Earlier this week, the Attorneys General of New Jersey, New York, and Connecticut sued the Treasury Department and the Internal Revenue Service challenging a new IRS rule that would preclude individuals in those states from claiming deductions for charitable contributions to local governments. This lawsuit is the latest chapter in the battle over the “SALT cap,” enacted as part of the 2017 tax reform legislation which imposes a $10,000 annual limitation on the deduction for state and local taxes.

Enacted in 2017, the Tax Cuts and Jobs Act was touted as the most significant tax reform legislation in three decades. Among its provisions is a $10,000 annual limitation on the deduction for state and local tax, which includes state and local income taxes, local real estate taxes and state sales taxes. Previously, there was no monetary limitation for an individual taxpayer’s SALT deduction. The new limitation is more detrimental to individuals in high tax states, such as California and New York. The average SALT deduction in California was around $18,500, while the average deduction in New York was around $22,000. The SALT limitation imposed by the TCJA applies to taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026.

Some states have attempted to work around the SALT limitation using creative legislative solutions. Last year, New York Gov. Andrew Cuomo signed into law a new state-operated charitable contribution fund to accept donations for the purposes of improving health care and public education in New York state. Taxpayers who itemize deductions may claim these charitable contributions as deductions on their federal and state tax returns. Any taxpayer making a donation may also claim a state tax credit equal to 85 percent of the donation amount for the tax year after the donation is made. Taxpayers may also make qualified contributions to certain not-for-profit organizations for specified purposes. The law also authorizes local governments and school districts to establish charitable gift reserve funds and to offer real property tax credits to incentivize contributions to these new local charitable funds.

New Jersey soon followed suit, with Gov. Phil Murphy signing into law a measure allowing municipalities, counties and school districts to establish charitable funds where taxpayers can donate in return for a property tax credit. In return for donations, taxpayers would receive credits on their property tax bill of up to 90 percent of the donation. Taxpayers would then be able to claim their donation as a charitable deduction on their federal income tax return.

In Connecticut, the General Assembly passed legislation in 2018 that allowed municipalities to create “community supporting organizations” classified as charitable organizations. Taxpayers could make contributions to these organizations and most of that donation would be credited toward their local property tax liability.

In response to these state initiatives, the IRS issued a new rule aimed at nullifying the tax benefits these states were making available to charitable givers. The new rule – set to take effect on August 12, 2019 – requires taxpayers to subtract the value of any state and local tax credits they receive for charitable giving from their federal charitable contribution deduction.

The lawsuit filed this week by New Jersey, New York, and Connecticut contends that the new IRS rule is arbitrary and capricious, in violation of the federal Administrative Procedures Act. The complaint further alleges that the rule threatens economic harm to the states by discouraging charitable giving, and by depriving school districts, municipalities, and counties of important funding.

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