IRS Regulation Preventing SALT Cap Workarounds Upheld

(Parker Tax Publishing September 2025)

The Second Circuit held that the IRS did not exceed its statutory authority when it issued the rule in Reg. Sec. 1.170A-1(h)(3) that reduces the amount of a taxpayer's charitable-contribution deduction by the amount of any state or local tax credit that the taxpayer receives in consideration for the taxpayer's payment or transfer. The court interpreted Code Sec. 170 and its implicit quid pro quo principle to allow the regulation's prohibition of a tax deduction when the taxpayer receives a corresponding tax credit from the recipient of the donation. State of New Jersey, State of New York, State of Connecticut v. Bessent; Village of Scarsdale, N.Y. v. IRS, 2025 PTC 279 (2d Cir. 2025).

Background

In the Tax Cuts and Jobs Act of 2017 (TCJA) (Pub. L. 115-97), Congress enacted Code Sec. 164(b)(6), which capped federal income tax deductions of state and local taxes (SALT) for married couples and single taxpayers at $10,000. In response to this legislation, New Jersey, New York, Connecticut (the States), and the Village of Scarsdale, New York (Scarsdale) enacted laws designed to help residents recover some of the tax benefit they had enjoyed before the SALT cap was enacted. Through these state and local programs, residents may voluntarily contribute money to a state-administered charitable fund and receive a sizeable state or local tax credit in return. The States and Scarsdale envisioned that contributors could then deduct the full amount of their contributions from their federal taxable incomes under Code Sec. 170.

However, in 2019 the IRS finalized Reg. Sec. 1.170A-1(h)(3)(i) (the "Final Rule") upending these tax credit programs. Under the Final Rule, a taxpayer claiming a charitable-contribution deduction under Code Sec. 170(c) must reduce that deduction 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. In effect, this nullifies any federal tax benefit a taxpayer might derive from participation in a state or local tax credit program.

The States and Scarsdale sued the Treasury Department, the IRS, and their officers (the "Government") in the Southern District of New York, alleging that the IRS exceeded its statutory authority under Code Sec. 170 in promulgating the Final Rule and that the Final Rule is arbitrary and capricious under the Administrative Procedure Act. The district court granted summary judgment for the Government. Relying on the rule of deference to agency interpretations of ambiguous statutes under Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984), the court concluded that the IRS's interpretation of Code Sec. 170 is a permissible construction of the statute. The court also found that the Final Rule is not arbitrary and capricious. The States and Scarsdale appealed to the Second Circuit.

Analysis

The Second Circuit affirmed the district court. The Second Circuit applied the rule under Loper Bright Enterprises v. Raimondo, 2024 PTC 237 (S. Ct. 2024), which overturned Chevron deference and requires courts to use every tool at their disposal to determine the best reading a statute and resolve the ambiguity. Under Loper Bright, the Second Circuit interpreted Code Sec. 170 and its implicit quid pro quo principle to allow the Final Rule's prohibition of a tax deduction where the taxpayer receives a corresponding tax credit from the recipient of the donation.

The Second Circuit found that, while the term "contribution or gift" in Code Sec. 170 are not statutorily defined, the construction of the term has been shaped by caselaw and the relevant precedents have set forth an important quid pro quo principle underpinning the meaning and objective of Code Sec. 170. Generally, these precedents (for example, U.S. v. Am. Bar Endowment, 477 U.S. 105 (1986) have held that a payment of money and property to an entity recognized by Code Sec. 170(c) cannot constitute a charitable deduction if the contributor expects a substantial benefit in return. Under the quid pro quo principle, if in exchange for a donation a taxpayer receives a return benefit commensurate with the payment, or if obtaining the benefit is the reason for making the payment, then the payment is a quid pro quo rather than a gift. Thus, in order to claim a deduction under Code Sec. 170, a taxpayer must at minimum demonstrate that he or she purposely contributed money or property in excess of the value of any benefit he or she received in return.

The Second Circuit found that the Final Rule comports with the quid pro quo principle. A tax credit that offset's a taxpayer's state or local tax liability, the court reasoned, is an identifiable benefit because it substantially reduces the amount of money that the taxpayer is ultimately on the hook for, freeing up those funds for other expenses. The court observed that, unlike more subjective benefits (like esteem or influence), the benefit is easily calculable based on external features as it is a defined percentage of the contribution's dollar amount. From a donor's perspective, the practical consequence of a donation to New York's fund, for example, is indistinguishable from the state handing the donor a stack of cash worth 85 percent of her contribution. Further, the court found that the "charitable organizations" - the state-administered public funds designated by the States and Scarsdale - should not expect a contribution from a taxpayer unless the taxpayer receives a specific benefit in return. The court said this point was shown by the fact that, once the tax credit was rendered valueless to taxpayers by the Final Rule, contributions to the States' and Scarsdale's funds all but dried up.

The Second Circuit further held that the Final Rule is not arbitrary and capricious. The court found that the IRS adequately explained the differing treatment of tax credits and deductions and considered the disincentives to charitable giving posed by the Final Rule. The provision in the Final Rule exempting tax credits at or below 15 percent of a contribution's value is not arbitrary, in the court's view, because it accounts for the fact that the top marginal state and local tax rates generally do not exceed 15 percent. Finally, the court found that the IRS did not impermissibly focus on Code Sec. 164, an unrelated provision not intended by Congress to be considered under Code Sec. 170. In the court's view, the SALT cap was designed to raise revenue and there was nothing improper about the IRS considering that congressional objective in designing the Final Rule, even if the authority to promulgate the Rule derives from Code Sec. 170.

For a discussion of the limitation on charitable contribution deductions made in exchange for state tax credits, see Parker Tax ¶83,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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