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New Jersey, New York, Connecticut Sue to Keep SALT Workarounds (3)

July 17, 2019, 1:28 PMUpdated: July 17, 2019, 5:54 PM

Three states sued the IRS and Treasury Department July 17 over recent rules meant to curb state workarounds of the $10,000 cap on state and local tax deductions.

The SALT cap has been among the most contentious elements of the 2017 tax law. Democrats in high-tax states have slammed the provision, saying it hurt their constituents. But they have also struggled with the reality that fully restoring the tax break would mostly help the wealthy.

The June final rules (T.D. 9864) at issue prohibit workarounds that states, including New York and New Jersey, established that allow state tax credits for donations made to newly created charitable funds aimed at a variety of state programs.

“More than 100 such programs exist in 33 states, incentivizing individuals to donate to causes ranging from natural resource preservation and aid for higher education to domestic violence shelters,” according to the complaint filed in the U.S. District Court for the Southern District of New York.

The final rules also rein in donations to some similarly structured charitable funds for private school tuition vouchers in Republican-led states such as Alabama and Georgia.

A group of Democratic senators on July 16 introduced a resolution of disapproval under the Congressional Review Act, a law that allows Congress to permanently overturn recently issued regulations using expedited floor procedures.

The Lawsuit

In their complaint, the states say the final rules from the IRS violate two laws: the Administrative Procedure Act, which provides rules on how executive agencies issue regulations, and the Regulatory Flexibility Act, which requires agencies to assess how regulations impact small government jurisdictions and other small entities.

Many of the legal claims revolve around tax code Section 170, which allows taxpayers to deduct “any charitable contribution” they make within the tax year from their taxable income. It says a charitable contribution can be deducted “only if verified under regulations prescribed” by the Treasury Secretary.

The states say the new IRS rules run contrary to the clear meaning of Section 170 in a handful of ways.

First, the states say the rules treat a SALT credit as a “quid pro quo,” or direct exchange, when the taxpayer receives it in return for having made a charitable contribution. Tax credits aren’t actually “a thing of value” in gross income under the tax code and so can’t be treated as a return benefit, the states say.

The states also say the new rules arbitrarily distinguish between tax benefits that come as deductions and benefits that come as credits, and between donors who do and don’t receive tax credits worth over 15% of the underlying donation.

In addition to those violations, the states allege that the IRS didn’t publish “an initial and a final regulatory flexibility analysis” as required by the Regulatory Flexibility Act.

The states may also be anticipating arguments about whether they are able to bring the lawsuit based on whether they can show the SALT cap harmed them. Their complaint specifically discusses injuries like making it harder to impose state taxes, depressing home equity values, and reducing the tax revenue they can collect.

“The SALT cap disproportionately harms taxpayers in the Plaintiff States, and it harms the Plaintiff States directly,” they say.

Village Also Sues

The village of Scarsdale, N.Y., also filed a lawsuit.

The village says its charitable gifts reserve fund received more than $500,000 in contributions in 2018, before the new rules, but that there haven’t been any more contributions since the rules took effect.

“The lack of further contributions to Scarsdale’s charitable gifts reserve fund is directly attributable to Defendants’ unlawful regulatory actions,” the village said in its complaint.

Like the states, Scarsdale argues that the new rules violate the Administrative Procedure Act by making arbitrary distinctions, including treating tax credits and tax deductions differently.

Other Workarounds

“The final IRS rule flies in the face of a century of federal tax law that says state choices to provide tax incentives for charitable donations do not affect the federal deductibility of those gifts,” New York Gov. Andrew Cuomo (D) said in a statement July 17, adding that the IRS shouldn’t be used as a political weapon.

The IRS hasn’t yet reached a decision on how it will approach other state workarounds that weren’t targeted in the final rules, IRS Chief Counsel Michael Desmond said late last month.

Rhode Island and Connecticut, for example, have workarounds that essentially allow owners of pass-through businesses to take bigger federal deductions and absorb some of the hit from the SALT cap.

Lawmakers have offered several bills to try and ease the cap, but a divided Congress has so far impeded progress. House Ways and Means Committee member Bill Pascrell (D-N.J.) is pushing legislation (H.R. 1142, S. 437) that would repeal the cap and raise the top income tax rate.

Another bill (H.R. 1757) from Illinois Democrats would increase the cap to $15,000 for individuals and $30,000 for couples.

The cases are N.J. v. Mnuchin, S.D.N.Y., No. 1:19-cv-06642, complaint filed 7/17/19 and Village of Scarsdale, N.Y. v. IRS, S.D.N.Y., No. 7:19-cv-06654, complaint filed 7/17/19.

To contact the reporters on this story: Colleen Murphy in Washington at cmurphy@bloombergtax.com; Aysha Bagchi in Washington at abagchi@bloombergtax.com

To contact the editors responsible for this story: Patrick Ambrosio at pambrosio@bloombergtax.com; Kevin A. Bell at kbell@bloombergtax.com