Internal Revenue Code (IRC) section 170 in 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” 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 have 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 IRC section 170 [e.g., Transamerica Corp. v. U.S., 15 Cl. Ct. 420, 465 (1988); Skripak v. Comm’r, 84 T.C. 285, 319 (1985)].
- Similarly, 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.
- 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 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. On September 30, a federal judge dismissed this lawsuit, ruling that the states failed to demonstrate that Congress lacked the authority to limit the SALT deduction. It is unknown whether the states will appeal the ruling.
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 might consider changing their tax residence to lower-tax states. Residency planning, however, requires careful preparation and strict attention to detail. Residency audit defense also requires a nuanced understanding of the applicable rules. Taxpayers should proceed with caution and seek professional advice when facing a question regarding residency planning or a residency audit.
These are complex issues, and the outcome of any litigation is unpredictable. CPAs should continue to monitor the case for noteworthy developments.