TaxProf Blog op-ed: Short- and Long-Term Implications of Treasury’s Final SALT Regulations, by Daniel Hemel (Chicago):
The Treasury Department’s final regulations on contributions in exchange for state and local tax credits came as no surprise to anyone who has watched this story unfold. The regulations, released yesterday, provide that a payment to a government entity or a charitable organization will not be treated as a deductible charitable contribution if the donor receives a state or local tax credit exceeding 15 percent of the donation’s fair market value. The final rule largely tracks the draft version released in August 2018 and vetted in a months-long notice-and-comment process. If there is any hard news story to emerge from yesterday’s release, it’s that Treasury (thankfully) did not cave to pressure from private-school voucher advocates to create a carve-out for programs that preexisted the December 2017 tax law’s $10,000 cap on state and local tax deductions.
It’s sometimes hard to see the big picture when one is too involved in an issue, and perhaps that applies to me here. I should say—in the interest of full disclosure—that I have advised lawmakers in New York and California about state responses to the $10,000 SALT cap, and I take some parental pride in one particular New York tax law change that was unaffected by yesterday’s regulations. To lay all my cards on the table, I’ll add that I think states like New York and California are acting entirely appropriately in trying to preserve their residents’ ability to pay for public goods and services with tax-deductible dollars. Public officials have a responsibility to look out for their constituents’ interests, and the $10,000 SALT cap—which will make it appreciably harder for states like New York and California to raise revenue from high-income residents to pay for schools, hospitals, and other public services—is no doubt damaging to the interests of New Yorkers and Californians, whatever one thinks of the provision from a federal tax policy perspective.
This is not the time or place to relitigate the SALT cap issue though. (I have a lot more to say about the subject in a forthcoming Tax Law Review article—the draft of which is available here.) I will try instead, at Paul’s prompting, to highlight a few of the immediate and long-term implications of yesterday’s announcement, doing my best not to let my own views color my analysis (though conscious that, of course, one’s own views always color one’s analysis).
— (1) “See You in Court.” Treasury’s promulgation of its final rule allows states, municipalities, and individual taxpayers to move ahead with long-planned lawsuits challenging the agency’s interpretation of the federal tax statutes. These likely challengers should, in fact, be quite pleased about yesterday’s announcement, because before it they were stuck in a sort of procedural purgatory: taxpayers were reluctant (though not entirely unwilling) to utilize state and local charitable credit programs, but any legal challenge to Treasury’s interpretation would have been dismissed by the courts as unripe.
As readers of this blog well know, challenges to Treasury regulations by individual taxpayers generally must be brought in Tax Court or through refund actions in the federal district court or the Court of Federal Claims. Challenges by states, in contrast, can potentially proceed on a faster track. In South Carolina v. Regan, the Supreme Court held that the Tax Anti-Injunction Act’s bar on pre-assessment challenges to federal tax laws did not apply to South Carolina’s suit to invalidate a federal tax law change that ended the tax-exempt treatment of state-issued bearer bonds. As the Court reasoned, South Carolina itself would never have an opportunity to challenge the federal law in a Tax Court petition or refund action, as the state does not itself pay federal taxes. Thus, the Anti-Injunction Act’s general rule—that challenges to federal tax laws must wait for Tax Court petitions and refund actions—cannot apply when the state is the aggrieved party.
South Carolina v. Regan is almost directly on point here. The distinction between South Carolina’s injury (loss of exemption) and the injury to states and municipalities arising from yesterday’s rule (loss of deduction) is, as far as the Tax Anti-Injunction Act goes, a distinction without any obvious difference. Thus the hurdle for state and municipal challengers to Treasury’s rule will likely not be jurisdictional. The closer question is whether there is anything in yesterday’s rule that warrants judicial invalidation.
The state and municipal challengers’ strongest argument is probably along the following lines: Section 170 allows a deduction for “charitable contributions.” The language is ambiguous as to whether a contribution is “charitable” if it results in a state or local tax benefit. Under Chevron U.S.A. v. Natural Resources Defense Council and Mayo Foundation for Medical Education and Research v. United States, courts must defer to Treasury’s interpretation of that ambiguous language if “the agency’s answer is based on a permissible construction of the statute.” So if (though only if) Treasury’s position is a permissible interpretation of section 170, it passes administrative law muster.
It would no doubt be “permissible” for Treasury to say, as the IRS used to maintain, that a contribution can be “charitable” regardless of any state or local tax benefits that the donor receives. It would also likely be a “permissible” interpretation of section 170’s language to say that the amount of any charitable contribution deduction must be reduced by the value of state and local tax benefits received in exchange. But there is simply no way to interpret the words of section 170 to mean what Treasury wants them to mean: that the entire amount of a payment is “charitable” if it results in a state or local tax deduction or a state or local tax credit of less than 15 percent, and yet once the credit crosses the 15% threshold, the deductible amount must be reduced cent for cent by the amount of the state tax credit. That is simply not an interpretation that once can plausibly glean from the ambiguous adjective “charitable.”
I’ll leave it to others to assess the strength of this argument. Much will depend upon the weight that a judge ascribes to Chevron/Mayo deference. It is at least interesting to note that the judges favored by the Trump administration so far tend to be Chevron skeptics, which here (as elsewhere) generates tension between the conservative movement’s jurisprudential inclinations and the Trump administration’s litigating positions.
— (2) See You in Nevada. A second implication of Treasury’s effort to shut down state SALT cap responses is that high-income taxpayers in high-tax states will have an added incentive to pursue state tax minimization strategies. Recall that under pre-2017 tax law, the marginal after-federal-tax cost to a top-bracket taxpayer of $1.00 in state or local tax payments was $0.604. Now, it is $1.00. That’s an increase of nearly 66 percent. It would be quite surprising if a 66 percent tax increase did not trigger taxpayer responses.
The most straightforward (though not necessarily the easiest) way to avoid high state and local taxes is to move to a low-tax jurisdiction. Most San Franciscans do not, of course, want to wake up tomorrow in Las Vegas, though for those on the fence, this development might be enough to push them through the Donner Pass. I would expect, though, that the increase (on an after-federal-tax basis) in state and local taxes will add to the attractiveness of Nevada incomplete-gift nongrantor trusts (“NINGs”), which allow high-income Californians (and high-income residents of most other states) to avoid state income tax liability on most capital gains, dividends, and interest income.
Other strategies to skirt the effect of the $10,000 SALT cap are somewhat less likely to take off. Some taxpayers might move real estate holdings into nongrantor trusts, each of which will be subject to its own $10,000 SALT cap, but the strategy is cumbersome and the tax benefits are not huge ($3,700 per year per trust). Condo associations might consider converting (in some cases reverting) back to co-ops, which—due to an apparent drafting error—appear to be exempt from the $10,000 SALT cap, though if conversations with neighbors around my Chicago condo building are any indication, relatively few folks here are enthusiastic about the possibility of going co-op.
— (3) Alternatives to Charitable Credit Programs. Treasury’s crackdown on state and local charitable credit programs is also likely to spark renewed interest in other state SALT responses. These include efforts—already enacted in Connecticut and Wisconsin—to allow passthrough business owners to shift some personal state tax liability to the entity level (a strategy about which I’m somewhat skeptical). A more promising approach, in my view, is to shift tax liability from employees to employers, who are not bound by the $10,000 SALT cap. New York is the only state to move forward with this latter approach, and hundreds of employers in the state are already operating under it. (See here for more about how this might work.) The fact that other states have not followed New York’s lead on this is rather surprising to me, though the new Treasury rule might motivate more states to do so.
Another possibility—pointed out on Twitter by Carl Davis of the Institute on Taxation and Economic Policy—is that more states may allow taxpayers to satisfy state tax liabilities through gifts of appreciated property, thereby avoiding federal capital gains tax. For a top-bracket taxpayer, satisfying $100 of state tax liability through the gift of a zero-basis stock saves $23.80 in federal income taxes that would be due if the taxpayer sold the stock and then paid the state tax. That’s not quite as good as a federal income tax deduction worth $37, but it may be an attractive arrangement for states such as California, where lots of taxpayers will hit the $10,000 SALT cap and lots of them have low-basis stock in their portfolios.
Beyond the immediate implications of Treasury’s regulations, a few potential longer-term realities and possibilities deserve note:
— (1) 2020 Foresight. The fight between blue state leaders and Treasury over the states’ SALT responses has injected the $10,000 cap into the 2020 presidential debate. Senators Cory Booker, Kamala Harris, and Kirsten Gillibrand all have signed on as cosponsors to legislation that would repeal the cap. Other leading presidential candidates—including Senators Bernie Sanders and Elizabeth Warren—have not, raising the possibility that SALT might be a point of policy differentiation among Democratic contenders. Several of the high-SALT states—including Connecticut, New Jersey, and New York—have primaries relatively late in spring 2020, though depending on how the race shakes out, that could make SALT cap-affected voters in those states even more pivotal in choosing the next Democratic nominee.
Ultimately, the fate of the SALT deduction will be determined not by any Treasury regulation, but by electoral and congressional politics. The $10,000 cap expires by its own terms at the end of 2025. For proponents of a full deduction, the looming court battle—while still significant—may turn out to be less impactful than the battle in the court of public opinion.
— (2) An Emboldened Treasury? A striking aspect of the new Treasury regulations is that the only authority the agency cites for its rule is 26 U.S.C. § 7805, which empowers the Treasury secretary to “prescribe all needful rules and regulations for the enforcement” of the Internal Revenue Code. If section 7805 is enough to authorize Treasury’s bright-line 15-percent rule here, then there is a lot more line-drawing that Treasury could do elsewhere to shut down tax shelters of all stripes. One upshot of the court battle over the SALT regulations is that it might lead to somewhat greater clarity regarding the scope of Treasury’s section 7805 authority, perhaps emboldening the agency under a future administration to adopt a more aggressive regulatory approach in other domains.
— (3) First Amendment Implications. Most readers of this blog are primarily interested in the tax implications of yesterday’s development. But First Amendment scholars should take note as well. Many of the dollar-for-dollar charitable credit programs established by states to fund private schools were adopted not for purposes of tax arbitrage, but for purposes of First Amendment arbitrage: the charitable credits gave states a way to support religious institutions without running into potential objections under the First Amendment Establishment Clause or state constitutional “Blaine amendments, which prohibit most states from providing direct aid to religious institutions.
Of course, nothing stops a state from maintaining a charitable credit program that produces purely state tax benefits, with no federal deduction available for contributions. But since yesterday’s regulations make charitable credit programs a somewhat less financially attractive Establishment Clause/Blaine amendment workaround, they up the incentive for states to support religious institutions with direct aid, thus setting up a number of potential constitutional confrontations (both over the scope of the federal constitution’s Establishment Clause and over the alleged federal constitutional infirmity of state Blaine amendments). These confrontations may ultimately occur anyway. But insofar as yesterday’s regulations speed them along, the SALT cap fight could have implications that extend far beyond the world of tax.