State of New Jersey v. Mnuchin

Background

Congress’s 2017 Tax Act limited the federal deduction for state and local taxes to $10,000. New York, New Jersey, Connecticut, and the Village of Scarsdale then created or authorized programs allowing taxpayers to contribute to state or local charitable funds and receive state or local tax credits in return.

In 2019, the Treasury Department and Internal Revenue Service issued a final rule interpreting Internal Revenue Code § 170. The rule provides that a taxpayer’s federal charitable-contribution deduction must be reduced by the amount of any state or local tax credit the taxpayer receives or expects to receive for the contribution. A taxpayer who contributes $10,000 and receives a $9,000 state tax credit therefore generally may claim only a $1,000 federal charitable-contribution deduction. The rule includes exceptions, including a 15-percent exception and certain safe harbors.

The plaintiffs argued under the Administrative Procedure Act that the rule exceeded the IRS’s statutory authority and was arbitrary and capricious. The Government moved to dismiss under Rules 12(b)(1) and 12(b)(6), and both sides moved for summary judgment. The opinion addressed the two related cases together.

Motions to dismiss

The court held that New York and Scarsdale adequately alleged standing. They presented evidence that contributions to their tax-credit programs had generated revenue and that contributions sharply declined after the proposed rule was announced. The court found those alleged losses sufficiently concrete and directly connected to the challenged rule.

The court held that New Jersey and Connecticut lacked standing. Those States had not established the tax-credit programs at issue, and the claimed loss of possible future revenue depended on a speculative chain of events. The court also rejected their argument that the rule interfered with their sovereign interests and their claim to represent their residents’ interests because the complaint alleged harm to the States rather than harm to their citizens.

The court rejected the Government’s argument that the Anti-Injunction Act barred the actions. Because the plaintiffs did not owe the federal tax at issue, they could not bring a refund action or use another statutory procedure to challenge the rule. The court concluded that the Act did not prevent them from pursuing their own claims for direct injury to their revenues.

The court dismissed the States’ Regulatory Flexibility Act claim. That statute requires certain analyses concerning the effects of regulations on small entities, but the court held that the 2019 rule directly regulates individual taxpayers rather than local governments or their charitable funds. The Government’s motion to dismiss was therefore granted in part and denied in part.

Summary judgment and the Administrative Procedure Act

The court granted the Government’s motion for summary judgment and denied the plaintiffs’ motions for summary judgment on their Administrative Procedure Act challenge.

First, the court held that Internal Revenue Code § 170 does not clearly answer whether a payment to a state or local government in exchange for a tax credit is fully deductible as a charitable contribution. Applying the two-step framework described in the opinion, the court held that the IRS reasonably interpreted the statute to require taxpayers to subtract the value of the tax credit from the federal charitable-contribution deduction. The IRS relied on the rule that a payment received in exchange for a substantial benefit is not fully charitable, the 2017 Tax Act’s $10,000 deduction cap, concerns about efforts to avoid that cap, and related tax-policy and administrative considerations.

The court also held that the IRS adequately explained its change from earlier guidance, including a 2010 Chief Counsel memorandum. The court found that the IRS identified changed circumstances after the 2017 Tax Act and explained why state and local tax credits should be treated differently from state and local tax deductions. It also found reasonable the rule’s 15-percent exception and the IRS’s decision to use a single percentage rather than require taxpayers to calculate individualized marginal tax rates.

Second, the court held that the rule was not arbitrary and capricious. The IRS considered the relevant issues, including the possible effect on charitable giving, and explained why it expected any overall decline in contributions to be small. The court declined to replace the agency’s judgment with its own.

Disposition

The court granted in part and denied in part the Government’s motions to dismiss. It granted the Government’s motions for summary judgment and denied the plaintiffs’ motions for summary judgment. The court directed the Clerk to enter judgment for the defendants and close both cases.