Challenges to State Deduction Cap, End-Runs Likely to Fail

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By John Herzfeld and Che Odom

New York’s Democratic governor and New Jersey’s Republican Senate whip may try the courts or a legislative resolution to contest the new federal tax law’s limit on the state-and-local deduction.

New York is still weighing a legal challenge to the new 2017 tax law’s cap on the deductibility of state and local taxes, Gov. Andrew M. Cuomo (D) said Dec. 28 during an appearance on CNN.

Cuomo said he’s “not even sure” what Republican sponsors of the tax law did is “legal or constitutional, and that’s something we’re looking at now.”

Several leading tax attorneys told Bloomberg Tax that neither the U.S. Constitution nor Supreme Court case law prevents Congress from acting as it did to limit the deduction.

New York’s threats are the latest in months-long protests over limiting the deduction by officials from high-tax jurisdictions, such as New York, New Jersey Connecticut, California and Illinois. Several of those states are rushing to get taxpayers property assessments for 2018 to allow them to prepay taxes before Dec. 31, so they can claim a limitless deduction.

New Jersey Senate Whip Joe Pennacchio (R) wants to try a less adversarial approach with the new federal law. He said in a Dec. 28 statement that he may introduce a bill this legislative session that asks Congress to reconsider the deduction limit.

“This is not a Republican issue, nor a Democratic one,” Pennacchio said. “In the past, both parties were able to set aside their differences and work on tax reform together for hardworking Americans.”

The federal tax law, signed Dec. 22 by President Donald Trump, allows taxpayers to deduct up to $10,000 of property taxes, and state and local income or sales taxes. There was previously no limit on the amount of state and local taxes that could be deducted.

In addition to asking Congress to rethink the limit, Pennacchio’s bill also would urge Congress to make the law’s individual tax cuts permanent.

Prepaying Tax

Many taxpayers had hoped to get around the new deduction limit by paying their 2018 taxes early, but a Dec. 27 news release from the Internal Revenue said taxpayers only have until end of this year to do so.

And first taxpayers must be assessed the taxes by their city, county, or state, which is proving to be a problem (see related story, this issue).

For example, residents of several cities and counties in the Washington, D.C., area may not be able to deduct prepaid 2018 property taxes.

Montgomery County, Md., said in a statement that the county’s 2018 tax assessment will be made in July 2018.

Prince George’s County, Md., council canceled an emergency session planned to allow prepayments from taxpayers saying the IRS guidance “precluded the tax-saving action we would have taken to benefit county taxpayers,” according to a statement

Alexandria, Va., director of communications Craig Fifer says the city doesn’t interpret IRS guidance, but Alexandria assesses in January and determines tax rates in May; “there is not a physical way for us to assess before the end of 2017”

Wisconsin, among other jurisdictions, also has said that property tax assessments for 2018 also won’t go out in time to allow for prepayments this year.

Double Taxation

Cuomo has called the tax-law fight “economic civil war.” Most of the higher-tax states lean Democratic, while many of those that largely vote Republican have lower or no income tax.

“You can change the tax code,” he said. “You can’t penalize my state because of its political affiliation. There’s never been a double taxation before in the history of the nation.”

Cuomo said New York is considering a legal challenge to the deduction cap, but several tax attorneys told Bloomberg Tax they could find no constitutional basis for doing so. In particular, they said the double-taxation argument that Cuomo and others doesn’t hold water.

“It’s political, and a bit misleading,” Charles S. Henck, a tax partner in Washington office of Ballard Spahr LLP, told Bloomberg Tax. “Even with full deduction the same income is taxed twice, once by the state and once by the feds. The deduction merely reduces the amount of the income subject to the tax at the federal level.”

Steven Wlodychak, an attorney and principal in the indirect tax practice of Ernst & Young LLP, agreed that the “double taxation” claim was “purely political.” The U.S. Supreme Court made clear in its 1988 opinion in South Carolina v. Baker that this is “not a constitutional problem.”

Nondiscriminatory

The claim that capping the deduction results in a prohibited form of double taxation is “rooted more in political rather than constitutional argument,” Jamie Yesnowitz, a principal and national tax office leader at Grant Thornton LLP, told Bloomberg Tax.

“A specific state has not been singled out by the restriction on the federal deduction for state taxes paid,” Yesnowitz said.

In addition, the continued availability of the deduction for income, property or sales tax up to the cap means that individuals from states with diverse tax systems all have the ability to take the deduction, he said.

“Obviously, one can quibble with the capping of a deduction that has been a part of the code on an unlimited basis for a very long time” and that the cap falls on blue-state residents “more dramatically than others,” he said. “And my sense is that some blue state governors may try to press the issue through some form of constitutional challenge.”

With assistance from Erik Wasson and Greg Sullivan of Bloomberg in Washington

To contact the reporter on this story: John Herzfeld in New York at jherzfeld@bloomberglaw.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

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