Blue states sue Treasury, IRS over rules blocking Trump tax law workarounds

New York, New Jersey and Connecticut on Wednesday announced a lawsuit challenging IRS and Treasury Department regulations that block workarounds to a controversial provision in President Trump’s 2017 tax law.

The lawsuit, filed in federal court in New York, is the latest example of leaders from blue states seeking to push back on the Trump tax law’s $10,000 cap on the state and local tax (SALT) deduction.

New York Gov. Andrew Cuomo (D) said in a statement that the lawsuit challenges “the IRS’s final rule that undermines states’ efforts to protect our taxpayers against the unprecedented, unlawful and politically motivated capping of the SALT deduction.”

The SALT deduction cap has been one of the most controversial portions of Trump’s tax law. Politicians on both sides of the aisle from high-tax, Democratic-leaning states have argued that the SALT deduction cap hurts their constituents and challenges their jurisdictions’ ability to provide public services to their residents.{mosads}

Following the passage of the GOP tax law in late 2017, New York, New Jersey and Connecticut made changes to their own tax laws in an effort to allow their residents to circumvent the SALT deduction cap.

The workarounds involved allowing residents to make donations to state and local funds in exchange for receiving state tax credits. The intention was for the residents to be able to deduct the donations as charitable deductions on their federal tax returns.

But last month, Treasury and the IRS issued final rules designed to block the workarounds. Under the regulations, taxpayers will only be able to take federal charitable tax deductions for contribution amounts that exceed the amounts of state tax credits they received.

New York, New Jersey and Connecticut argue in their lawsuit that the rules violate the Administrative Procedure Act because they are inconsistent with the section of the federal tax code about deductions for charitable contributions. The states also argue that the rules violate the Regulatory Flexibility Act because the IRS didn’t publish a regulatory flexibility analysis.

The states are asking a judge to set aside the rules.

“The final rule is contrary to law and arbitrary and capricious,” they said in their lawsuit. 

New York, New Jersey and Connecticut, along with Maryland, also filed a lawsuit last year challenging the constitutionality of the SALT deduction cap. That lawsuit is ongoing.

Local governments in the New York City suburbs are also challenging the Treasury and IRS regulations. The village of Scarsdale, N.Y., with the backing of a host of other suburban municipalities, filed its own lawsuit on Wednesday challenging the rules, a lawsuit which has similarities to the one filed by New York, New Jersey and Connecticut.

The lawsuits were filed one day after a group of Senate Democrats, led by Senate Minority Leader Charles Schumer (D-N.Y.), filed a resolution to disapprove of the IRS rules under the Congressional Review Act (CRA).

Senators can make a motion to proceed on a CRA resolution if it has written support from at least 30 senators. But the resolution is unlikely to be adopted, since the Senate is controlled by Republicans who support the SALT deduction cap.

Republicans included the SALT deduction cap in their 2017 tax law in order to raise revenue to pay for tax cuts elsewhere in the legislation and to limit the tax code from subsidizing high state taxes. They have encouraged blue-state politicians who dislike the cap to cut state and local taxes.

Key GOP lawmakers have expressed support for the IRS regulations on the workarounds. And they have noted that most people in high-tax states received a tax cut under Trump’s law, even with the SALT deduction cap.

Rep. Kevin Brady (Texas), the top Republican on the House Ways and Means Committee and a key author of the GOP tax law, predicted that the blue states’ new lawsuit would not be successful. 

“File away. They are going to fail,” he said.

Brady added that he thinks that “those states and cities want a green light to tax their local citizens unmercifully, and with the hope that someone else will pay for it.”

Updated: 4:42 p.m.