Connecticut this week joined New York, New Jersey, and Maryland in suing the federal government over new limits on state and local tax deductions.

The suit, filed Tuesday in Federal District Court in Manhattan, calls the tax changes an "unconstitutional assault" on states' rights.

Those limits on SALT deductions were a major component of the federal tax overhaul approved by Congress last year and significantly impact taxpayers in a number of high-tax states.

The lawsuit focuses on the new $10,000 cap on SALT deductions and seeks an injunction against enforcement of that limit.

Maryland has the highest percentage of taxpayers taking the SALT deductions—46% in 2015—while 41% of Connecticut and New Jersey taxpayers claimed state and local taxes on their federal returns that year.

According to the IRS, over 700,000 Connecticut taxpayers claimed $13.6 billion in state income and local property tax deductions on their 2014 federal returns—or an average $19,500.

States Skirt Federal Changes

Connecticut's state income and property taxes are among the highest in the country. State and local governments rely heavily on those revenues to fund services and operations, including public sector employee compensation and retirement benefits.

The lawsuit claims federal tax law now "deliberately seeks to compel certain states to reduce their public spending. This court should invalidate this unconstitutional assault on the states' sovereign choices."

The four states also argued that the SALT deduction "ensures that states have the prerogative to determine the appropriate mix and level of public investments to make on behalf of their residents, as well as the authority to choose how to raise revenue to pay for those investments."

The lawsuit claims federal tax law now deliberately seeks to compel certain states to reduce their public spending.
Lawmakers in New York, New Jersey, and Connecticut all passed legislation this year to allow taxpayers to circumvent the cap on deductions, with a number of other states also considering similar bills.

Connecticut approved several measures, including enabling cities and towns to allow taxpayers to make voluntary payments to municipally approved charitable organizations, in exchange for a tax credit against their state and local taxes.

Those payments could then be deducted as charitable deductions, which are not capped, from federal income taxes.

Pass-Through Entity Tax

Connecticut also adopted a new 6.99% state income tax on pass-through entities, usually small businesses registered as S corporations or limited liability partnerships.

That tax is offset by a new personal income tax credit for small business owners that effectively neutralizes the impact of the federal tax changes.

[Those changes also created widespread confusion among small business owners, particularly around the recharacterization of estimated quarterly tax payments.]

The IRS pushed back almost immediately against state efforts to skirt federal law, announcing in May that it will issue proposed regulations addressing SALT deductions, casting doubt over the future of Connecticut's approach.

"Despite these state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purpose," the IRS notice said.