The $10,000 federal cap on the state and local tax itemized deduction for individuals (“SALT limitation”) continues to generate considerable debate, as well as efforts to narrow its scope. Several states have enacted entity-level income taxes on pass-through entities as partial workarounds, and as we went to press Congress was considering proposals that would either drastically raise the cap or allow an unlimited deduction for 2021. Less well known is a long-running—and, to some, dubious—legal action brought by four states seeking to invalidate the SALT limitation on constitutional grounds. The states’ constitutional challenge has now been unanimously rejected by the Second Circuit of the U.S. Court of Appeals (“Second Circuit”). New York v. Yellin, Docket No. 19-3962-CV (2d Cir. Oct. 5, 2021).

Background: Under the federal Tax Cuts and Jobs Act of 2017, for federal income tax purposes an individual taxpayer (including married joint filers) is limited to an annual $10,000 itemized state and local tax deduction. Shortly after its enactment, four of the states most affected by the SALT limitation—New York, Connecticut, New Jersey, and Maryland, all high-tax states—commenced a lawsuit to enjoin enforcement of the cap. The states claimed that the Constitution precluded any congressional attempt to meaningfully limit the long-standing SALT deduction, and that the purpose of the SALT limitation was to unconstitutionally “coerce” the states into changing their preferred higher tax policies.

In 2019, a federal District Court judge dismissed the lawsuit, and the states appealed to the Second Circuit.

Second Circuit Decision: The states fared no better on appeal, with the Second Circuit unanimously affirming the lower court’s dismissal of the states’ constitutional claims. The Second Circuit first held that the states had standing to proceed with their claims because the states made credible claims of “injury in fact,” i.e., lost property tax and transfer tax revenues. It also found that the states’ claims were not precluded by the Anti-Injunction Act, which bars lawsuits seeking to restrain the collection of federal taxes and requires that challenges be brought pursuant to claims for refund.

The Second Circuit then addressed the states’ constitutional claims. First, it rejected their claims that the Constitution effectively “mandates” the SALT deduction. Tracing the history of the SALT deduction, the court noted various instances where the SALT deduction was limited (e.g., 1986 legislation eliminating a deduction for state and local sales taxes and 1990 legislation reducing the deduction for high income earners). As the court noted, “[p]rior to 2017, it appears, Congress did not view its authority to limit the SALT deduction as subject to any relevant constitutional constraints” and “the history of the deduction helps the Plaintiff states virtually not at all.”

The Second Circuit then addressed the states’ claim that the SALT limitation “coerced” the states to abandon their preferred fiscal policies in violation of the Tenth Amendment, which reserves to the states powers not constitutionally delegated to the federal government. It noted that the U.S. Supreme Court had only once before deemed a Congressional condition as being constitutionally “coercive” in violation of the Tenth Amendment. The case was Nat’l Fed’n of Indep. Bus. v. Sebelius, 567 U.S. 519 (2012), where Congress threatened to withhold all state Medicaid grants unless the states agreed to new expanded funding and conditions.

The Second Circuit found that the states had “failed to plausibly allege that their injuries are significant enough to be coercive.” In short, the court was unpersuaded that the claimed detrimental economic effects of the SALT limitation were significant enough to give rise to a constitutional violation and concluded that the SALT limitation did not unconstitutionally infringe on state sovereignty. As for the states’ claim that Congress unfairly targeted them, the court, quoting from Nat’l Fed’n, noted that “Congress may use its spending power to create incentives for States to act in accordance with federal policies” as long as “pressure [does not] turn[] into compulsion.”

It was widely recognized that the states’ lawsuit was more a political act than a bona fide constitutional challenge. Two federal courts have now rejected each constitutional argument raised by the states to oppose the SALT limitation. Although the states may yet seek appeal to the U.S. Supreme Court, Congress is the proper forum to address the states’ concerns about the SALT limitation.