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States Again Sue IRS Over Federal Tax Law

Connecticut, New Jersey, New York and a local government coalition allege that a new IRS rule unlawfully puts an end to their tax reform workarounds.

IRS headquarters
The Internal Revenue Service building in Washington, D.C.
Three states and a coalition of local governments are suing the IRS and Treasury Secretary Steven Mnuchin over new regulations that block them from circumventing limits on tax deductions imposed by the 2017 federal tax overhaul. 

Two separate lawsuits were filed Wednesday over IRS regulations finalized last month that ban residents from fully deducting their charitable contributions if they receive tax credits in return. Three Democratically controlled states, Connecticut, New Jersey and New York, have filed a joint lawsuit over the rules. A separate suit has been filed by the Coalition for the Charitable Contribution Deduction, a New York coalition of localities, school districts and professional organizations.

The lawsuits allege that the IRS overreached its authority when it closed states’ charitable deduction loopholes. That's because the ban applies to long-established state-run trusts that give out tax credits in exchange for donations for things like environmental preservation and charter schools. Dozens of states -- not just high-tax states or those controlled by Democrats -- have these trusts.

The federal rule targets any donation from an individual who has already hit the $10,000 state and local tax deduction cap. In addition to the three states in the lawsuit, Oregon has also approved a charitable deduction workaround and similar proposals were pending in California and Illinois.

In announcing the suit Wednesday, New Jersey Gov. Phil Murphy accused the IRS of “weaponizing” the federal tax code for the sake of politics. “We followed decades of precedent,” he said. In writing its regulations, he added, “the agency relied on multiple distinctions and multiple lines of reasoning that do not fit with the tax code and are simply irrational.”

For its part, the IRS points to two established policies to make its case: substance-over-form, which says a taxpayer is bound by the economic substance of a transaction even if the substance varies from its legal form. In other words, all this shifting around of who's paying the tax doesn't change the fact that it started out as an income tax.

The other policy the IRS cites is quid pro quo, which applies when someone donates to a charity and receives a small gift in return. That person is supposed to subtract the value of that gift when claiming the charitable contribution on tax forms.

In its complaint, the Coalition for the Charitable Contribution Deduction warned that state and municipal charitable funds nationwide “will continue to suffer irreparable harm” unless the IRS rules are overturned. It noted that Scarsdale, N.Y’s charitable gifts reserve fund received more than $500,000 in 2018 contributions prior to the new IRS rule. Of that, $25,000, or 5 percent of these contributions, was leftover after tax credits to spend on local priorities and administering the fund. Since the IRS rules went into effect, however, no further contributions have been made, which the suit argues is depriving Scarsdale of thousands of additional charitable dollars.

The lawsuits come exactly one year after Connecticut, Maryland, New Jersey and New York sued the federal government over the tax law itself. That ongoing suit argues that the cap on deductions for state and local taxes (SALT) is unjust because it violates the U.S. Constitution’s Equal Protection Clause and the 10th Amendment, which protects states’ rights.

Tim Foley, a spokesman for the coalition, says it’s unlikely the new lawsuits will be consolidated into the existing one because they target different issues. One is the constitutionality of the SALT cap, the other is the charitable deduction rule. “Let’s say the constitutional lawsuit succeeds and removes the cap on SALT,” Foley says. “That’s obviously helpful, but it doesn’t do anything for the changes being made to the charitable deduction for programs that predate the passage of the federal law.”

Given that the IRS and Congress have nipped and tucked the state and local tax deduction several times over the past 50 years, observers think it’s unlikely the constitutional argument will prevail.

Liz Farmer, a former Governing staff writer covering fiscal policy, helps lead the Pew Charitable Trusts’ state fiscal health project’s Fiscal 50 online resource.
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