Second Circuit Confirms SALT Cap Workaround Ban

The higher $40,000 cap phases out for taxpayers with modified adjusted gross income (MAGI) that exceeds $500,000 (with a minimum $10,000 floor regardless of income). The cap will be reduced by 30 percent of the excess (if any) of the taxpayer's MAGI over the threshold amount (which will also be adjusted for inflation, from $500,000 in 2025 to $505,000 in 2026).

Because of this phase-out, higher-income taxpayers (who, of course, are also likely to have the highest SALT deductions) may see limited usefulness from the increase to $40,000—thus, the value of using state-level workarounds remains.

In an effort to offset the federal-level SALT cap, New York, New Jersey, Connecticut and the town of Scarsdale created programs that would allow taxpayers to contribute to state-sponsored charities and receive state or local tax credits for those contributions. While the IRS has not challenged pass-through entity tax (PTET) workaround strategies, it has issued regulations that require taxpayers who take federal charitable contributions deductions to reduce the deduction by the amount of any state and local tax credit the taxpayer received for the contributions.

The states (and Scarsdale), in turn, sued to overturn these regulations based on the argument that they were arbitrary and capricious under the Administrative Procedure Act (APA) and that the IRS exceeded its statutory authority with the regulations.

The New York Challenge and Second Circuit Case

Initially, the district court analyzed the plaintiffs’ claims and found that only New York and Scarsdale had standing to sue (because New Jersey and Connecticut had paused their programs following the release of IRS regulations). The court analyzed the regulations under the now-overturned Chevron standard and granted summary judgment to the IRS. The plaintiffs appealed to the Second Circuit.

The court first determined that the Ant-Injunction Act did not prohibit the case from proceeding. The Ant-Injunction Act generally prohibits suits that are filed for the sole purpose of prohibiting the federal government from collecting taxes. The court allowed the case to proceed despite Ant-Injunction Act challenges because the plaintiffs had no alternative route for challenging the IRS regulations.

The court also held that the IRS did not exceed its statutory authority by treating the state-level tax credits as benefits that the taxpayers would receive in return for the charitable contributions (charitable contribution deductions are generally not permitted to the extent that the taxpayer receives some benefit in return for the contribution). Because the taxpayers received benefits in return for their contributions, the court found that the contributions more closely resembled trades and were less similar to gifts.

The court then considered the IRS’ statutory interpretation of IRC Section 170 under the new Loper Bright standard following the overturning of the Chevron defense doctrine. The court concluded that the IRS was correct in its interpretation. Further, the court found the IRS regulations were not arbitrary and capricious under the APA because the IRS had demonstrated that it considered all relevant factors, provided detailed explanations for its policy choices and drew a rational, informed connection between their rule and the facts.

The crux of the decision was that the state and local tax credits amounted to a benefit received in return for the charitable contribution—so it was proper for the IRS to require that any otherwise-available federal deduction be reduced by the value of the tax credit.

Conclusion

The Second Circuit decision is not entirely surprising. The IRS has been clear that SALT cap workarounds involving the federal charitable contributions deduction will not be permitted. The government, however, has not touched the PTET strategy—but taxpayers should pay close attention to ongoing IRS attention with respect to these workaround efforts.