District Court Rejects Charitable Contribution Workaround to SALT Deduction Cap

(Parker Tax Publishing May 2024)

A district court held that, while certain states and a locality had standing to challenge Reg. Sec. 1.170A-1(h)(3)(i), under which a taxpayer's charitable contribution deduction is reduced by the amount of any state or local tax (SALT) credit received in exchange for the payment, their challenge ultimately failed. The court concluded that nothing in Code Sec. 170 suggested that Congress intended that charitable contributions made to state or local government sponsored funds in exchange for tax credits would be exempt from the standard rule that the amount of a charitable contribution deduction is reduced by the amount of any benefit received. State of New Jersey, State of New York, and State of Connecticut v. Mnuchin; Village of Scarsdale, N.Y. v. IRS, 2024 PTC 120 (S.D. N.Y. 2024).

Background

In the Tax Cuts and Jobs Act of 2017 (TCJA) (Pub. L. 115-97), Congress enacted Code Sec. 164(b)(6), which capped federal income tax deductions of state and local taxes (SALT) for married couples and single taxpayers at $10,000. In response to this legislation, New York, New Jersey, Connecticut (the States), and the Village of Scarsdale, New York (Scarsdale) enacted legislation authorizing tax credit programs that allowed residents to make charitable contributions to their state or municipality and receive a state tax credit in return.

In 2019, the IRS issued Reg. Sec. 1.170A-1(h)(3)(i) (the Final Rule), which provides that the amount of a taxpayer's charitable contribution deduction under Code Sec. 170(a) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer's payment or transfer of funds to a state or municipality. The preamble to the Final Rule in T.D. 9864 refers to the "quid pro quo" doctrine which provides that where a taxpayer receives a benefit in return for a donation, the taxpayer is permitted to deduct only the net value of the donation as a charitable contribution.

Before the Final Rule was proposed, a New York tax credit program, which funds health care and education services, received $78.7 million in donations. Because New York retains 15 percent of these contributions, it realized as much as $11.8 million in revenue. This revenue constituted a net increase in the amount of state-controlled funds used for public purposes, such as health care and education.

After the issuance of the Final Rule, the States and Scarsdale sued the Treasury Department and the IRS, seeking a declaration that the Final Rule is invalid under the Administrative Procedure Act (APA). They argued that the regulation's interpretation of "charitable contribution" in Code Sec. 170 conflicts with the text and purpose of the statute and therefore exceeds the IRS's statutory authority and is arbitrary and capricious and thus in violation of the APA. The States also claimed the regulation violated the Regulatory Flexibility Act (RFA), 5 U.S.C. Sections 601-12.

The RFA requires agencies that issue proposed rules to prepare and make available for public comment an initial regulatory flexibility analysis that describes the impact of the proposed rule on small entities. Moreover, an agency issuing a final rule must prepare a final regulatory flexibility analysis that describes a statement of the significant issues raised by the public comments in response to the initial regulatory flexibility analysis, a statement of the assessment of the agency of such issues, and "the steps the agency has taken to minimize the significant economic impact on small entities."

The government argued that (1) the States and Scarsdale lacked standing to pursue their claims; (2) the Anti-Injunction Act (AIA) barred their actions because they were challenging the validity of a regulation concerning taxpayers' federal tax liability; and (3) the claims that Treasury and the IRS violated the RFA had to be dismissed for failure to state a claim. Alternatively, the government moved for summary judgment, arguing that the States and Scarsdale had not demonstrated that (1) the IRS acted in excess of its statutory jurisdiction in issuing the Final Rule; and (2) the IRS's interpretation of Code Sec. 170 was arbitrary, capricious, an abuse of discretion, or not otherwise in accordance with the law. Finally, according to the government, the States and Scarsdale did not prove that they have suffered, or will suffer, an injury traceable to the Final Rule.

Generally, to establish standing, a taxpayer must have (1) suffered an injury in fact, (2) that is fairly traceable to the challenged conduct of the defendant, and (3) that is likely to be redressed by a favorable judicial decision. According to the States, the Final Rule implicated all three categories of injury because the States (1) have an interest in protecting a net increase in state revenue that would strengthen the States' fiscal health and their capacity to carry out their sovereign functions; (2) have an interest in protecting the charitable revenue streams that flow to state institutions and other charitable organizations and by diminishing the value of charitable deductions, the Final Rule reduces the incentive to itemize, which in turn weakens the incentive to make charitable contributions; and (3) have an interest in protecting a net increase in revenue for their governmental subdivisions, including counties, municipalities, and school districts. Scarsdale alleged that the 2019 Final Rule has caused it injury by (1) reducing the amount of revenue it collected, and (2) making it more expensive for Scarsdale residents to contribute to the Scarsdale Fund, leading to a corresponding decline in contributions and, accordingly, Scarsdale's overall revenue.

While New Jersey and Connecticut did not have any state-sponsored funds similar to New York and Scarsdale, they argued that the 2019 Final Rule prevented their state-sponsored funds from getting off the ground, thus depriving them of the increase in funds they expected to gain at some point in the future.

Analysis

The district court held that New York and Scarsdale had standing because they identified injuries that were sufficiently concrete and particularized, and actual or imminent. The court rejected the government's argument that New York and Scarsdale had alleged nothing more than a "general decrease in a source of state revenue," as opposed to "a quantified decrease in a specific stream of tax revenues." In the court's view, the States and Scarsdale were not required to demonstrate that they derived a significant revenue from contributions made to their tax credit programs in order to qualify for standing. However, the court concluded that the arguments by the states of New Jersey and Connecticut regarding their potential income from future state-sponsored funds required such a "highly attenuated chain of possibilities" and "speculative chain of events," and, thus, those states did not qualify for standing.

The court rejected the government's argument that the AIA barred the court from hearing the States and Scarsdale's claims after finding that the exception to the AIA as outlined by the Supreme Court in South Caroline v. Regan, 465 U.S. 367 (1984) applied. The district court noted that, because the States and Scarsdale incurred no tax liability under the 2019 Final Rule, they could not bring a refund suit or "utilize any statutory procedure to contest" the 2019 Final Rule and they thus would have no alternative path to judicial review were the court to find that the AIA barred their claims. Given their claim that the 2019 Final Rule injures their proprietary rights, the court concluded that the States and Scarsdale should be permitted to pursue their claims on their own behalf and for those reasons, the court concluded that the AIA does not bar their claims.

The court granted the government's motion to dismiss the claims relating to the RFA after finding that the 2019 Final Rule does not directly regulate local governments and their charity funds, but instead addresses individual taxpayers who contribute to local government charity funds. Thus, the court said, Treasury and the IRS did not violate the RFA by failing to conduct an analysis of the effect that the 2019 Final Rule would have on Scarsdale and other local municipalities, and the charity funds they operate.

Finally, the court concluded that the IRS's issuance of the 2019 Final Rule was not arbitrary and capricious and thus rejected arguments by the States and Scarsdale that the IRS and Treasury exceeded their statutory authority in issuing the Final Rule. The court applied the analysis set forth in Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) and observed that the IRS is generally entitled to Chevron deference on judicial review of its interpretations of the Code. The court found that nothing in Code Sec. 170 suggested that Congress intended that charitable contributions made to state or local government sponsored funds - in exchange for tax credits - would be exempt from the standard rule that the amount of a federal charitable contribution is reduced by the amount of the benefit received. The court rejected arguments by the States and Scarsdale that when Congress enacted the TCJA, it had an opportunity to amend Code Sec. 170 to reduce the charitable deduction by state tax incentives if it had intended that result and if Congress had intended the quid pro quo principle to be applied to state or local tax credits, it would have amended Code Sec. 170 to so state. This was not a situation, the court observed, where Congress had ample opportunity to amend the Code if it disagreed with the state and local tax credit programs since it was not until after the TCJA became effective that states and municipalities created their tax credit programs.

For a discussion of the limitation on charitable contribution deductions made in exchange for state tax credits, see Parker Tax ¶83,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com