With the Second Circuit having recently unanimously rejected a constitutional challenge to the $10,000 deduction cap on state and local taxes, that leaves an appeal to the Supreme Court, various state SALT “workarounds” or congressional action as hoped-for remedies.
In New York, Connecticut, Maryland and New Jersey v. Yellen, the four states sought to invalidate the SALT cap, alleging that it violated both the Tenth and Sixteenth Amendments. They alleged that the cap, enacted as part of the Tax Cuts and Jobs Act, is unconstitutional on its face under the Sixteenth Amendment, or, alternatively, that it violates the Tenth Amendment because it coerces the states to abandon their preferred fiscal policies.
“The Second Circuit said that nothing in the Sixteenth Amendment [which authorized the federal income tax] even requires a deduction for state and local taxes,” said Scott Smith, state and local tax national leader at BDO USA. “So the Sixteenth Amendment doesn’t prohibit the denial of a deduction.”
The court likewise rejected the states’ alternative argument — that the SALT deduction cap coerces them to abandon their preferred fiscal policies in favor of lower taxes, and reduced spending in violation of the Tenth Amendment.
“We are not persuaded that the cap unconstitutionally infringes on state sovereignty,” it stated. “Congress may use its taxing and spending authority to ‘encourage a state to regulate in a particular way,’ and may ‘hold out incentives to the states as a method of influencing [their] policy choices.’”
The states alleged that their citizens face a federal tax burden that will rise, that the value of their homes will fall, and their jobs will disappear.
“Specifically, the plaintiff states allege that their taxpayers ‘will pay hundreds of millions of dollars in additional federal taxes, relative to what they would have paid had Congress enacted the 2017 Tax Act without the cap.' We accept these allegations as true, and we assume without deciding that a claim or coercion under the Tenth Amendment can arise from injuries to a state’s citizens rather than to the state itself. Yet even then, we conclude that the plaintiff states have failed to plausibly allege that their injuries are significant enough to be coercive,” the court concluded.
“For now, the constitutional challenge has gone by the wayside,” observed Smith. “The next step is to petition the Supreme Court to review the decision.”
“It’s not clear what will happen in Congress,” he said. “There have been proposals floated to repeal the cap, or to raise the limitation to, say, $20,000. It’s caught up in the spending proposals and its impact on revenue raisers.”
Working around it
Meanwhile, 19 states have enacted “workarounds,” attempts to change what would otherwise be an individual deduction into a pass-through expense deduction, he noted. “Massachusetts is the most recent state to do this. On Sept. 30, 2021, Massachusetts overrode the governor’s veto to enact such a pass-through entity tax.”
There are generally two types of workarounds, according to Smith. “In one, the pass-through can elect to be taxed at the entity level, and partners or shareholders are not taxed on their share of entity income. In the second type, the entity elects to pay tax at the entity level. Partners and shareholders are still taxed on their share of pass-through income, but receive a credit for tax that the entity pays to the state.”
“The IRS gave its blessing to both types of statutes in Notice 2020-75 in November 2020,” he noted. “But it’s important to keep in mind that there are a number of state and federal tax issues that the notice did not address. We may have to wait for proposed regulations for questions on the federal issues to be answered.”
A state-level issue is whether, if you are a non-resident partner, your state of residence will grant you credit for your share of entity-level tax that the partnership pays. “Some will, some will not,” said Smith. “None of these statutes are alike. They all have their own nuances.”
