United States: Second Circuit upholds District Court’s dismissal of lawsuit challenging USD 10,000 cap on state and local tax deduction

In brief

In New York v. Yellen, Dkt. No. 19-3962-cv (2d Cir. 5 Oct. 2021), the United States Court of Appeals for the Second Circuit affirmed the judgment of the United States District Court for the Southern District of New York in New York v. Mnuchin, Dkt. No. 18-CV-6427 (JPO) (S.D.N.Y. 30 Sept. 2019), a 2019 decision dismissing a lawsuit filed by several states challenging the constitutionality of the USD 10,000 cap on the federal deduction for state and local taxes (“SALT Deduction Cap”) that was enacted as part of the Tax Cuts and Jobs Act of 2017 (Pub. L. No. 115-97).

New York, Connecticut, New Jersey, and Maryland (together, “Plaintiff States”) initiated the lawsuit against the US government in 2018 to challenge the SALT Deduction Cap on constitutional grounds. In New York v. Yellen, the Second Circuit held that the federal deduction for state and local taxes is not constitutionally mandated and that the SALT Deduction Cap does not unconstitutionally infringe on state sovereignty. In addition to contesting the complaint on the merits, the US government sought to dismiss the complaint on jurisdictional grounds, alleging that the Plaintiff States did not have standing to sue the federal government and, even if they did, the case was barred by the federal Anti-Injunction Act (AIA). The Second Circuit’s decision ultimately leaves the SALT Deduction Cap intact for now—subject, of course, to any Congressional changes that may be forthcoming.

Background: The SALT deduction cap & ensuing state reaction

Individual taxpayers who elect to itemize their personal income tax deductions may reduce their federal income tax liability by claiming a deduction for certain state and local taxes (“SALT Deduction”). Throughout its history and until 2017, the SALT Deduction was generally unlimited in nature, with few exceptions (for example, taxpayers subject to the Alternative Minimum Tax were prevented from claiming the deduction). In December 2017, Congress passed the Tax Cuts and Jobs Act of 2017 (TCJA), which included the SALT Deduction Cap among its sweeping tax reform provisions.

In their lawsuit, the Plaintiff States expressed their view of the SALT Deduction Cap as a politically-motivated maneuver by the Trump administration and Congressional Republicans because the jurisdictions expected to be most impacted by its enactment were those led predominantly by the Democratic party (which have historically imposed higher taxes relative to other states and whose residents may be more severely impacted by the SALT Deduction Cap). See New York v. Mnuchin at eight (“Further, the States maintain, the exclusively Republican legislators who voted to enact the SALT cap — and the Republican president who signed it into law — intended this differential impact. According to the States, the cap's ‘true purpose’ was ‘to coerce a handful of States with relatively high taxpayer-funded public investments — States that are primarily Democratic leaning — to change their tax policies.’”). State legislatures mobilized almost immediately after the TCJA to propose and pass legislation designed to combat the potential impact of the SALT Deduction Cap on their residents (which, for New York residents alone, was predicted to result in an additional USD 121 billion of federal tax between 2018 and 2025). Id. While a detailed analysis of the workarounds explored by states are beyond the scope of this article, proposals included, among others: (1) allowing residents to make a charitable gifts to the state, effectively in lieu of paying state personal income taxes and, in exchange, residents would receive a state income tax credit for the entire amount of their charitable gift to offset all or a portion of their state income tax due (in IRS Notice IR-2018-172 (23 Aug. 2018), the IRS ultimately announced its intent to shut down this charitable gift workaround by requiring taxpayers to reduce any federal charitable deductions claimed by the amount of state tax credits received for their charitable gifts to the state); and (2) enacting elective or mandatory pass-through entity taxes for the purpose of shifting the state tax burden from individuals (who are subject to the SALT Deduction Cap) to entities that are not subject to the SALT Deduction Cap (e.g., S corps and partnerships), whose deduction would then flow through to the individual owners of the pass-through entity without limitation. In IRS Notice 2020-75, the IRS effectively accepted this workaround by affirming that partnerships and S corporations are not subject to the SALT Cap Deduction.

The Plaintiff states challenge the SALT Deduction Cap in District Court: New York v. Mnuchin

On 17 July 2018, the Plaintiff States filed a complaint in District Court against former Secretary of the Treasury Steven T. Mnuchin and others in the United States government, alleging that the SALT Deduction Cap “violates the federalism principles that undergird the US Constitution.” Specifically, the Plaintiff States alleged that the SALT Deduction Cap violates Article 1, Section 8 and the Tenth and Sixteenth Amendments of the United States Constitution. On 2 November 2018, the Government moved to dismiss the complaint, contending that the District Court lacked jurisdiction over the suit and that the Plaintiff States failed to state a valid legal claim. The Plaintiff States, in turn, filed a cross-motion for summary judgment. In a September 2019 decision, the District Court granted the Government’s motion to dismiss and denied the Plaintiff States’ cross-motion for summary judgment, holding that, while the Plaintiff States had standing and their claims were not barred by the AIA, nothing in the US Constitution prevents Congress from limiting the SALT Deduction, and thus, the SALT Deduction Cap is constitutional. See New York v. Mnuchin at 37.

Appeal to the Court of Appeals for the Second Circuit: New York v. Yellen

On 26 November 2019, the Plaintiff States appealed the District’s Court’s Opinion and Order to the Second Circuit, in New York v. Yellen. On appeal, the Plaintiff States argued that the District Court erred in its determination that the SALT Deduction Cap was constitutional, while the Government maintained that the District Court lacked jurisdiction (both for lack of standing and because of the AIA), but otherwise defended the District Court’s judgment on the constitutional merits of the SALT Deduction Cap.

The Government’s jurisdictional claims

As to the Government’s first jurisdictional challenge—standing—the Second Circuit agreed with the District Court that the Plaintiff States had standing to bring their constitutional claims because the Plaintiff States demonstrated a “direct injury in the form of a loss of specific tax revenues”—namely, Plaintiff States demonstrated that the SALT Deduction Cap “makes homeownership more expensive for taxpayers whose state and local tax liability exceeds USD 10,000” which, in turn, reduces demand in the housing market, causing lower prices and fewer sales and leads to specific losses in tax revenue derived from property and real estate transfer taxes.” This “realistic” showing of “predictable” economic events, the Second Circuit held, is distinguishable from the “allegations of generalized economic harm” involved in the cases cited by the Government.

As to the Government’s second jurisdictional challenge—that the lawsuit is barred by the AIA, which provides that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed”—the Second Circuit similarly agreed with the District Court and sided with the Plaintiff States. The Government classified the lawsuit as “a ‘suit for the purpose of restraining the assessment or collection of any tax,’” but, according to the Second Circuit, this argument “ignores that the AIA was never intended to leave a party without any forum in which to assert its tax claims.” Since “the Plaintiff States cannot assert their claims in a forum other than federal court,” and the AIA applies “only when Congress has provided an alternative avenue for an aggrieved party to litigate its claims on its own behalf,” the AIA did not deprive the District Court of jurisdiction to decide the matter.

Constitutionality of the SALT Deduction Cap

Turning to the merits, the Plaintiff States argued that the SALT Deduction is mandatory under Article I, Section 8 and the Sixteenth Amendment of the US Constitution. Therefore, they argued, the SALT Deduction Cap “effectively eliminates a constitutionally mandated deduction for taxpayers.” In addition, the Plaintiff States argued that the SALT Deduction Cap “coerces them to abandon their preferred fiscal policies in violation of the Tenth Amendment” of the US Constitution. The Second Circuit ultimately disagreed with the Plaintiff States’ contentions, holding that (1) neither Article I, Section 8 nor the Sixteenth Amendment forecloses Congress “from eliminating or curtailing” the SALT Deduction, and (2) the SALT Deduction Cap does not unconstitutionally infringe on the Plaintiff States’ fiscal sovereignty, thereby violating the Tenth Amendment.

With respect to the Plaintiff States’ Article I, Section 8 and the Sixteenth Amendment claims, the court noted that the Plaintiff States’ argument is based on their view that Congress has never before 2017 curtailed or eliminated the SALT Deduction; however, the Second Circuit disagreed, holding that there is no express structural limitation in the Constitution that prevents Congress from limiting the SALT Deduction, nor has Congress’ historical perception of the SALT Deduction given rise to any implied limitation. On the latter point, the Second Circuit examined the history of the SALT Deduction and made note of instances where Congress limited the SALT Deduction in some way without regard to whether it was constitutionally permissible. For example, in support of its holding, the Second Circuit focused on 1986 and 1990 amendments to the SALT Deduction, which (1) eliminated the SALT Deduction for state and local sales taxes and (2) introduced the Pease limitation (which reduced the value of the SALT deduction for high-income earners).

With respect to the Plaintiff States’ Tenth Amendment claim, the court concluded that “the Plaintiff States have failed to plausibly allege that their injuries are significant enough to be coercive.” In general, Congress may use its taxing authority to “encourage a State to regulate in a particular way” and it may even hold out incentives from a state in order to influence its policy choices. However, this “encouragement” cannot amount to “compulsion” or “coercion” that impedes a state’s right to regulate areas of law in its purview. In order for a federal condition to be deemed unconstitutionally coercive under the Tenth Amendment, the condition must leave the state with no legitimate choice but to adopt the policy the Government seeks to encourage or the financial inducement, in reality, must be a “gun to the head.” Id. at 31. Turning to the Plaintiff States’ allegations, the court accepted as true that the SALT Deduction Cap would cost the States’ resident taxpayers millions of dollars in additional taxes, that the value of home prices in the States would fall, and jobs in the States would disappear. The court also assumed without deciding that a claim of coercion under the Tenth Amendment could arise from injuries to the States’ citizens rather than to the State itself. Nevertheless, the court concluded that none of these injuries were significant enough to be coercive. In particular, the court emphasized that the alleged harms seemed either too small to be significant (e.g., New Jersey claimed it was likely to lose over USD 100 million in property and real estate transfer taxes in 2019 and 2020, but its 2019 budget alone was USD 37.3 billion), or that the numbers lacked any baseline figures to put them in context. Thus, while acknowledging the potential impact of the SALT Deduction Cap on the Plaintiff States’ economies, the court still found it “implausible that the amounts in question give rise to a constitutional violation.”


Technically, the constitutional status of the SALT Deduction Cap is also not yet finally settled—the Plaintiff States have the option of petitioning the Supreme Court of the United States to review the Second Circuit’s decision in New York v. Yellen. However, there is no indication that the States will do so, and even if they do, the likelihood of success at the Supreme Court is unknown. While the Plaintiff States may have lost in the Second Circuit, the ultimate impact of the SALT Deduction Cap remains an open question. The IRS for now appears to have accepted the pass-through entity tax workaround vehicle discussed above as a legally viable option, and several states have adopted pass-through entity tax regimes that are intended to provide SALT Deduction relief to individual owners of pass-through entities. See IRS Notice 2020-75. Under current law, the SALT Deduction Cap is set to automatically sunset at the end of 2025, though extensions may be a possibility. The Build Back Better Act as passed by the House on 19 November 2021, would increase the cap from USD 10,000 to USD 80,000, but would extend its life to 2031 in exchange (for 2031 only, the cap would again drop to USD 10,000). Ultimately, the current debates among legislators and the Government’s victory in New York v. Yellen indicate that the SALT Deduction Cap may not disappear any time soon.

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