Proposed regulations thwart state plans to work around the new $10,000 federal limit on state and local tax deductions.

Background

“The Tax Cuts and Jobs Act,” Pub. L. No. 115-97, limits an individual's deduction under IRC §164 for the total amount of state and local taxes (SALT) paid during the calendar year to $10,000 ($5,000 for a married individual filing a separate return). State and local tax payments exceeding those amounts aren't deductible. This new limitation applies to taxable years 2018 through 2025.

State Law Workarounds

Responding to this new limitation, New York, New Jersey, Connecticut and Maryland enacted laws allowing their taxpayers to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that taxpayers are required to pay.

These laws allow the states' taxpayers to characterize their transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state and local tax liabilities.

The detailed proposed regulations cover a number of situations—taking into account taxpayers who are subject to the alternative minimum tax and those who aren't. REG-112176-18.

Proposed Regulations in a Nutshell*

• A taxpayer who gets a state credit for her contribution is entitled to a federal income tax deduction only for the amount of her payment exceeding the credit (subject, of course, to AGI and carryover rules).

• When a state credit for a taxpayer's contribution is 15 percent or less, her federal income tax deduction for the contribution is fully deductible (subject to AGI and carryover rules).

• A taxpayer who gets a state tax deduction for a contribution to the state that isn't in payment of taxes won't be affected by the proposed regulations. Thus any deductions allowable on a state income tax return are deductible contributions on federal income tax returns (subject to AGI and carryover rules).

SALT Suit

New York and three other states sue to invalidate the $10,000 deductibility ceiling on state and local taxes (SALT). The actions seek declaratory and injunctive relief.

• The new cap effectively eviscerates the SALT deduction, overturning more than 150 years of precedent by drastically curtailing the deduction's scope. As the drafters of the Sixteenth Amendment and every subsequent Congress have understood, the SALT deduction is essential to prevent the federal tax power from interfering with the states' sovereign authority to make their own choices about whether and how much to invest in their own residents, businesses, infrastructure, and more.

• A SALT deduction has been a part of every federal income tax law since the first federal income tax was enacted in 1861. The deduction is necessary to ensure that the exercise of the federal government's tax power does not unduly interfere with the sovereign authority of the states to determine their own taxation and fiscal policies by crowding the states out of traditional revenue sources, like income, property, and sales taxes.

• The necessity of protecting the states' sovereign authority to determine their own taxation and fiscal policies was an explicit concern for the Founders at the time of the ratification of the Constitution. That necessity informed all decisions about imposing the first federal income tax during the Civil War, and it was confirmed in the subsequent enactment history of the Sixteenth Amendment.

• The new cap on the SALT deduction is unprecedented, unlawful, and will cause significant and disproportionate injury to the plaintiff states and their residents.

• The new cap will significantly increase the amount of taxes residents in plaintiff states will pay to the federal government.

• In addition to disproportionately harming the plaintiff states relative to others, the new cap on the SALT deduction will cause significant and irreparable direct harm to the plaintiff states and their taxpayers.

• The new cap on the SALT deduction is likely to substantially decrease home values in the plaintiff states, hurting both in-state homeowners and the plaintiff states themselves.

• Homes are the most valuable assets many homeowners possess. With depressed home prices, many homeowners will lose the equity on which they depend to finance retirement, school tuition, and other investments.

For all these reasons (and many others detailed in the states' complaint), the plaintiff states seek a declaration that the new cap on the SALT deduction violates the U.S. Constitution, and an injunction barring the new cap's enforcement.

State of New York, State of Connecticut, State of Maryland, and State of New Jersey v. Steven T. Mnuchin, in his official capacity as Secretary of the United States Department of Treasury; David J. Kautter, in his official capacity as Acting Commissioner of the United States Internal Revenue Service 

U.S. District Court for the Southern District of New York, Civil Action No. 18-cv-6427

This Just In

The proposed regulations should be withdrawn for the reasons stated by the attorney generals of New York, New Jersey, Connecticut and California in an October 11 letter to IRS Commissioner Charles Rettig: “The IRS should withdraw its proposal as both the law and common sense demand. The IRS should not play politics; it should instead confirm its longstanding interpretations of federal law.”

A public hearing on the proposed regulations is scheduled for November 5.

Be Careful Out There

Commentators believe the lawsuit to invalidate the SALT limitation will be unsuccessful. The IRS will deny claimed charitable deductions for what are, in effect, required tax payments—and impose interest and penalties.

*In a nutshell has a long, distinguished history dating back to Cicero, who claimed in the first century B.C. that someone actually copied all 24 books of Homer's epic poem The Iliad in a handwriting minuscule enough to fit in a walnut shell (a feat that has since been repeated several times). The phrase the Iliad in a nutshell later came to be in a nutshell, meaning 'very small.'” From: QPB Encyclopedia of Word and Phase Origins (Second Edition).