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State Involvement in Federal Tax Policy, Part 2: SALT and Donors

Posted on Sep. 17, 2018

The question of standing to challenge federal tax statutes is particularly relevant today, not only because of its potential application to possible Treasury regulations indexing capital gains for inflation but also because courts are being asked to consider whether states having standing in a challenge to the state and local tax deduction cap in the Tax Cuts and Jobs Act (P.L. 115-97) and in a lawsuit over the IRS’s new donor disclosure rules.

Attempts to use the courts to shape federal tax policy are increasing. New York, Connecticut, Maryland, and New Jersey have asked them to override Congress’s decision to cap the SALT deduction. Montana’s governor wants the courts to require the IRS to remain a reliable and convenient clearinghouse for information about donors to tax-exempt organizations. The states and state tax authority are the nominal vehicles for bringing these cases, but the interests being asserted aren’t sovereign. (Prior analysis: Tax Notes, Aug. 27, 2018, p. 1208.)

A challenge to the recently proposed SALT regulations appears to be on the horizon (REG-112176-18). New Jersey’s attorney general said the state would challenge any guidance that deviated from the “IRS’s longstanding position” that contributions to state agencies for which a taxpayer receives a state tax credit are deductible charitable contributions for federal tax purposes. Presumably, the decision by the IRS and Treasury to reduce amounts otherwise deductible as charitable contributions by the amount of state or local tax credits received will prompt New Jersey to make good on that threat. The IRS and Treasury responded to both the existing complaints and New Jersey’s threat in the preamble to the regs, which observes that although the guidance is a response to the state workarounds, “the rules in these proposed regulations are based on longstanding federal tax law principles, which apply equally to taxpayers regardless of whether they are participating in a new state and local tax credit program or a preexisting one.”

Courts should carefully consider the standing question in resolving cases like these, because as the docketed lawsuits show, it’s easy for state representatives to confuse their political interests with the state’s sovereign interests. Rigorous application of the standing doctrine keeps those two interests separate and ensures that legislators remain accountable for policy decisions.

New York v. Mnuchin

The basis of the lawsuit filed by New York, Connecticut, Maryland, and New Jersey is that “by reducing the wealth of taxpayers in the Plaintiff States and undermining the States’ revenue sources, the new cap on the SALT deduction will ultimately make it more difficult for the States to maintain their current taxation and fiscal policies, and deprive the Plaintiff States of the ability to raise revenue in the future.” In other words, without the federal tax subsidy, the taxpayer-voters of New York, Connecticut, Maryland, and New Jersey might pressure lawmakers to reduce or reprioritize state spending, or even vote them out of office. Those states seek declaratory and injunctive relief invalidating the new law.

The fundamental flaw in the states’ claims is that the injury alleged isn’t to their sovereign (or quasi-sovereign) interests, but to the interests of the state legislators who have mistakenly, if understandably, conflated their own interests with the states’. The state legislators want the federal treasury to continue subsidizing their states’ spending at the same level, but that isn’t a cognizable injury for standing purposes.

The states assert that because the TCJA’s limit takes a larger bite out of their residents’ incomes, it undermines state revenue sources. But if that were sufficient to establish standing, every change in federal tax law that raises taxes on one taxpayer would be susceptible to challenge.

The states’ argument that they suffer harm because they might need to change their laws or otherwise make administrative changes to maintain the status quo is questionable. In contrast to what the Fifth Circuit held in Texas v. United States, 809 F.3d 134 (5th Cir. 2015), these states don’t have to change anything and will collect the same amount of taxes as before. According to the Fifth Circuit, as the result of a federal rule change, Texas would have had to spend more on driver’s licenses because of an increase in applicants. However, the SALT deduction limit doesn’t directly decrease the states’ revenues. They claim they’ll collect less in property taxes simply because housing prices will drop due to the increase in the cost of homeownership.

Making it harder for state legislators to do what they want is precisely what the Supreme Court said wasn’t a harm that could establish state standing in Florida v. Mellon, 273 U.S. 12 (1927). The statute at issue was alleged to be intentionally hostile to Florida’s refusal to tax estates, but Justice George Sutherland said there was still no injury to the state. “If the act interferes with the exercise by the state of its full powers of taxation or has the effect of removing property from its reach which otherwise would be within it, that is a contingency which affords no ground for judicial relief,” he wrote.

Mellon’s logic also applies to the SALT case. Florida’s legislators felt pressure to enact an estate tax so that Florida residents could benefit from the credit Congress had passed, but they didn’t want to enact one, presumably as a deliberate policy choice intended to attract residents to their state. The Supreme Court told Florida that it was lawmakers’ choice whether to impose an estate tax, but if they refused, that couldn’t cause a harm that would allow for state standing. Responsibility for the policy choice therefore stayed where it belonged — with the state legislators who were accountable to the voters. Congress had used its taxing power to pressure Florida and the other states without an estate tax to enact one, but that wasn’t a harm for state standing purposes. Voters of Florida or any other state could register disagreement with Congress’s plan in the voting booth.

The claims of New York and the other states are arguably less sympathetic than Florida’s. Unlike Florida’s attempt to preserve its no-estate-tax policy, which didn’t affect other states except through competitive pressure, the policy pursued by New York and its fellow plaintiffs shifted state income and property taxes to the federal government and thus to state taxpayers who had no say in other states’ policies.

There is no express authorization to challenge the SALT deduction limit. If the “special solicitude” standard of Massachusetts v. Environmental Protection Agency, 549 U.S. 497 (2007), stands — and if authorization is a key component of a court’s solicitousness — the challenges might falter on that ground.

On the substantive question whether the SALT limit should be judicially repealed, the complaint uses the history of the SALT deduction to argue that the federal government should be made to revive an unlimited deduction. There the substantive question in the SALT case is more straightforward, because it’s a challenge to an act of Congress, whereas both Montana’s suit and any potential indexing-by-fiat case involve regulatory actions by the executive. The taxing power of Congress is broad and so presents a major hurdle for challenges. The states claim that the SALT deduction “is essential to prevent the federal tax power from interfering with the States’ sovereign authority.” But offsetting state expenses through the federal tax code is an encroachment on state sovereignty, not an essential mechanism of support for it. (Prior analysis: Tax Notes, July 2, 2018, p. 7.)

The states allege that the deduction is based on “Congress’s historic understanding that a deduction for all or a significant portion of state and local taxes is constitutionally required because it reflects structural principles of federalism embedded in the Constitution.” However, even the quotes that the complaint cites in support of that idea are ambiguous. For example, the complaint notes that former Rep. Justin Smith Morrill said, “It is a question of vital importance to [the States] that the General Government should not absorb all their taxable resources — that the accustomed objects of State taxation should, in some degree at least, go untouched. The orbit of the United States and the States must be different and not conflicting.” To the extent that legislative history has any bearing on the constitutional status of a statute, that seems to support a deduction, but Morrill didn’t link his statement to the deduction. Further, as Tax Notes contributing editor Joseph J. Thorndike has noted, “it seems more likely that he was explaining the broader decision to devise an entirely new sort of tax; because the states did not impose income taxes, Congress adopting one was itself an expression of fiscal federalism.” (Prior analysis: Tax Notes, Oct. 9, 2017, p. 176.)

The New York complaint reads more like a stump speech than a complaint because it’s the argument candidates should make to voters in the November elections, not to the courts. The political efficacy of the argument is precarious because it’s tough to explain why voters should approve of lower taxes on people with relatively high incomes or relatively expensive homes when most of that same group otherwise does well under the TCJA.

Bullock v. IRS

Montana’s challenge to Rev. Proc. 2018-38, 2018-31 IRB 280, asserts that the governor and state tax authority have standing to sue the IRS because Montana uses federal tax exemption determinations as part of its analysis for state tax exemptions. The complaint says that “given the strength and uniformity of federal disclosure requirements, many states treat the IRS’s tax-exemption and private inurement determinations as highly reliable and persuasive — if not authoritative — in making their own state law determinations.” The state argues that by changing the donor disclosure rules, the IRS unlawfully interfered with Montana’s ability to gather data it needs to administer its tax laws.

One construction of the basis for standing in the Montana complaint is similar to the situation in the possible indexing case: The state plaintiff is seeking to compel the federal government to impose — or rather, renew — burdens on taxpayers even when the federal government wants to remove them. Montana requires applicant organizations to indicate whether they have received a federal exemption, and the state relies on the IRS’s determination of tax exemption. “Because of the rigor of the existing federal tax-exemption process, federal tax-exemption determinations are part of Montana’s analysis for tax exemptions,” the complaint states.

The injuries alleged are that (1) by reducing the information available to the state from the IRS, the revenue procedure harms the state’s ability to make private inurement determinations; (2) Montana will be forced to obtain information directly instead of through the IRS, resulting in administrative costs to the state; and (3) if Montana makes more mistakes in the tax exemption process, or more taxpayers abuse the exemption, the state might lose revenue.

Montana’s reliance on the former procedures for federal exemptions makes a weak case for standing. Montana admits that it didn’t always request the names and addresses of significant contributors from the IRS; requests were made only when the state Department of Revenue decided to seek additional information. Although the state would have to make administrative changes to maintain its former practice of occasionally requesting donor information because it would have to request the information directly from the tax-exempt organization, this type of injury is distinguishable from the one the Fifth Circuit found in Texas. The Fifth Circuit acknowledged that the possibility that a plaintiff could avoid injury by incurring other costs doesn’t negate standing, but it held that Texas couldn’t change its laws or procedures and avoid injury altogether because avoiding injury would require it to pursue a different policy. Montana’s complaint says that to continue to administer its tax laws the same way, it only has to modify its administrative procedures to get the same information it previously obtained from the IRS.

Challenges to regulatory guidance like Montana’s have the same basic standing problem as challenges to statutes. Before his appointment to the federal judiciary, Chief Justice John G. Roberts Jr. wrote in the Duke Law Journal in 1993 that the injury requirement of standing is essential, because without it, the courts would be “ombudsmen of the administrative bureaucracy, a role for which they are ill-suited both institutionally and as a matter of democratic theory.”

The substantive allegation of Montana’s complaint is that Rev. Proc. 2018-38, 2018-31 IRB 280, violates the Administrative Procedure Act. This raises an interesting twist because, as Andy Grewal of the University of Iowa pointed out in a blog post, the IRS bypassed the notice and comment process when promulgating the reporting rules, which puts Montana in the strange position of arguing that the IRS’s failure to follow notice and comment procedures should invalidate a revenue procedure that altered regulations that themselves failed to follow proper notice and comment procedures.

What if No One Has Standing?

The Supreme Court muddied the waters of standing doctrine over a decade ago in Massachusetts. The problematic “special solicitude” principle has reached its logical endpoint in the state lawsuits over tax regulations, so it’s possible that one of those cases will eliminate it. A tax case might be a good vehicle for that, because only money is at stake and it’s therefore easier to untangle the standing question from issues like the obvious problem of climate change to see the standing issues more clearly. Questions like those raised in the lawsuits over the SALT deduction limit and donor disclosure rules are ones that should be put to voters, not courts.

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