Connecticut sues IRS over tax changes

Connecticut joined New York and New Jersey Wednesday in suing the Internal Revenue Service and the Treasury Department to block a rule that would undercut a plan lawmakers approved in 2018 to blunt the impact of federal tax law changes.

The General Assembly’s action last year allowed cities and towns in Connecticut to establish charitable organizations that taxpayers could contribute to and correspondingly reduce their tax bill. The move was seen as a workaround to the new tax law’s $10,000 limit on state and local tax deductions because there is no cap on charitable deductions.

But the Treasury Department said Connecticut and other states with similar legislation were circumventing the socalled SALT cap in a way that violated a longstanding principle of tax law. They issued a rule change, scheduled to take effect Aug. 12, that would require tax credits received in exchange for a charitable contribution to be deducted from the total contribution.

“When a taxpayer receives a valuable benefit in return for a donation to charity, the taxpayer can deduct only the net value of the donation as a charitable contribution,” the Treasury Department said. “The rule applies that principle, known as the quid pro quo principle, to state tax benefits provided to a donor in return for contributions.”

Gov. Ned Lamont and state Attorney General William Tong disagree.

“Connecticut won’t stand idly by while the Trump Administration harms our taxpayers,” Tong said in a written statement. “Our legislature sought to ease the financial burden this cap has on residents by passing a law to protect our taxpayers. The IRS final rule not only undermines those legislative efforts but it eliminates the state’s ability to mitigate the harmful effects of this law. Our office stands ready to protect Connecticut taxpayers.”

While the legislature cleared the way for cities and towns to set up the charitable organizations, none of the state’s municipalities have taken advantage of that option.

The $10,000 limit on state and local tax deductions disproportionately impacted high-tax states like the three that sued. The Connecticut Department of Revenue Services has said the cap will impact more than 171,000 Connecticut filers, resulting in more than $10.3 billion in lost deductions. The average SALT deduction across all filers in the state in 2015 was $19,665, nearly double the $10,000 limit, according to the state Office of Legislative Reach.

Other filers in Connecticut have benefited from changes in the Republican tax overhaul, including the doubling of the standard deduction for those who don’t itemize. Tax rates across all income ranges were also reduced.

But Lamont argued the limit on state and local tax deductions unfairly targeted hightax states that are primarily led by Democrats.

“This was a purely partisan bill and — let’s be frank — aimed directly at blue states like Connecticut, New York, and New Jersey,” he said, in a written statement. “It’s unfair, discriminatory, and unconstitutional.”

The lawsuit, which was filed in the U.S. District Court for the Southern District of New York, says proponents of the cap were “clear about their objectives.”

“According to Secretary Mnuchin, the cap would ‘send a message’ to states with generous social welfare programs that their tax and spending policies would need to conform to those of the administration and the Republican Congress,” the lawsuit reads.

The case is a “long shot” and likely to be thrown out by a judge, said Lawrence Zelenak, a tax law professor at Duke University School of Law. The legal challenge would have a better chance coming from someone who was hurt by the IRS regulations, such as a wealthy individual who paid more in taxes because of the rules, he said.

This is the second lawsuit northeastern states have filed in an attempt to nullify the SALT cap. The village of Scarsdale and the town of Rye, both wealthy New York City suburbs, also filed a lawsuit against the IRS regulations Wednesday.

Last year, the states sued the Trump administration seeking to get the cap itself declared unconstitutional. That case, which many legal experts also say is a long-shot, is still working its way through the courts.

Information from The Washington Post is included in this report.

Russell Blair can be reached at rblair@courant.com.