An appeals court has rejected the latest attempt by Connecticut and three other states to overturn federal income tax limits on state and local tax deductions.

The 2nd U.S. Circuit Court of Appeals in Manhattan upheld a 2019 U.S. District Court ruling that the federal government has the authority to cap income tax deductions.

In an unanimous decision Oct. 5, the three-judge panel called the case a “non-justiciable political question,” saying it was “not persuaded” the cap was unconstitutional, as the states' lawsuit claimed.

Judge Raymond Lohier wrote in the court's opinion that the four states “point us to nothing that compels the federal government to protect taxpayers from the true costs of paying their state and local taxes."

The decision also noted that the states did not provide sufficient data to back their claims of economic harm or impediment to their ability to set fiscal policies.

SALT Challenge

Connecticut, New Jersey, New York, and Maryland brought the suit, challenging the $10,000 cap on SALT deductions that was implemented as part of the 2017 federal tax overhaul.

The cap significantly impacts taxpayers in high tax states, with the four states behind the lawsuit claiming the policy violated the 10th Amendment by unfairly punishing their tax policies.

Rather than reducing state and local tax burdens, Connecticut and other states filed the lawsuit suit and also devised workaround programs to limit the cap's impact.

Connecticut implemented a 6.99% pass-through entity tax in 2018 that essentially allowed small businesses registered as partnerships, S corporations, and LLCs to circumvent the federal cap.

The court noted the four states "point us to nothing that compels the federal government to protect taxpayers from the true costs of paying their state and local taxes."

Like business taxes paid by non-pass-through entities, the tax is paid at the business level rather than the personal level and, as a result, is fully deductible from federal income taxes as a business expense.

However, in 2019 Connecticut reduced the credit from 93.01% to 87.5%—effectively retaining a portion of those tax revenues—to help balance the state budget.

That move costs Connecticut small businesses $53 million annually. CBIA has called for policymakers to restore the credit to its original level.

The IRS approved the pass-through entity tax workaround in 2020, noting those tax payments were permitted as federal income tax deductions and "consistent with the longstanding position" of the agency.

Setback

Another SALT cap workaround that Connecticut and other states attempted did not survive IRS scrutiny.

States adopted legislation permitting municipalities to let taxpayers make voluntary payments to approved charitable organizations, or "community supporting organizations," in lieu of paying local property taxes, in exchange for a corresponding tax credit.

The IRS quickly adopted regulations prohibiting taxpayers from deducting those contributions from federal income taxes as charitable donations, which are not capped.

The lawsuit appears to be more about defending unsound fiscal policies than protecting businesses and residents from high taxes.

The appeal court's decision is a significant setback to the states’ legal challenge to federal tax law.

A spokesperson for Connecticut Attorney General William Tong said his office was "reviewing the decision and evaluating next steps."

None of the other three attorneys general have commented—perhaps because the lawsuit appears to be more about defending unsound fiscal policies than protecting businesses and residents from high taxes?


For more information, contact CBIA's Eric Gjede (860.480.1784) | @egjede