Three States File Lawsuit Over Federal Rules Blocking SALT Workaround

New Jersey Gov. Phil Murphy, a Democrat seen here at an event earlier this month, says new IRS rules related to the state and local tax deduction amount to a "weaponization of the tax code."

New Jersey Gov. Phil Murphy, a Democrat seen here at an event earlier this month, says new IRS rules related to the state and local tax deduction amount to a "weaponization of the tax code." AP Photo/Seth Wenig

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Treasury and the IRS last month prohibited charitable contribution programs meant to provide taxpayers a way around a cap on federal deductions for state and local taxes.

New Jersey, New York and Connecticut filed a lawsuit Wednesday over rules the Trump administration issued last month blocking state policies designed to give taxpayers a way to avoid a cap on the deduction they can claim on their federal taxes for the state and local taxes they’ve paid.

It’s the latest volley in the battle over the $10,000 limit on the "SALT" deduction, which higher tax states that lean Democratic have decried as unfairly targeting their taxpayers. The cap was adopted as part of the sweeping Republican-led federal tax overhaul enacted in 2017. 

Some states offered their taxpayers a way to circumvent the cap with policies allowing for them to make “charitable contributions” to government entities, like school districts and counties, and to then receive tax credits roughly on par with those contributions in return.

Unlike the deduction for state and local taxes, charitable contributions can still be fully written off when people file their federal taxes.

But, last month the Treasury Department and the Internal Revenue Service put in place rules that put the kibosh on these types of state workarounds. 

The new lawsuit the three states filed in U.S. District Court for the Southern District of New York challenges these rules and seeks to strike them down.

Announcing the lawsuit at a news conference, New Jersey Gov. Phil Murphy, a Democrat, said that the rules are inconsistent with past IRS policies and court precedents.

“Our actions were perfectly legal under both the federal tax code and long established IRS practices,” Murphy said. “But for the sake of pure politics, and the further weaponization of the tax code, the IRS has decided to change its policy.”

New Jersey Attorney General Gurbir Grewal said “there was absolutely nothing new, nothing novel, or nothing unique about what we did.”

The SALT workaround program New Jersey adopted authorized local units of government, like municipalities, counties, or school districts to establish “charitable funds.” Donors to the funds became eligible for a property tax credit worth 90 percent of their contribution. 

Connecticut, Oregon and New York moved ahead with similar policies.

The lawsuit argues that until recently the IRS allowed programs akin to these to operate.

“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,” the court complaint filed by the states says.

“These diverse programs encourage charitable giving and citizen engagement, ensure the financial viability of philanthropic organizations, relieve the burdens on state and local governments, and promote a vibrant civil society,” it adds.

The lawsuit describes the new rules as “a radical break” with historical precedent and practice, and claims that they violate the Administrative Procedure Act and the Regulatory Flexibility Act.

It names Treasury Secretary Steven Mnuchin, IRS Commissioner Charles Rettig and their respective agencies as defendants.

New Jersey, New York, Connecticut and Maryland are involved in a separate lawsuit, filed about a year ago, over the cap itself.

A federal judge heard arguments on competing motions in that case last month. The federal government is seeking to have the states’ lawsuit dismissed and the states are seeking a summary judgement in their favor. A ruling from the judge on those motions is pending.

Eliminating the full SALT deduction for individual taxpayers promises to raise more than $600 billion in federal revenues over a decade. GOP lawmakers used this anticipated revenue to help balance out the tax cuts and other policies that were central to their 2017 tax legislation.

The nonpartisan Joint Committee on Taxation released estimates last month showing that if the cap were repealed, about $40 billion of the $77 billion in reduced tax liability in 2019 would benefit people earning $1 million or more.

People with $100,000 to $500,000 of income would see about $22 billion of the tax savings. Overall about 99% of the decrease in tax liability would accrue to people earning $100,000 or more, according to the committee’s analysis.

State and local officials pushing back against the cap have argued that it amounts to double taxation and makes it more difficult for their jurisdictions to levy taxes to cover their costs.

A common counter argument is that these places should lower their taxes.

Murphy touched on this issue in his comments on Wednesday, suggesting New Jersey's revenues enable it to have high quality schools, safe hospitals and help make it a good place to raise children.

"That does not come for free,” he said. “The question is: what's the fair price to pay?”

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Bill Lucia is a Senior Reporter for Route Fifty and is based in Olympia, Washington.

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