Will the Cap on the State and Local Tax Deduction Survive Its First Legal Challenge? (article)
Four East Coast states recently sued the U.S. government alleging the federal cap on state tax deductions in the recent tax reform law interferes with the states’ sovereign authority to regulate taxation and fiscal policies. New York, New Jersey, Connecticut, and Maryland filed their complaint on July 17 to argue that the $10,000 cap is an unconstitutional exercise of federal powers intended to “coerce the plaintiff states into lowering their taxes and cutting the services those taxes support.” Many legal scholars believe that the case is unlikely to succeed.
The 2017 tax reform law, commonly known as the Tax Cuts and Jobs Act (TCJA), contained steep rate cuts for corporations, smaller rate cuts for individuals, and a new deduction for Qualified Business Income (QBI). The rate cuts and the QBI deduction will decrease federal revenues substantially, and in order to minimize the effect on the deficit, the law contains several measures to cut deductions. One such measure was a $10,000 limit on the total deduction for state and local income and property taxes. Together with the repeal of many itemized deductions, this measure is expected to generate $1.2 trillion in additional revenue. While this offsets only part of the total cost of the TCJA, it was a critical element of the TCJA’s passage under complicated budgetary procedures in the Senate.
The effect of this cap on taxpayers is not uniform across all of the states. Negative consequences are particularly acute in states with high income tax rates, high property tax rates, or both. States that have these high rates are pushing back in an attempt to mitigate the effects of the new limitation. This has taken different forms – from discussions on implementing a payroll tax in lieu of an income tax, to contemplating deductible charitable contributions in lieu of state tax payments. The lawsuit brought by New York, New Jersey, Connecticut, and Maryland is the latest effort to prevent the implementation of the limitation.
This lawsuit challenges the constitutionality of the deduction cap as a violation of the 10th and 16th amendments of the U.S. Constitution, and as an excessive use of Congressional powers granted by Article I, Section 8 of the Constitution. The 10th amendment states that all powers not specifically granted to the federal government are reserved for the states. The 16th amendment authorized the collection of an income tax. Article I, Section 8 outlines the powers granted to Congress.
The allegations in the Complaint are intertwined, but express an overall theme that Congress, in enacting this new limitation, exceeded its constitutional authority and impinged on the separation of powers integral to the Constitution. As New York Attorney General Barbara Underwood put it in a press release, “This cap is unconstitutional – going well beyond settled limits on federal power to impose an income tax, while deliberately targeting New York and similar states in an attempt to coerce us into changing our fiscal policies and the vital programs they support.”
The Complaint faces several large hurdles in order to prevail. The first hurdle is not related to any of the baseline arguments of the case. Instead, it is a procedural issue related to whether these states can pursue their claims in the first place. The federal government is likely to maintain that the “Anti-Injunction Act” bars federal courts from hearing challenges related to any assessment or collection of tax. If the federal government’s argument is successful, the case will likely be dismissed. This would leave the states with little or no recourse to further challenge the $10,000 cap, as the law does not provide an alternative mechanism for challenge.
However, some speculate that the lack of an alternative method to challenge the law may work in the states’ favor, because the court may be less inclined to dismiss the case if there is no proper forum to proceed. This is precisely the grounds upon which a similar proceeding advanced to the Supreme Court previously in South Carolina v. Regan. That case, however, involved different facts. South Carolina would have been required to actually issue bonds before its case could proceed, whereas the present case theoretically can be raised by affected individuals without prerequisite actions.
If the states are unsuccessful in their bid to challenge the law, individual taxpayers would need to challenge the $10,000 cap – a process replete with its own procedural hurdles. On the other hand, if the states’ complaint is not dismissed on procedural grounds, it will be up to the court to determine the merits of the case. Any potential ruling on the issue would likely be appealed by the losing party, which would prolong finality on the case. And any success the states may have is likely to be appealed all the way to the Supreme Court, which by then will probably have all nine Justices in place, and as result, a strong conservative majority.
Until these matters are resolved, the $10,000 state tax cap is the law, and individuals must report accordingly. If you have further questions about this case, contact your local CBIZ MHM tax professional and stay tuned for further updates as this and other tax reform issues develop.
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