Appeals Court Rejects One Workaround to the SALT Deduction Cap
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On August 13, 2025, the United States Court of Appeals for the Second Circuit upheld an IRS regulation disallowing one of the “workarounds” that states have adopted to counteract the $10,000 limit on federal deductions of state and local taxes (SALT).
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In 2017, the law was changed to cap the federal income tax deduction for SALT at $10,000 for individuals ($5,000 for married taxpayers filing separately). (Effective in 2025, Congress raised this cap to $40,000 for many taxpayers.) To mitigate the impact of this limitation on their residents, several states enacted workarounds to afford a larger federal deduction for the SALT paid by their residents. Under one such workaround, taxpayers making contributions to certain state- or locality-administered charitable organizations are entitled to a credit against their state or local taxes equal to between 85% and 95% of the contribution. The IRS quickly intervened, issuing a regulation reducing the charitable deduction for any such contribution by the tax credit.
New Jersey, New York, Connecticut and Scarsdale, New York brought an action in the U.S. District Court for the Southern District of New York alleging that this regulation is invalid. The District Court held for the federal government. On appeal, the Second Circuit held the regulation to be valid on the ground that the tax credit is a benefit the donor receives in return for the contribution.
Notably, the more popular workaround – allowing pass-through entities such as partnerships and S corporations to pay taxes at the entity level, which effectively allows a full deduction by their owners, was not challenged and indeed has been blessed by the IRS. While there were legislative proposals to repeal this workaround, they were rejected and it remains valid. Pennsylvania is one of the few states with an income tax that has not enacted such a workaround.
Author Mark E. Berg is chair of the tax practice group at Klehr Harrison.