On Oct. 5, 2021, the U.S. Court of Appeals, Second Circuit affirmed a judgment of the U.S. District Court and held that the $10,000 cap on the federal tax code’s state and local tax (SALT) deduction does not violate the U.S. Constitution.1 Federal courts had jurisdiction to consider the challenge to the SALT deduction cap that was filed by four states adversely affected by the cap. However, the complaint was dismissed because the cap is not coercive in violation of the Tenth Amendment or the principle of equal sovereignty.
The federal tax code has long allowed taxpayers to deduct from their taxable income the money they paid in state and local income and property taxes. However, the Tax Cuts and Jobs Act (TCJA) of 2017 imposes a $10,000 cap on the SALT deduction for individual taxpayers for the 2018 through 2025 tax years.2 The greatest effect of the SALT deduction cap is experienced in states where the SALT liability of individual taxpayers often greatly exceeds the $10,000 limitation.
Four of the states most affected by the SALT deduction cap—New York, Connecticut, New Jersey and Maryland—sought to enjoin the federal government from enforcing the cap.3 According to the states, the cap violates the Sixteenth Amendment4 of the U.S. Constitution because the federal income tax must permit “a deduction for all or a significant portion of state and local taxes.” The states also claimed that the cap violates both Article I, Section 8,5 and the Tenth Amendment6 of the Constitution because it coerces them to lower taxes or cut spending. Because a disproportionate share of their taxpayers’ state and local tax burdens exceed the $10,000 maximum, these states argued that their taxpayers “are likely to bear the brunt of the cap.” The states claimed that the cap increases the effective cost of state and local property taxes, depresses home equity values and reduces the number of real estate sales, resulting in reduced revenue from property taxes and real estate transfer taxes.
The federal government argued that the states lacked standing, their claims presented a political question that should not be considered by courts and the claims were barred by the Anti-Injunction Act (AIA). The government also defended the cap on its merits. The U.S. District Court for the Southern District of New York rejected the federal government’s jurisdictional arguments.7 However, the District Court dismissed the complaint because the U.S. Constitution does not require a SALT deduction as part of the federal income tax and the complaint failed to assert a plausible claim of coercion. The states appealed this judgment dismissing the complaint.
SALT deduction overview
The Court of Appeals began its opinion by reviewing the long history of the federal income tax and the SALT deduction, which has been included in the federal income tax calculation since 1913. While the SALT deduction has been in place for a long period of time, several changes to the Internal Revenue Code (IRC) have made the deduction limited in various respects. For example, the introduction of the standard deduction in 1944 practically limited the SALT deduction to taxpayers who decide to itemize their deductions. More recently, the SALT deduction has been limited to certain types of state and local taxes, and the availability of the deduction decreased prior to the enactment of the TCJA in 2017 through the application of the alternative minimum tax regime and Pease limitations on itemized deductions for high-income taxpayers.
Prior to the TCJA, taxpayers generally could elect to deduct: (i) all state and local real and personal property taxes; and (ii) either all state and local income taxes or all state and local sales taxes, subject to the above overarching limitations on deductions. However, the TCJA placed a $10,000 cap on the SALT deduction, and proponents of the new cap openly proclaimed that states imposing higher overall SALT regimes would be adversely impacted in comparison to other states with lower SALT burdens.
Federal Courts had jurisdiction to consider claims
States had standing to bring action
The Court of Appeals agreed with the District Court that the states had standing to proceed with their challenge of the SALT deduction cap. The Court of Appeals explained that the question of standing in this case turned solely on whether the states had sufficiently alleged an injury in fact. The states argued that they had standing because the SALT deduction cap was estimated to result in the loss of hundreds of millions of dollars of revenue from property taxes and real estate transfer taxes. The SALT deduction cap makes homeownership more expensive for taxpayers whose SALT liability exceeds $10,000 because they cannot fully deduct their property taxes from their federally taxable income. To support their claim, the states provided specific estimates of the decreases in tax revenue caused by the SALT deduction cap. The estimated lost tax revenues supported the states’ standing to bring suit.
Claims not barred by AIA
In affirming the District Court, the Court of Appeals also rejected the government’s jurisdictional argument under the AIA. This federal law provides in relevant part that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.”8 The federal government argued that the AIA bars this action as a “suit for the purpose of restraining the assessment or collection of any tax,” but the Court of Appeals explained that the AIA was never intended to deprive a party of any forum to assert its tax claims. In South Carolina v. Regan, the U.S. Supreme Court held that the AIA does not bar “actions brought by aggrieved parties for whom [Congress] has not provided an alternative remedy.”9 Similar to Regan, the states in this case could not assert their claims outside of federal court and could not bring a refund suit. On the basis that the AIA exception provided in Regan applied, the Court of Appeals held that the AIA does not prevent its review of the states’ claims.
SALT deduction cap is constitutional
Constitution does not mandate SALT deduction
The Court of Appeals agreed with the District Court that the Constitution does not require a SALT deduction. The states argued that Congress cannot eliminate or curtail the SALT deduction because it did not specifically limit the deduction before 2017. According to the states, the principles of federalism protect each state’s sovereign authority to raise revenue and prohibit the federal government from usurping a state’s traditional revenue sources. The Court noted that the states failed to show that their taxpayers’ total federal tax burden has increased to the point that the states cannot fund themselves. The states asked the Court to consider the “historical understanding and practice” relating to the SALT deduction cap. However, the Court determined that the history of the deduction did not support the states’ argument. As discussed above, the role of the SALT deduction cap has diminished over the years. The Court concluded that “[p]rior to 2017, it appears, Congress did not view its authority to limit the SALT deduction as subject to any relevant constitutional constraints.” This supported the Court’s conclusion that the Constitution does not limit the federal government’s authority to impose the SALT deduction cap.
In further support of its determination that the SALT deduction is not mandated by the Constitution, the Court noted that the states’ arguments mimic the arguments that the U.S. Supreme Court rejected in South Carolina v. Baker. 10 In this prior case, the Supreme Court held that Congress had the power to tax interest earned on state-issued bonds even though it had not previously taxed this income. According to the Supreme Court, the owners of state bonds had no constitutional entitlement not to pay tax on the income from the bonds. Consistent with Baker, the Court of Appeals rejected the argument that the SALT deduction is mandated by the Constitution.
Cap is not coercive in violation of 10th Amendment or equal sovereignty
The states unsuccessfully argued that the SALT deduction cap violates the 10th Amendment by coercing them to abandon their fiscal policies in favor of lower taxes and reduced spending. The Court of Appeals affirmed the District Court’s holding that the states did not have a Tenth Amendment claim. As explained by the Court of Appeals, the SALT deduction cap did not unconstitutionally infringe on state sovereignty. Congress may use its taxing and spending authority to “encourage a State to regulate in a particular way,”11 but “compulsion” is not allowed.12 The Court of Appeals noted that the Supreme Court has only once held that the Tenth Amendment was violated because a condition was unconstitutionally coercive. In National Federation of Independent Business (NFIB), Congress threatened to withhold all of a state’s Medicaid grants unless the state accepted new funding and certain conditions.13 The Court of Appeals noted that two factors supported the Supreme Court’s decision in NFIB. First, Congress required states to comply with the conditions to receive new Medicaid funding as well as Medicaid funding that previously was available. Second, Congress threatened to withhold funds constituting over 10% of state budgets.
The states argued that their citizens face a substantial harm because their federal tax burdens will rise, the value of their homes will decline and some of their jobs will be eliminated. However, the Court of Appeals determined that the states did not allege injuries that were coercive. The states relied on an improper comparison of the tax burden under the TCJA as enacted, versus a hypothetical version of the TCJA without the cap. This comparison did not show the actual financial effects of the SALT deduction cap. Further, any cost to taxpayers was not nearly as great as the 10% of state budgets at issue in NFIB. The Court of Appeals also rejected the states’ argument that their reduced tax revenues coerced them to change their fiscal policies. As noted by the Court, New Jersey alleged that it is likely to lose over $100 million in property and real transfer taxes in 2019 and 2020, but its 2019 budget was over $37 billion. The Court concluded that losses of such a small portion of New Jersey’s budget do not create coercion to support a constitutional violation. The states also unsuccessfully argued that the SALT deduction cap violates the independent constitutional principle of equal sovereignty among states. According to the states, Congress knew that the cap’s adverse effects would be unevenly realized by states. The Court noted that the cap applies to every state and the fact that the cap may affect how states exercise their sovereign authority does not render the law unconstitutional. Finally, the Court disagreed with the states that Congress unfairly targeted them. Comparing the SALT deduction cap to other federal laws with benefits and burdens unevenly distributed among states, the Court considered the cap as a permissive method by Congress to influence tax policy, rather than impermissible coercion.
The $10,000 SALT deduction cap enacted by the TCJA has been controversial and received considerable attention, with the states that have been most adversely affected looking for ways to challenge or avert it. The most popular reaction from a state legislative perspective has been the adoption of pass-through entity (PTE) tax regimes as a means to shift taxes from PTE owners that would be subject to the $10,000 cap to the PTE itself.14 In November 2020, the Internal Revenue Service confirmed that PTEs may claim an uncapped entity-level deduction for state and local income tax paid under state laws that shift the tax burden from individual owners to the business entity. 15
However, the ascendancy of PTE tax regimes in approximately 20 states to date does not help individuals that earn income outside of ownership interests in PTEs. Fearful that residents may leave en masse for lower-tax states if the cap is not altered in some manner, it is not surprising that the cap was challenged in court by four states with taxpayers that are largely bearing the brunt of the cap. The Court of Appeals’ dismissal of the states’ challenge to the SALT deduction cap on Tenth and Sixteenth Amendment grounds likely means that the impacted states will be pushed from the constitutional to the political sphere, in which they will have to pursue the federal legislative route for broad-based prospective relief.
While historically it has been difficult for states to obtain the attention of Congress with respect to issues involving SALT, the cap in question relates to a limit on a federal deduction, with a significant effect on federal tax revenues. As such, there currently is a potential window for action in Congress, as the cap is the subject of ongoing budget negotiations while broader changes to federal tax policy are being considered in the upcoming months. While a final legislative outcome on the cap is impossible to predict at this time, the possibility exists that either the size of the cap for some or all taxpayers could be substantially increased, or the cap itself could be repealed for a two-year period.
1 New York v. Yellen, U.S. Court of Appeals, Second Circuit, No. 19-3962-cv, Oct. 5, 2021.
2 P.L. 115-97, adding IRC § 164(b)(6).
3 The four states bringing this action are simply referred to as the “states” throughout this SALT Alert.
4 Under the Sixteenth Amendment, Congress has the power to impose an income tax without apportioning the tax among the states based on population.
5 Art. I, Sec. 8, lists the powers provided to Congress.
6 The Tenth Amendment provides that powers not delegated to the federal government are reserved to the states.
7 New York v. Mnuchin, 408 F. Supp. 3d 399 (S.D. N.Y. 2019).
8 26 U.S.C. § 7421(a).
9 465 U.S. 367, 378 (1984).
10 485 U.S. 505, 515-27 (1988).
11 New York v. United States, 505 U.S. 144, 166 (1992).
12 National Federation of Independent Business v. Sebelius, 567 U.S. 519, 578 (2012).
14 States have also attempted other workaround mechanisms that would apply to a broader category of taxpayers. For example, some states would have allowed individuals to make contributions to either a state-run fund or to private charities in exchange for a federal deduction and a state tax credit. However, the U.S. Treasury Department and the Internal Revenue Service acted to prevent this approach. New York has also offered an elective payroll tax regime, which has not gained much traction to date.
15 Notice 2020-75, Forthcoming Regulations Regarding the Deductibility of Payments by Partnerships and S Corporations for Certain State and Local Income Taxes, U.S. Department of Treasury & Internal Revenue Service, Nov. 9, 2020. For further discussion, see GT Tax Flash: “IRS permits SALT deduction pass-through workarounds.”
Matthew DiDonato is a State and Local Tax (SALT) practice partner in the New York office and leads the Metro New York SALT practice. He has more than 18 years of public accounting, private industry and legal state and local tax experience.
Iselin, New Jersey
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Jamie C. Yesnowitz
Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
Washington DC, Washington DC
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