District Court Upholds TCJA Limit on State and Local Tax Deductions

(Parker Tax Publishing October 2019)

A district court dismissed a complaint by several states that challenged the constitutionality of Code Sec. 164(b)(6), enacted by the Tax Cuts and Jobs Act of 2017, which imposes a $10,000 limit on the federal deduction of state and local taxes (i.e., the SALT cap). The court found that Congress enacted the SALT cap pursuant to its broad taxing powers and rejected the states' argument that the SALT cap constrained the exercise of their sovereign tax powers and unlawfully coerced them to lower their tax rates. State of New York v. Mnuchin, 2019 PTC 375 (S.D. N.Y. 2019).

Background

The deduction for certain state and local taxes (SALT) in Code Sec. 164 has been a mainstay of the federal income tax since its earliest inception, although the deduction has taken various forms over the years. For example, the addition of the standard deduction in 1944 made the SALT deduction relevant only to taxpayers who itemized deductions. In 1964, Congress specified the types of state and local taxes that were deductible. The deduction for state and local sales taxes was eliminated in 1986, but partially reinstated in 2004. As in effect in December 2017, Code Sec. 164 allowed taxpayers who itemized their deductions to deduct (1) all state and local real and personal property taxes, and (2) their choice of all state and local income taxes or all state and local sales taxes. The Tax Cuts and Jobs Act of 2017 (TCJA) took the novel step of placing an upper limit on the amount of the SALT deduction. Under Code Sec. 164(b)(6), a single or jointly filing married taxpayer may deduct up to $10,000 for state and local real and personal property taxes (SALT) for years 2018 through 2025 (i.e., the SALT cap).

In July of 2018, four states with relatively high tax rates - New York, Connecticut, Maryland, and New Jersey - sued the federal government, alleging that the SALT cap was a departure from longstanding federal tax policy that violated the federalism principles in the U.S. Constitution. New York claimed that its residents who itemized deductions claimed an average SALT deduction of $21,943 before the introduction of the cap and predicted that between 2018 and 2025 its taxpayers will end up paying $121 billion more in federal taxes than they would have absent the SALT cap. Connecticut, Maryland, and New Jersey estimated that in 2018 alone their taxpayers paid $7.5 billion more to the federal government than they would have paid without the SALT cap.

The states filed a motion for summary judgment and sought an injunction barring the federal government from enforcing the SALT cap. They argued that the SALT cap exceeded federal tax power by verging into territory that is constitutionally reserved to the states. According to the states, the fact that every prior version of the federal income tax included a near-total SALT deduction was evidence of a constitutional limit on Congress's power to tax sums paid for state and local taxes, and any attempt to eliminate or substantially curtail the deduction would upset the constitutional balance of state-federal power. The states further contended that, based on the legislative history, the purpose and effect of the SALT cap was to coerce Democratic-leaning states with relatively high taxpayer-funded investments to bring their tax policies in line with the federal government's preferences for lower tax rates. Thus, the states argued that the SALT cap not only worked as an unlawful coercive effect in violation of the Tenth Amendment, it did so in a disparate manner that violated the constitutional principle of equal sovereignty among the states. The federal government filed a motion to dismiss, arguing that the court lacked jurisdiction and the states had failed to state a valid legal claim.

Analysis

The district court granted the federal government's motion to dismiss. The court found that the SALT cap was a valid exercise of Congress's broad taxing powers and was not unconstitutionally coercive. First, the court determined that it had jurisdiction over the case. The states had standing, in the court's view, because their argument that the SALT cap would diminish revenues was sufficiently concrete and particularized. The court also found that the states' claim was not barred by the Anti-Injunction Act and was not a political question because there were judicial standards for resolving the dispute.

On the merits, the court found that the novelty of the SALT cap did not necessarily imply a structural limitation built into the Constitution. The court found that Congress has broad powers to tax income and to grant exemptions from tax, and the states cited no constitutional principle that would bar Congress from exercising its otherwise plenary power to impose an income tax without a limitless SALT deduction. The court also found that the SALT cap did not infringe on the states' powers under the Tenth Amendment to impose taxes because the states remained free to exercise their power to tax however they wish, even if the SALT cap made certain state and local policies more attractive than others as a practical matter.

The court further concluded that the SALT cap did not unconstitutionally coerce the states into bringing their tax policies in line with federal preferences. According to the court, an otherwise valid federal law is not unconstitutional simply because it seeks to affect state policies. The court noted that, for example, withholding federal highway funds from states with a legal drinking age below age 21 is a valid exercise of Congress's authority because, although the law favors one policy choice over others, the ultimate decision of where to set the drinking age remains the prerogative of the states. In the court's view, the same reasoning applied in this case. The court said that the taxing power gives the federal government considerable influence in areas over which it cannot directly regulate. Just as Congress can impose conditions on federal spending in order to encourage federally preferred state-level policies, it may also influence the states by enacting a tax on an activity that it cannot otherwise control. Even if Congress enacted the SALT cap in order to exert downward pressure on state and local tax rates, the court reasoned, such a motive posed no constitutional problem as long as the states remained free, not merely in theory, but in fact, to set their own tax policies.

The court also found that the states failed to show that the claimed harms that resulted were sufficient to establish that the SALT cap was coercive. In the court's view, the effects of the SALT cap could not be isolated from all of the other tax effects of the TCJA. The court also found that the states did not plausibly allege that the effects would be so harmful that they would be left with no real option but to acquiesce in the federal government's preferred state and local tax policies. According to the court, the SALT cap simply required the states to exercise their sovereign powers, however they wished, to avert the cap's effects or else suffer the uncertain budgetary effects of doing nothing. The court concluded that, if being put to such an open-ended choice was coercion, most federal legislation would violate the Tenth Amendment.

For a discussion of the deductibility of state and local taxes, see Parker Tax ¶83,100.

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.

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