This article provides an in-depth analysis of the Second Circuit’s decision in New Jersey v. Bessent; Village of Scarsdale v. IRS, a significant case heard during the August Term, 2024, and decided on August 13, 2025. The ruling addresses the interplay between state-level tax credit programs designed to circumvent the federal cap on state and local tax (SALT) deductions and the federal charitable contribution deduction under 26 U.S.C. § 170.

Factual Background

In 2017, the Tax Cuts and Jobs Act (TCJA) capped the federal tax deduction for state and local taxes (SALT) at $10,000 for individuals and married taxpayers filing jointly, and $5,000 for married taxpayers filing separately. Prior to this, taxpayers could deduct a substantially larger, if not unlimited, amount of their SALT liability.

In response to this new limitation, high-tax states such as New Jersey, New York, and Connecticut, along with the Village of Scarsdale, New York, enacted legislation. These laws established state-administered charitable funds or empowered localities to create similar programs. The design of these programs allowed residents to make voluntary contributions to a state-administered charitable fund and, in return, receive a sizable state or local tax credit, often ranging from 85% to 95% of the contribution amount. The Appellants envisioned that taxpayers would then be able to deduct the full amount of these contributions from their federal taxable incomes under the charitable-contribution deduction codified at Internal Revenue Code (I.R.C.) § 170. For example, a New York taxpayer contributing $200,000 to the state’s designated fund would receive a state tax credit of $170,000, reducing her state tax liability. The expectation was to then deduct the entire $200,000 as a charitable contribution on her federal return, potentially saving $74,000 in federal tax, thus circumventing the $10,000 SALT cap.

However, the Internal Revenue Service (IRS) and Treasury Department promulgated a new regulation, the "Final Rule," interpreting I.R.C. § 170. This Final Rule requires that a taxpayer claiming a charitable-contribution deduction reduce that deduction by "the amount of any state or local tax credit that the taxpayer receives or expects to receive in consideration for the taxpayer’s payment or transfer". This effectively nullified any federal tax benefit taxpayers hoped to gain from participation in these state and local tax-credit programs, although an exception was provided for tax credits amounting to 15% or less of a taxpayer’s contribution.

The impact of the Final Rule was immediate and substantial. After its publication, contributions to New York’s public fund "sharply decreased," from $78.7 million in 2018 to just $25,416 in 2019. Scarsdale’s fund, which received over $500,000 in 2018, received no further contributions after the Proposed Rule was announced. Localities in New Jersey and Connecticut halted their plans for similar funds entirely.

Taxpayers’ Request for Relief

The State of New Jersey, State of New York, State of Connecticut, and the Village of Scarsdale, New York (collectively, the "Appellants") sued the Treasury, IRS, and their officers (the "Government") in the U.S. District Court for the Southern District of New York. Their primary contention was that the IRS exceeded its statutory authority under 26 U.S.C. § 170 in promulgating the Final Rule. Additionally, they argued that the Final Rule was arbitrary and capricious under the Administrative Procedure Act (APA), 5 U.S.C. § 706.

The district court (Judge Paul G. Gardephe) granted summary judgment for the Government. It concluded that New Jersey and Connecticut lacked Article III standing due to speculative injury, but New York and Scarsdale did have standing. The court also held that the Anti-Injunction Act (AIA) did not bar New York’s and Scarsdale’s claims. On the merits, the district court relied on Chevron deference to uphold the IRS’s interpretation of § 170 as permissible and the Final Rule as not arbitrary or capricious.

Appellate Court’s Analysis of the Law

The Second Circuit Court of Appeals, comprising Judges Sack, Robinson, and Pérez, reviewed the district court’s decision de novo.

Article III Standing

The Court first affirmed that New York and Scarsdale possessed Article III standing, which was sufficient to hear all Appellants’ claims. The Government, while initially contesting standing at the district court level, largely relinquished this argument on appeal, focusing instead on the Anti-Injunction Act. The Court, however, acknowledged its independent obligation to ensure standing.

Citing Biden v. Nebraska, 600 U.S. 477 (2023), the Court reiterated that a plaintiff must demonstrate an "injury in fact—a concrete and imminent harm to a legally protected interest, like property or money—that is fairly traceable to the challenged conduct and likely to be redressed by the lawsuit". The Court found that New York and Scarsdale met this standard by presenting evidence of "actual and imminent" dives in program-related revenues directly resulting from the Proposed and Final Rules. This monetary loss, supported by "declarations from tax and budgetary experts" and "basic economic logic," was deemed sufficiently concrete and particularized to establish injury. The injury was "fairly traceable" to the Final Rule, and it was likely that contributions would resume if the Final Rule were set aside, satisfying the redressability requirement. The Court noted that the standing of New York and Scarsdale was sufficient, making the standing of Connecticut and New Jersey academic, referencing Rumsfeld v. F. for Acad. & Inst’l Rits., Inc., 547 U.S. 47 (2006) and Bowsher v. Synar, 478 U.S. 714 (1986).

Anti-Injunction Act (AIA)

The Court next addressed the Government’s argument that the suit was barred by the Anti-Injunction Act (26 U.S.C. § 7421(a)), which generally prohibits suits to restrain the assessment or collection of any tax. The Government contended that the Final Rule should be challenged via the "pay first, litigate later" refund procedure.

The Court concluded that the AIA did not bar the appeal, relying on the exception established in South Carolina v. Regan, 465 U.S. 367 (1984) and applied in New York v. Yellen, 15 F.4th 569 (2d Cir. 2021). The Regan exception applies when "Congress has not provided the plaintiff with an alternative legal way to challenge the validity of a tax". Since the Appellants themselves faced no direct tax liability under the Final Rule, they could not pursue a refund suit. They were "without any forum in which to assert [their] tax claims". The Court rejected the notion that Appellants were obligated to find taxpayers willing to litigate on their behalf, noting that the suits were aimed at remedying their own lost revenues. The Court also explicitly declined to limit the Regan exception solely to constitutional claims, citing Larson v. United States, 888 F.3d 578 (2d Cir. 2018), In re Westmoreland Coal Co., 968 F.3d 526 (5th Cir. 2020), and In re Walter Energy, Inc., 911 F.3d 1121 (11th Cir. 2018), which suggest a broader application to APA challenges where no alternative review mechanism exists.

Statutory Authority Under I.R.C. § 170

This segment of the Court’s analysis was significantly impacted by the Supreme Court’s decision in Loper Bright Enterprises v. Raimondo, 603 U.S. 369 (2024), which overturned Chevron deference after the district court’s ruling. Consequently, the IRS’s interpretation of I.R.C. § 170 was entitled to "no deference". Instead, the Court was mandated to "use every tool at their disposal to determine the best reading of the statute and resolve the ambiguity".

The Court began its interpretation of I.R.C. § 170 by noting that the term "charitable contribution" is defined as a "contribution or gift to or for the use of . . . [a] State . . . or any political subdivision [thereof], . . . but only if the contribution or gift is made for exclusively public purposes". Given the sparse legislative history and lack of further definition for "contribution" or "gift," the Court turned to decisional law, which has shaped the understanding of an "implicit quid pro quo principle".

This principle dictates that a payment "generally cannot constitute a charitable contribution if the contributor expects a substantial benefit in return". If the return benefit is "commensurate with the payment or if obtaining the benefit is the reason for making the payment, . . . the payment is a quid pro quo rather than a gift," citing Hernandez v. Comm’r, 819 F.2d 1212 (1st Cir. 1987), affirmed, 490 U.S. 680 (1989). The test for a quid pro quo is objective, focusing on the "external features of the transaction in question" rather than the donor’s subjective state of mind or motivation to receive a tax deduction. As held in Scheidelman v. Comm’r, 682 F.3d 189 (2d Cir. 2012), a charitable contribution is "a transfer of money or property without adequate consideration," and this consideration "need not be financial".

Application of the Law to the Facts

The Court applied the quid pro quo principle to the Appellants’ tax-credit programs:

Tax Credits as Substantial Benefits: The Court determined that a tax credit offsetting a taxpayer’s state or local tax liability is an "identifiable benefit" because it substantially reduces the amount of money the taxpayer owes, effectively freeing up funds. This benefit is also "easily calculable based on external features," being a defined percentage of the contribution. The Court highlighted that the practical consequence for a donor in New York’s fund was akin to "the State handing the donor a stack of cash worth 85% of her contribution". The fact that contributions "all but dried up" after the Final Rule’s implementation demonstrated that the tax credit was the "specific benefit in return" that taxpayers expected.
Distinction Between Tax Credits and Deductions: The Appellants argued that the Final Rule was inconsistent by treating state tax credits as return benefits while not treating state or federal charitable contribution deductions as such. The Court countered that the "tax benefit" discussed in prior caselaw (e.g., Scheidelman, 682 F.3d at 200) that does not vitiate charitable intent is almost universally the § 170 deduction itself, not a separate tax credit received from the beneficiary. The Court reasoned that I.R.C. § 170 explicitly permits federal tax deductions for gifts to the United States, which would be contradicted if the federal deduction itself constituted a quid pro quo. Thus, Congress did not consider a tax deduction to be a return benefit that negates charitable intent. In contrast, a tax credit directly offsets a tax bill and provides a "specific [and] measurable" benefit, unlike a deduction whose value varies with a taxpayer’s marginal rate. This variability suggests deductions are not the target of the quid pro quo principle, which requires a "commensurate return".
"Goods or Services" Interpretation: Appellants attempted to limit the quid pro quo principle only to exchanges for "goods or services". The Court rejected this narrow interpretation, stating that precedents indicate the principle applies whenever a "substantial benefit in return" is received, regardless of its form. It referenced American Bar Endowment, 477 U.S. 105 (1986) and Hernandez, 490 U.S. 680 (1989). The Court further noted that even under a broad definition, tax credits could be considered "goods" (things that "have value") or "benefits", citing Black’s Law Dictionary (12th ed. 2024) and 26 C.F.R. § 1.170A-13(f)(5).
Relevance of Taxable Income: Appellants argued that since tax benefits are not considered "money or income" for taxable events (Randall v. Loftsgaarden, 478 U.S. 647 (1986)) or "amount realized" on a sale, they should not be considered return goods for § 170. The Court found this argument unconvincing, reiterating that a return benefit under § 170 "need not be financial".
Congressional Acquiescence: Appellants claimed Congress’s silence on existing state tax-credit programs implied acquiescence to the IRS’s prior interpretation of § 170. The Court stated that "overwhelming evidence" of acquiescence is required, such as Congress having "considered and rejected the ’precise issue’ presented" (Solid Waste Agency of N. Cook Cnty. v. U.S. Army Corps of Eng’rs, 531 U.S. 159 (2001) and Rapanos v. United States, 547 U.S. 715 (2006)). No such evidence existed, especially given that the 2017 Tax Act spurred the creation of these new tax-credit programs, which then led to the Final Rule.

The Court ultimately concluded that the Final Rule correctly interpreted I.R.C. § 170 as applied to the Appellants’ tax-credit programs, and thus the IRS did not exceed its statutory authority.

Arbitrary-and-Capricious Review

Finally, the Court reviewed whether the Final Rule was arbitrary and capricious, noting that this standard of review is "narrow and particularly deferential" (Env’t Def. v. EPA, 369 F.3d 193 (2d Cir. 2004)). An agency action survives this review if the agency "examine[d] the relevant data and articulate[d] a satisfactory explanation for its action including a rational connection between the facts found and the choice made" (New York v. Raimondo, 84 F.4th 102 (2d Cir. 2023)).

The Court rejected Appellants’ arguments:

Inconsistent Treatment of Credits vs. Deductions: Appellants claimed the IRS failed to explain this distinction or consider disincentives to charitable giving. The Court found the Final Rule’s preamble adequately explained that dollar-for-dollar state deductions raised different concerns than credits, as their economic benefit is limited by marginal rates, posing a lower risk of circumventing the SALT cap and leading to less potential revenue loss. Administrative complexities also justified the distinction. This focus on "protect[ing] the public fisc" (United States v. Hughes Props., Inc., 476 U.S. 593 (1986)) was within a "zone of reasonableness" (FCC v. Prometheus Radio Project, 592 U.S. 414 (2021)).
Disincentive to Charitable Giving: The IRS adequately considered this. The Final Rule only limits deductions for contributions receiving substantial tax credits, allowing deductions for gratuitous transfers. It targets specific programs, not general charitable giving.
15% Exemption: Appellants argued the 15% threshold for the exception was arbitrary and created a "cliff effect". The Court found this reasonable, acknowledging that lines must be drawn. The 15% threshold reflected "the combined top marginal state and local tax rates," aiming to treat taxpayers in states offering economically equivalent credits similarly to those with deductions.
Reliance on Section 164: Appellants argued the IRS improperly focused on the SALT deduction (Section 164). The Court held it was not improper for the IRS to consider the revenue-raising objective of the SALT deduction cap when promulgating a rule under § 170, as tax provisions should be construed within the framework of the entire Internal Revenue Code.
Change in Policy (2010 CCA): Scarsdale claimed the IRS failed to acknowledge a change in existing policy from earlier internal memos (2010 IRS Chief Counsel Advice or "CCA"). The Court confirmed that an agency changing its position must "display awareness that it is changing position and show that there are good reasons for the new policy" (Encino Motorcars v. Navarro, 579 U.S. 211 (2016)). The Final Rule explicitly "questioned the reasoning of the 2010 CCA" and explained its departure, noting the 2010 CCA did not address the specific issue of tax credits as quid pro quo and was based on assumptions that no longer held true after the 2017 Tax Act and new state tax-credit schemes. It was reasonable for the IRS to revisit its position in light of these developments.

Conclusion

For the foregoing reasons, the Second Circuit affirmed the judgment of the district court. The Final Rule was found to correctly interpret I.R.C. § 170 and was not arbitrary or capricious. This decision solidifies the IRS’s stance on state-administered charitable funds that offer tax credits in exchange for contributions, confirming that such tax credits are indeed considered a "substantial benefit in return" under the quid pro quo principle, thereby reducing the allowable federal charitable contribution deduction.

Prepared with assistance from NotebookLM.