Second Circuit denies SALT cap workaround

The Second Circuit affirmed a district court’s decision denying a challenge by three states and a New York village to IRS regulations prohibiting a federal charitable deduction for the amount of a related state tax credit.

Facts: The Tax Cuts and Jobs Act, P.L. 115-97, established that itemized deductions for state and local taxes (SALT) are capped at $10,000 ($5,000 for married taxpayers filing separately) (increased for 2025—2029 to $40,000 ($20,000 for married taxpayers filing separately) by H.R. 1, P.L. 119-21, known as the One Big Beautiful Bill Act). In response, New Jersey, New York, and Connecticut, as well as the village of Scarsdale, N.Y., enacted programs that enabled residents to make contributions to public charitable funds administered on a state or local level. These programs allowed residents of these states, as well as Scarsdale, to receive state or local tax credits for these contributions. These credits normally ranged between 85% and 95% of the contribution amount and were designed to help taxpayers offset the federal SALT cap by claiming these contributions as federal charitable contribution deductions under Sec. 170.

In August 2018, the IRS issued a proposed notice of rulemaking (REG-112176-18, 83 Fed. Reg. 43,563) and finalized it the next year (T.D. 9864, 84 Fed. Reg. 27,513). The final regulations, which took effect Aug. 12, 2019, require a taxpayer who claims a federal charitable contribution deduction to reduce that deduction by the amount of any state or local tax credit the taxpayer received. As a result, there was a sharp decline in contributions to the programs already operating. For example, New York’s designated public fund raised $78.7 million from 487 contributions before the proposed regulations but only $25,416 from 17 contributors in 2019, a decrease of more than 99.9%. Scarsdale experienced a similar decline, with its fund having received more than $500,000 in 2018 and no contributions after the proposed regulations. In states including New Jersey and Connecticut, lawmakers either delayed or halted similar initiatives.

New Jersey, New York, Connecticut, and Scarsdale filed suit in district court, arguing that the IRS exceeded its statutory authority in promulgating the final regulations and that the regulations were arbitrary and capricious under the Administrative Procedure Act (APA). The district court found that, while Scarsdale and New York state had standing, New Jersey and Connecticut did not. It then, analyzing the regulations under the standard of Chevron U.S.A. Inc. v. National Resources Defense Council, Inc., 467 U.S. 837 (1984) (subsequently overturned by Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024)), found that the IRS did not exceed its statutory authority in promulgating the final regulations, which were not arbitrary and capricious under the APA, and granted summary judgment to the federal government (New Jersey v. Mnuchin, No. 19 Civ. 6642 (S.D.N.Y. 3/30/24)). The states and Scarsdale appealed to the Second Circuit.

Issues: The states raised several interconnected legal issues concerning statutory interpretation, standing, and administrative law review. First, the Second Circuit had to determine whether the states and village had standing to challenge the final regulations, given that New York and Scarsdale had implemented programs and documented lost contributions, while New Jersey and Connecticut had planned but not finalized theirs. The Second Circuit held that the case could proceed, as New York and Scarsdale had demonstrated concrete financial harm in the form of lost revenues, which was sufficient to demonstrate a “personal stake” in the case for all parties (Biden v. Nebraska, 600 U.S. 477 (2023)).

The Second Circuit also had to consider whether the Anti-Injunction Act barred the suit since the states’ claims concerned federal tax collection (Sec. 7421). The Anti-Injunction Act is a federal law that generally restricts taxpayers from filing lawsuits for the sole purpose of preventing the federal government from collecting taxes. However, the court noted that an exception applies where Congress has not provided the parties challenging regulations an alternative statutory avenue to litigate claims on their own behalf (citing South Carolina v. Regan, 465 U.S. 367 (1984), and New York v. Yellen, 15 F.4th 569 (2d Cir. 2021)). The court, finding that the states did not have an alternative statutory procedure to challenge the final regulations, held that the Anti-Injunction Act did not prevent the lawsuit.

The core issue in the states’ and Scarsdale’s case, though, was whether the IRS exceeded its statutory authority under Sec. 170, which enables taxpayers to deduct charitable contribution payments made during a given tax year. The states argued that the IRS had exceeded its statutory authority by treating the credits tied to these contributions as return benefits that reduce the federal charitable contribution deduction. The Second Circuit, citing case law, including American Bar Endowment, 477 U.S. 105 (1986), and Hernandez, 490 U.S. 680 (1989), analyzed how “benefits” and “gifts” are understood under Sec. 170. According to the court, these cases showed that receiving value back in exchange for a donation is not truly a charitable gift. Instead, these transactions are more like a trade, or a quid pro quo. While the states argued that the tax benefits derived from the charitable contribution arrangement were not a quid pro quo, the court found that precedent held that the benefits “need not be financial” to be considered a monetary quid pro quo (Scheidelman, 682 F.3d 189, 199 (2d Cir. 2012)).

The Second Circuit also considered the statutory interpretation of Sec. 170 in light of Loper Bright. Under Loper Bright, courts must use every tool to identify the best understanding of the statute rather than deferring to a governmental agency for an answer. Therefore, the court undertook an independent construction of Sec. 170 to determine if the regulation requiring taxpayers to reduce charitable deductions by the value of the credit reflects the best reading of Sec. 170 and the quid pro quo principle. The court concluded that the final regulations correctly interpreted Sec. 170 with respect to the tax credits and that the IRS did not exceed its statutory authority.

Finally, the court had to address whether the final rule was arbitrary and capricious under the APA’s arbitrary-and-capricious standard. The APA’s standard grants the courts the ability to overturn an agency’s decision if it is deemed “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” (5 U.S.C. §706(2)(A)). In this context, the court had to evaluate whether the IRS adequately explained the distinction between tax credits and tax deductions, considered important aspects such as the impact on charitable giving and administrative concerns, and offered a rational connection between the facts and its policy choice. Applying the framework found in Motor Vehicle Manufacturers Association of U.S., Inc. v. State Farm Mutual Insurance Auto Company, 463 U.S. 29 (1983), the court analyzed whether the IRS had considered the relevant factors, provided satisfactory explanations for its policy choices, and put across a rational connection between the facts and the rule adopted, which the court found it had.

Holding: The court concluded that contributions generating state tax credits constitute transactions in which donors receive a return benefit. The court also found adequate and rational distinctions between tax credits and tax deductions and concluded that the regulation was neither arbitrary nor capricious under the APA. As a result, the court affirmed the judgment of the district court.

• State of New Jersey v. Bessent, No. 24-1499-cv(L) (2d Cir. 8/13/25)

— Matthew Tardif is a student in the Charles H. Dyson School of Applied Economics and Management at Cornell University. Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.