Second Circuit Rejects States' Challenge to SALT Workaround Rules

Forbes

5 days ago

In a recent case, the U.S. Court of Appeals for the Second Circuit addressed and rejected arguments by several States who challenged updated regulations that would prohibit many of the state and local tax (SALT) deduction workarounds passed in the wake of the Tax Cuts and Jobs Act.
Prior to the law known as the Tax Cuts and Jobs Act, taxpayers could deduct, with no dollar limit, their state and local taxes on their federal taxes (if they itemized deductions). As part of the Tax Cuts and Jobs Act (Pub. L. No. 115-97), though, the state and local tax deduction was capped at $10,000. (Importantly, this limit has been changed under the 'One Big Beautiful Bill Act,' see Pub. L. 119-21, § 70120).
Not surprisingly, this limit greatly affected taxpayers who reside in states that generate large SALT liabilities. Those states tried to implement various workarounds to the federal SALT cap. The quintessential example of these workarounds was the creation of a state charitable fund (or a local version of the same), which could accept payments from residents, who would then receive a state or local tax credit.
In the case, the Second Circuit provided an example of how these workarounds typically worked. For example, consider a New York taxpayer who owes $200,000 in state taxes. That taxpayer could, instead, voluntarily pay $200,000 to the New York Charitable Fund and receive a corresponding state-tax credit of $170,000 (as New York's program offered an 85% tax credit). After this credit, the remaining state tax burden would be $30,000.
Importantly, though, when filing her federal taxes, the taxpayer could deduct the $200,000 paid to New York state not as a state or local tax, but rather as a charitable contribution—as charitable contributions are not subject to SALT cap. This, of course, would correspondingly reduce the taxpayers federal tax liability (due to the deduction).
In 2018, the IRS issued proposed rulemaking to disallow the charitable-deduction workaround. In essence, the proposed rule required that taxpayers would have to reduce their federal charitable deduction for the amount of any state or local tax credit received 'in consideration for the taxpayer's payment or transfer.' 83 Fed. Reg. 43,564. After public comment, the Final Rule and updated regulations under § 170 (the charitable deduction section) likewise provided that, with a limited exception, 'if a taxpayer makes a payment or transfers property to or for the use of an entity described in section 170(c), the amount of the taxpayer's charitable contribution deduction under section 170(a) is reduced by the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer's payment or transfer.' Treas. Reg. § 1.170A-1(h)(3)(i).
Going back to the earlier example, under the Final Rule, then, that taxpayer would be allowed only a $30,000 charitable deduction (not $200,000).
The Final Rule, moreover, distinguished between state and local tax credits (like in the example above) and state and local tax deductions. Of course, tax credits are more valuable than deductions because tax credits reduce tax liability dollar for dollar. Concerning deductions, the Final Rule provided that, in general, '[i]This summary will not review the entire procedural posture of the related cases. As related to the substantive tax matter, the district court held that the federal government did not exceed its authority in issuing the Final Rule. The government plaintiffs (e.g., the States) appealed to the Second Circuit. On appeal, the Second Circuit had to address several issues in addition to the substantive tax merits, such as Article III standing and the Anti-Injunction Act, which will not be addressed here.
Let's focus on the core tax claims. The first claim was that the Final Rule was contrary to § 170, which is the charitable deduction section.
The crux of § 170 for a charitable contribution is that the taxpayer cannot receive a quid pro quo—because, if so, then the payment does not really represent a contribution or a gift. Indeed, the Supreme Court has noted that, under § 170, a payment 'generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return.' United States v. Am. Bar Endowment, 477 U.S. 105, 116 (1986). Thus, to the extent a taxpayer receives benefit that is commensurate with the payment, it really isn't a gift—it is a quid pro quo.
Now, of course, the taxpayer may receive some subjective value or benefit from donating, like satisfaction, reputation, or even some tangible tax benefit. The analysis, though, according to the Second Circuit, should focus on whether the transaction is structured as a quid pro quo. Indeed, a sister court of appeals had earlier noted that, '[t]he test is not the economic character of what the payor receives but whether there is a specific, measurable quid pro quo for the donation in question.' Graham v. Comm'r, 822 F.2d 844, 849 (9th Cir. 1987).
In sum, the Second Circuit found that the Final Rule complied with the historic quid pro quo principle of § 170. Specifically, it found that the tax credit was an 'identifiable benefit,' and, unlike other subjective benefits, it was 'easily calculable based on external features.'
The Second Circuit then addressed the argument that motivation should not deprive a taxpayer of the benefits of § 170. Under this argument, it should not be the case that a desire to obtain a tax credit disqualifies the taxpayer from the credit—if so, then other charitable gifts (or even other tax credits or deductions) could be in jeopardy. The Second Circuit reasoned that the argument misstates the quid pro quo principle. The heart of the quid pro quo analysis in this case, according to the Second Circuit, is on the 'outward, quantifiable features of the transaction.' The Second Circuit said that the transaction represented essentially a 'this-for-that' transaction, which is the quintessential 'reciprocal exchange' that disqualifies a payment under § 170. As well, the Second Circuit emphasized that it was not the taxpayer's desire to claim the § 170 deduction that was disqualifying, but rather it was the receipt of the state tax credit.
The Second Circuit also held that the Final Rule was not invalid because it treated state tax credits different from state tax deductions. The Second Circuit also rejected some of the other arguments made, such as the quid pro quo principle applies only in the exchange is for goods and services. The Second Circuit also considered and then rejected arguments that the Final Rule was arbitrary and capricious.The case is New Jersey v. Bessent; Village of Scarsdale v. IRS, Docket Nos. 21-1499-cv(L); 24-1503-cv(CON) (2d Cir. Aug. 13, 2025), which you can read here.
This is only a summary of the case and some portions—including facts, issues, citations, or analysis—may have been omitted or edited; if you need advice in this area, please review the case in its entirety and consult an attorney.