It is summertime and beautiful in California. Unfortunately, it’s not all sunshine and roses for conservation easements at the United States Tax Court. We haven’t provided an update since January because it has been hard to keep up with all the bad news coming in. And that is not even counting all the news about the pandemic, current events, politics, and the unacceptable institutional violence perpetuated on people of color.
But, since we are continuing to advocate and work on conservation projects despite the news (which has been highlighting the importance of open space even more these days!), and because I just provided a scintillating overview of the Tax Court cases from the past six months at the California Council of Land Trusts Law Forum, it is time to put pen to paper and share the updates with those who could not attend the forum.
There have been 14 conservation tax cases since our last January update on this blog, 13 of them bad for the taxpayer. Since several have overlapping holdings and fact patterns, I’ve divided them into general takeaways that are terrible and not-so-terrible for legitimate donors:
Terrible for Legitimate Easement Donors
- After-built improvements cannot be excluded from the extinguishment proceeds formula and the fact that the IRS only started implementing this interpretation in 2016 is just fine. The full roster of judges at the Tax Court addressed the IRS’s extinguishment proceeds clause argument once and for all and upheld it in a published division opinion, Oakbrook Land Holdings, 154 T.C. No. 10 (May 12, 2020). Despite the many policy flaws with this tack (explained in Judge Holmes’s brilliant dissent published with the opinion and also explained in our article here), this is the law now, at least at the IRS and Tax Court level and in the Fifth Circuit due to PBBM-Rose Hill. Once the rest of the appellate courts get involved, we might start seeing different rules applied in different circuits.
- Much of the discussion in Oakbrook Land Holdings revolves around the Administrative Procedure Act and whether the IRS is behaving properly by interpreting the statute and regulations in this manner. Basically, the court held that (1) the IRS properly promulgated the Treasury Regulations regarding the division of proceeds and (2) the IRS’s interpretation of those regulations (which are silent on after-built improvements) is reasonable.
- Strangely, the court did not address Executive Order 13892 (Oct. 9, 2019), which instructs executive branch agencies such as the IRS to avoid “unfair surprise” when undertaking enforcement actions. Implementing a new interpretation decades after an agency’s regulations would seem to qualify as “unfair surprise.”
- Many non-abusive easements recorded before 2017 are vulnerable to attack using this argument because many land trust forms excluded after-built improvements from the formula. The first case in which the extinguishment proceeds argument arose, Carroll, did not involve an abusive syndication.
- Several other Tax Court opinions this year have denied a deduction based on this argument: Railroad Holdings, Rock Creek Holdings, Woodland Property Holdings, Habitat Green Investments (a summary judgment order for three separate cases), Hewitt, and Harris. Each of these involved an overvalued syndicated deal except for Hewitt and Harris.
- Hewitt involved a long-held family farm. There is an interesting twist in that one, though, in that the donor later became a syndicator in many other deals after getting a taste of the tax benefits resulting from the first, legitimate donation he made.
- Unfortunately, Harris is completely unrelated to syndications, but the Tax Court denied the deduction based on the extinguishment proceeds clause, citing Oakbrook. This holding belies the fact that the IRS and Treasury have stated that they are not focused on destroying legitimate donations.
- Takeaway point: The Proceeds Clause in deductible conservation easements should copy the language at Treasury Regulation 1.170A-14(g)(6)(ii) with no deviation, even if doing so is awkward because the regulation is not drafted in a manner that lends itself to contractual language and even if the end result is patently unjust for families who build homes on the property after the easement is conveyed. The Tax Court and the IRS are using this argument to attack and defeat legitimate conservation easement donations.
- Logic does not necessarily apply when it comes to conservation challenges. Even legitimate conservation deals can face over a decade of litigation from the IRS, as was the case in Johnson, TC Memo 2020-79 (June 8, 2020), where the Tax Court judge meticulously parsed several appraisals and several appraisers’ testimony line by line before splitting the deduction baby 70/30 in favor of the IRS. The amount the IRS gained from this 13-year battle and use of limited agency and court resources to fight a non-abusive conservation easement? Approximately $63,000, using the back-of-the-envelope calculation and a 30% cash value for the lost portion of the easement deduction. Unfortunately, the costliness of this type of dispute is the reason the IRS is leaning harder on foot faults, like the extinguishment proceeds clause, rather than going through a prolonged battle of the appraisers.
- No floating homesites, ever. The Tax Court continues its reasoning from 2018’s Pine Mountain in a Tax Court memo opinion, Carter, T.C. Memo 2020-21 (Feb. 3, 2020), holding that the landowner’s retention of the right to move a homesite will destroy the deduction. Somehow the court found that protections afforded by applying at least some restrictions to the envelope are automatically insufficient regardless of how restrictive and protective those restrictions may be.
- Of note, the Carter opinion went one step further than Pine Mountain and questioned the appropriateness of homesites at all. It will be interesting (and terrifying) to see whether that reasoning starts popping up in additional building envelope cases.
- Sixth Circuit agrees with IRS and Tax Court in that a “deemed approval” clause will destroy the deduction. The deduction will be defeated if the conservation easement contains a “deemed approval clause” that requires approval to be automatically granted if the easement holder doesn’t reply to a request for approval within a certain time. The IRS and Tax Court, and now the Sixth Circuit, have found that including such a clause means the conservation values will not be perpetually protected and thus, no deduction is allowed. Now, landowners will have to sue the easement holder if the easement holder ignores a request. The circuit has refused to re-hear the case en banc. Hoffman Properties II v. Comm’r, No. 19-1831 (6th Cir., April 14, 2020), rehearing denied June 17, 2020.
Not-So-Terrible for Legitimate Easement Donors
- Easements in the Eleventh Circuit will be upheld even where only a small portion of the property has important conservation values. In the only recent positive case for CE donors, the Eleventh Circuit overruled the Tax Court and held that a golf course easement can protect important conservation values where a portion of the property contains threatened species and is slightly visible to the public, in Champions Retreat v. Comm’r, No. 18-14817 (11th, May 13, 2020).
- Even where golf course pesticides may drain into sensitive habitat of the species being protected, the court notes that a golf course is still more protective than development.
- The court also notes that if there is question as to whether the claimed value of the protections is actually impaired by the reserved rights, then that is an appraisal valuation question and should not automatically destroy the deduction entirely. This reasoning could have interesting applications in the floating building envelope cases, because arguably some conservation values may still be protected within the envelopes and the extent of that protection may be a valuation question.
- Failing to put your basis on the Form 8283 will destroy the deduction, which we already knew because of a few other cases. We discussed this issue in our overview of Belair Woods last year. Basically, abusive syndicators have been skipping the basis box on the 8283 because they don’t want to flag to the IRS that they paid $100,000 three months prior and now are claiming a $10 million deduction. The court wisely continued to hold that the whole point of that basis box is to flag shenanigans like this in Oakhill Woods, T.C. Memo 2020-24 (Feb. 13, 2020).
- Note, the Tax Court didn’t have a problem with skipping the basis box in last week’s Hewitt opinion, because the property there had been in the family’s hands for over 60 years and the donor credibly testified that he did not know the basis because his deceased father had acquired the property and there were no records.
- Maybe the Tax Court will not approve penalties for legitimate conservation easements, even if the deduction is lost because of the technicalities described above. In Hewitt, T.C. Memo 2020-89 (June 17, 2020), the easement deduction was denied because of the extinguishment proceeds clause. However, the Tax Court did not approve the IRS’s imposition of accuracy or gross overvaluation penalties on the taxpayer. The Tax Court pointed to the mitigating factors that the property had been in the family for 60+ years and the deal was not an abusive syndication nor grossly overvalued. If this reasoning holds for future denials based on technicalities, legitimate donors could be shielded from having to pay steep penalties for the privilege of thinking they were doing the right thing when they donated a conservation easement and claimed a deduction.
Is There a Way Forward?
The most troubling aspect of this bloodbath is that the carnage is mostly due to obscenely overvalued syndicated easements. The IRS’s take-no-prisoners litigation strategy is beginning to chill legitimate conservation donations, defeating the entire point of Internal Revenue Code § 170(h) and the Conservation Easement Enhanced Tax Incentive. So what is the solution?
The most troubling aspect of this bloodbath is that the carnage is mostly due to obscenely overvalued syndicated easements.
The Treasury just proposed a settlement program for syndicators that lets non-controlling partners of the investment vehicles pay a 10 – 20% penalty, in addition to paying back the claimed deduction. However, the proposed settlement gives no break for planners or controlling partners in the syndications, who will likely be required to pay up to 40% in penalties in addition to paying back the claimed deduction. It seems unlikely that many of the syndicators will bite.
The ongoing train wreck of an underfunded agency running amok to battle a well-funded tax shelter behemoth, with no regard for collateral damage by either party, is terrible to watch. The Land Trust Alliance has been working to pass the Charitable Conservation Easement Program Integrity Act in Congress, which would help nip many of the abusive syndications in the bud. However, the proposed Act does nothing to address the existing bad case law that is being used to defeat legitimate charitable deductions for easements that pre-date the new IRS positions regarding extinguishment proceeds and floating building envelopes. Perhaps the proposed Act could be modified to provide clarity around extinguishment proceeds and building envelopes, since those foot fault arguments stem from the vagueness of the original statutory language.
Another potential solution is to create a valuation board that can settle these issues without generating a body of law that makes no sense in the context of non-abusive syndications and without requiring a judge to parse and compare complicated appraisals, line by line. In the art context, the Commissioner created an Art Advisory Panel and the IRS runs an Art Advisory Service to streamline valuation disputes over art. A similar panel and service for conservation easement valuation would be more time- and cost-efficient. Again, this doesn’t solve the problem of existing bad precedent, but could help allay some of the IRS’s wrath and save some of the litigation costs expended by the public fisc.
One would hope that the Tax Court would inject some reason into the overall process (and not just with regard to penalties) or that the IRS and Treasury would find a more efficient and responsible solution than destructive case law hinging on foot faults. But not today, folks. Here is hoping for tomorrow.