The IRS and folks working in charitable conservation transactions are certainly being kept on their toes with all of the case law that has come down over the past couple of years. Whoever is in charge of keeping the IRS’s Audit Techniques Guide for Conservation Easements up to date has their work cut out for them. To reflect current judicial interpretations and the IRS’s litigation strategies, the IRS updated its Audit Techniques Guide for Conservation Easements on November 9, 2020, and again on January 21, 2021. It has been a few months since those release dates, so let’s think of this article as more of an analysis, rather than an announcement, shall we?
For those of us who aren’t familiar with Audit Technique Guides (ATGs), they are developed by the IRS to provide guidance to IRS examiners during tax return reviews by explaining the important issues that are particular to certain industries. ATGs are also meant to assist small business owners and tax professionals for tax planning purposes within those industries; however, each ATG contains a disclaimer that it is not “an official pronouncement of the law or position of the Service and cannot be used, cited, or relied upon as such.”
For our purposes, the Conservation Easement ATG provides a window into what IRS examiners are looking for when they review a taxpayer’s claim for charitable contribution—which helps us avoid tripping any wires. As many an unhappy taxpayer has learned recently, conservation easement contributions are exceedingly technical and easy to mess up (at least in the past ten years), even with the most honorable of intentions.
The last few updates to the Conservation Easement Audit Techniques Guide were issued January 24, 2018, November 4, 2016, and March 15, 2012. I wrote a little analysis of the 2016 update back in 2016 since it reflected four years of change and that article included a redline showing the changes.
The 2021 update and 2020 update were issued within a few months of each other and brought meatier changes due to the flood of Tax Court and appellate cases over the past three years, so we’ll start with those two in Part I and Part II, respectively. The 2018 update wasn’t too exciting, but in the interest of posterity, Part III rounds up those changes.
Two notes before diving in:
(1) You can find a redline of the 2020 ATG changes shown against the 2018 ATG here and a redline of the 2021 ATG against the 2020 ATG here. Fair warning, though, the redline is difficult to read because of the PDF conversion and because of the length of the document. The following summary is thus a gift to all humanity by your intrepid author, in an effort to spare the rest of you from having to parse those messy redlines.
(2) The strongest conclusion that manifests after taking a look at the ATG changes over the past decade is how much abusive syndications have mucked up this field. The 2016 and 2018 changes were mild and affectionate in comparison to the 2020 and 2021 updates. If the IRS’s strategies and the case law continue developing on the same trajectory, the donative easement may be an endangered species soon. To avoid this fate, it’s critical that we see some legislative action soon reining in abusive syndications and also calling the IRS to heel on challenging legitimate donations based on technicalities. Distressingly, one of the IRS’s deputy chief counsel noted at an ABA Tax Section meeting on January 27, 2021, that, included among counsel’s packed conservation easement docket, are plenty of “garden-variety easements.”
If we’re going to meet President Biden’s 30×30 challenge to conserve 30% of the nation’s open space by 2030, we must be able to include the donated easement in the conservation toolbox, and the IRS’s scorched-earth approach is directly contrary to that goal.
Feel free to jump around with these links:
Part I: 2021 Updates – More on Syndications
The 2021 ATG update focuses exclusively on the weaknesses inherent in the two primary vehicles for abusive syndicated conservation easements: (1) grossly overvalued appraisals and (2) limited partnerships.
For appraisals, the revised ATG now directs the examiner to focus on ensuring that the appraisal:
a. Describes exactly what is being donated: If the appraisal only values the underlying fee title and does not provide a value for the conservation easement, then it is not a qualified appraisal, as discussed in Costello v. Commissioner, T.C. Memo. 2015-87.
b. Analyzes prior transfers of the subject property: If there is a discrepancy in value between the easement and the prior transfer(s) of the property, then the appraisal should reconcile that discrepancy. It is not uncommon for an abusive syndicated easement to involve property that was acquired by the partnership a month or two (or even a day!) before the donation of the easement, with the claimed easement value being an order of magnitude higher than the purchase price.
c. Complies with USPAP and includes any extraordinary assumptions or hypothetical conditions:
An extraordinary assumption or hypothetical condition may be a red flag to the examiner that the appraisal did not adequately address the actual condition of the property.
In addition, the examiner is instructed to determine whether there is a relationship between the appraiser and a promoter of syndications, which may indicate that the appraiser has been providing frequent inflated appraisals for the promoter’s projects.
Section X of the 2021 ATG contains detailed guidance on the various arguments that may be available to the IRS in the fight against abusive partnership syndications, including partnership anti-abuse rules, the substance-over-form doctrine, the step-transaction doctrine, and the economic-substance doctrine. Given the extensive background and case law relating to those doctrines, I’m not going to dig into them here, but the ATG provides a nice outline if you are curious.
For our purposes (i.e., legitimate easement donors), however, it is important to note that if a conservation easement is going to be donated by a partnership, such as a family limited partnership or LLC, the partnership should pre-exist, and be independent of, the conservation easement: The partnership should not be created for the sole purpose of donating the conservation easement. Importantly, the partners/members should have a legitimate interest in the business of the partnership and the underlying property, and not just in the tax benefits that may arise from a conservation easement donation.
That’s it for 2021. The 2020 updates contain many more revisions that impact the non-abusive conservation easement.
Part II: 2020 Updates – The Parade of Horribles Redux
Extinguishment Proceeds, Floating Homesites, Deemed Approval Clauses, Conservation Purposes, Quid Pro Quo, and Gift Substantiation, and OMG So Much About Penalties
If you’ve been reading our updates and keeping up with conservation easement news, it’ll come as no surprise to you that the IRS is very keen on ensuring that certain clauses are drafted just so. I won’t rehash the arguments for these, but the updated ATG is a good refresher on the recent hot topics of extinguishment proceeds, floating homesites, deemed approval clauses, conservation purposes, quid pro quo, and gift substantiation (read: 8283s, contemporaneous written acknowledgments, and appraisals). The ATG has appropriately been revised to reference the case law that has come down on those topics. The ATG also has plenty to say about partnership audits and penalties for valuation misstatements, which are a big issue in the syndicated easement cases right now and, as discussed above, are further fleshed out in the 2021 ATG update.
Curated below are the interesting takeaways on the hot topic areas relevant to legitimate/non-syndicated easements:
1. Extinguishment Proceeds: We all probably know the extinguishment proceeds clause issue front and back by now, but just in case here’s a recap: The Fifth Circuit upheld the IRS’s argument in the 2018 decision, PBBM-Rose Hill, prohibiting the exclusion of the value of after-built improvements from the proceeds that go to the easement holder if the easement is extinguished. The Tax Court further upheld the IRS’s argument in the 2019 decision, Coal Property Holdings, prohibiting the satisfaction of prior claims prior to calculating the easement holder’s share of the proceeds.
2. Floating Homesites: The Eleventh Circuit’s October 2020 decision in Pine Mountain was a breath of fresh air for the taxpayer, overturning the tax court’s holding that an easement with a homesite that is not set in stone is not deductible. The ATG notes the Eleventh Circuit’s decision, but then cites the Golsen rule, which holds that where a tax case is appealable in a particular circuit, the tax court must follow the appellate decision in that circuit but is not required to do so in other circuits.
The ATG’s reference to the Golsen rule is a clear signal that IRS will continue to push its arguments against floating homesites in other circuits in hopes that the Tax Court will continue to side heavily with the IRS.
3. Deemed Approval Clauses: An easement cannot contain a clause that provides for automatic approval of a proposed use if the easement holder does not reply to a request within a certain period of time, per Hoffman Properties II v. Comm’r (6th Cir. 2020).
4. Conservation Purposes: We’re seeing a bit more action on what exactly constitutes an appropriate conservation purpose and whether the easement in fact furthers that purpose. The ATG references the Fifth Circuit’s holding in PBBM-Rose Hill that the easement satisfied the conservation purpose test because the deed stated that the property was being protected for outdoor recreation “for use by the general public.” The ATG also includes a lengthy discussion of Champions Retreat v. Comm’r (11th Cir. 2020), which found 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. The ATG notes that there is a pending motion to amend the opinion in the 11th Circuit, which indicates that the IRS is not taking this one lying down.
5. Quid Pro Quo: The amount of the deduction available for a charitable contribution must exclude any consideration that the taxpayer may have received in exchange for the contribution (referred to colloquially as a “quid pro quo”).
a. The ATG discusses the new IRS regulations regarding state and local tax credits with reference to Treas. Reg. section 1.170A-1(h)(3), which provides that the amount of any state or local tax credit must be excluded from the amount of the federal deduction available for a charitable contribution.
b. The ATG also adds Florida to the list of states with CE tax credit programs because Florida provides an exemption for conservation easement-burdened land from real property tax. Many states have real property tax exemptions or permit reassessment due to conservation easements because the property can no longer be developed as previously assessed.
It is unclear whether this change to the ATG indicates that the IRS is going to survey all the states for the property tax exemption that may arise upon a donation of a conservation easement and challenge the value of the easement due to the property tax exemption.
If so, such an effort would provide another example of the IRS undermining federal goals to incentivize conservation. Local property tax assessments are directly based on how much the property can be monetized (whether by development, extraction, etc.). This is not a quid pro quo: It only makes sense to reduce the property assessment if the land can no longer be exploited to pay the higher property taxes.
c. The ATG also includes a discussion of two recent cases that discuss quid pro quo, Triumph Mixed Use Investments (T.C. Memo 2018-65) and Wendell Falls (T.C. Memo 2018-45). Wendell Falls is a mess of a case, as described in my article linked in the prior sentence, while Triumph Mixed Use Investments provides an excellent outline of how the quid pro quo issue should be analyzed.
6. Gift substantiation: Form 8283, Gift Letters, and Appraisals
a. Form 8283: Failure to put your basis in the basis box in the Form 8283 will kill your deduction, à la Belair Woods and Oakhill Woods. The ATG fails to note that another case came down last year which forgave this sin (Hewitt) because of the length of time that the subject property had been in the taxpayer’s family.
b. Gift Letters: Charitable contributions must be accompanied by a “contemporaneous written acknowledgment” (aka gift letter) from the donee to the donor. Some recent opinions have held that the conservation easement itself can serve as a contemporaneous written acknowledgment in some circumstances. The ATG instructs the examiner to contact IRS counsel if a taxpayer makes this argument. Recommendation: Don’t make this argument. Get a gift letter.
c. Qualified Appraisals: There’s lots of new stuff about appraisals in the 2020 ATG.
i. Discussion of the new gift substantiation regulations adopted in 2018.
ii. Additional detail regarding the reasonable cause exception.
iii. Discussion regarding qualifications for appraisers, particularly regarding “captured” appraisers and IRS-disbarred appraisers.
iv. Discussion of the USPAP rules of ethics.
v. Instruction to review the aggregate investment by partners in the partnership as a factor for determining fair market value of the underlying property, with reference to Plateau Holdings and TOT Property Holdings.
vi. Appraisal Fees: The ATG notes that (I) prior to 2018, appraisal fees for donations were deductible as miscellaneous itemized deductions, subject to the 2% AGI limitation and (II)
Appraisals fees are not deductible as miscellaneous itemized deductions on Schedule A for tax years 2018 – 2025.
vii. Filing Methodology:
1. The ATG states that, if the return is filed electronically, then any attachments, including the appraisal, can be scanned and attached as well. If they are not scanned and attached, then the originals should be mailed with Form 8453. This is great paper-saving news for the trees we’re trying to protect!
2. It also states that the failure to attach the appraisal does not automatically defeat the deduction if the failure is due to reasonable cause and not willful neglect.
7. Partnership Audit and Penalties: There are lengthy new sections on “Partnership Anti-Abuse Rules, Judicial Doctrines, and Codified Economic Substance Doctrine,” the penalty approval process, the codified economic substance doctrine, and penalties specifically related to reportable transactions. These sections are also supplemented by the 2021 update I described in Section I above.
8. The Grab Bag of Other Stuff:
a. Access: The 2020 ATG now includes reference to the requirement that the donee have access to the property to inspect. I’m not aware of any case where this issue arose, so maybe it is just a reminder to the auditor.
b. Facade Easements: Includes much more detail regarding the requirement that the public have visual access to the protected property and lists factors that may be used to determine the appropriate type of access.
c. Cash Donations: Addition of “cash donation to the easement donee” as an example of potential issues to keep an eye out for. It is unclear why this was added. One staff person at the IRS indicated that this was included to ensure that the auditor confirms that the cash gift has been properly substantiated with a gift letter.
d. Third-Party Contact: Note that the examiner is required to provide a 45-day notice to the taxpayer before contacting any third parties.
e. Substantial Compliance Doctrine: Section XIII.B.1 of the ATG contains a meaty discussion of the Substantial Compliance Doctrine, which is an argument that can be used by a taxpayer to defend against the denial of deduction if the taxpayer failed to follow the substantiation requirements strictly, but did provide enough information so as to substantially comply with the requirements. One would think that the existence of this doctrine would clear up a lot of the drama over the past few years, but not so much. The doctrine has been interpreted very narrowly. The revisions to the ATG flesh out the limitations of this doctrine and include new references to many new cases (Hewitt, Kaufman, Izen, 310 Retail, Big River, Belair Woods, and Brannan Sand & Gravel).
Whew, the 2020 updates are exhausting. Have no fear, Part III on the 2018 updates is shorter and actually sweeter (for the taxpayer at least).
Part III: 2018 ATG Roundup – A Little Something for the Donor
Conservation Purposes, Baselines, Gift Substantiation, and Cash Donations
If you read through Parts I and II of the Conservation Easement ATG Takeaways, you’ll see two glaring differences between the 2020 and 2021 updates and the 2018 updates: There were only a few minor changes in 2018 and they mostly acknowledged new court holdings friendly to the taxpayer and contrary to prior IRS positions. You can find a redline of the 2018 ATG changes shown against the 2016 ATG here. As noted in Part I, the redline is difficult to read because of the PDF conversion and the length of the document. Below are the highlights.
The 2018 changes reflected case law that was so much better for the taxpayer. Looking back at how nice the courts were to taxpayer donors pre-2018, it is easy to see how much abusive syndicators have really brought down the wrath of khan onto easement donors in the past three years. These changes are so refreshing, comparatively:
a. Conservation Purposes:
i. Of the four permissible conservation purposes required to be protected under Section 170(h)(4)(a), easements with the purpose of preserving open space must yield a significant public benefit. The 2018 ATG added a notation that the public benefit “is usually visual access from a public highway.”
ii. Further, with respect to the protection of relatively natural habitat as a conservation purpose, the prior 2016 ATG stated that “the CE must protect a habitat that is significant” and the 2018 ATG removed that requirement. It’s unclear why this was removed—the 11th Circuit issued an opinion in Champions Retreat v. Comm’r, 959 F.3d 1033 (11th Cir. 2020) which disagreed with the IRS’s threshold for significance for relatively natural habitat on golf courses, but that was much later than the 2018 ATG’s issuance.
b. Baseline Aerial Photos: The prior 2016 ATG stated that baselines must include an aerial photograph of the property “taken at an appropriate scale taken as close as possible to the date the donation is made.” The 2018 ATG removed this language because of Bosque Canyon Ranch, L.P. v. Commissioner, 774 F.3d 221 (5th Cir. Aug. 11, 2017), which held that “The Tax Court’s hyper-technical requirements for baseline documentation, if allowed to stand, would create uncertainty by imposing ambiguous and subjective standards for such documentation and are contrary to the very purpose of the statute. If left in place, that holding would undoubtedly discourage and hinder future conservation easements.”
c. Contemporaneous Written Acknowledgments: The easement deed itself can constitute the contemporaneous written acknowledgment that Internal Revenue Code Section 170(f)(8) requires the nonprofit to provide to the donor if the deed states no consideration was received for the gift and also contains a merger clause stating that the entire agreement of the party is merged into the deed. This update reflects several decisions by the Tax Court (Averyt (2012), RP Golf (2012), French (2016)). Even if the deed does recite that there is nominal consideration (such as $1) for purposes of contract enforceability, the deed nonetheless can serve as a bargain-sale gift letter, so long as there is a merger clause (310 Retail (2017) and Big River Development (2017)). Note, however, that the 2020 update advised the examiner to contact IRS counsel if the taxpayer makes the argument that the conservation easement serves as the contemporaneous written acknowledgment, so it appears the IRS still expects to exploit some vulnerabilities here.
Lesson: Get a gift letter and don’t rely on the easement to serve this purpose.
d. Cash Payments for Stewardship Endowments: The 2018 ATG finally acknowledged that a “properly substantiated stewardship fee may be deductible if it meets the requirements of IRC § 170,” reflecting the holding in Scheidelman v. Comm’r, 755 F.3d 148 (2nd Cir. 2014), regarding the donation of a cash contribution contemporaneously with a donated conservation easement.
That’s it on Audit Guides for now. If you made it through Parts I, II, and III, congratulations, that was a lot to digest! The IRS seems to be on a roll updating these now, so we’ll plan to touch base on this again with the next update (which is hopefully spread out a little better than the last two!).