On October 28, 2019, the Tax Court released its opinion in Coal Property Holdings, LLC v. Comm’r, 153 T.C. No. 7 (2019). This case comes at a sensitive time of year where deadlines are looming in order to file conservation deeds to qualify for the deduction under Section 170(h), relating to qualified conservation contributions, for the 2019 tax year.1 Coal Property Holdings brings with it some mighty large numbers and illustrates the extreme importance of strict compliance with the regulations under Section 170, and in particular the extinguishment regulations.
Prior to going in-depth, it is worthwhile to consider some of the benefits and burdens of the opportunities afforded by Section 170(h) of the Internal Revenue Code. This provision gives taxpayers an opportunity to qualify for a charitable deduction with enhanced benefits by giving partial interests in property to qualified organizations, as defined under Section 170(h)(3). In making a qualified conservation contribution, a taxpayer is able to achieve certain things that one would not otherwise be able to ordinarily do under Section 170, such as obtaining a tax deduction for gifts of a partial interest in property, utilizing the deduction against up to 50% of adjusted gross income where normal gifts of long-term capital gain property to public charities are limited to only 30%, and being able to carryforward the unused deduction for up to 15 years. However, while Congress seems to show a sincere desire to entice taxpayers to make these gifts to preserve the natural resources of this country, the IRS and the judicial system makes compliance in making the gifts an absolute nightmare. Courts have held that deductions are “a matter of legislative grace, and that the burden of clearly showing the right to the claimed deduction is on the taxpayer.”2 Courts thus demand strict compliance with statutory requirements for claiming deductions. While Congress has greatly incentivized gifts of qualified conservation easements, it has also imposed a number of restrictions and requirements that taxpayers must satisfy to qualify in order for such gifts to be deductible. The IRS has added its own requirements through regulations interpreting the statutory requirements. The statutory and regulatory requirements are often technical and complex. IRS has successfully litigated a number of cases where deductions were denied for donations of qualified conservation easements because of the taxpayer’s failure to strictly comply with arguably minor technical requirements.3 One particularly troubling aspect of this approach is that a gift is actually made and cannot be taken back (i.e. the gift cannot be extinguished). This case illustrates just such an issue. A stick (property right) is removed from the bundle (collection of property rights), never to be held again by the taxpayer. In other words, the restriction on the land is permanent and the taxpayer can no longer utilize the real property in a certain manner limiting both value and potential enjoyment of the property. At the end of the day, the taxpayer in question has made a contribution gift out of its own generosity and goodness of its heart.
In 2013, Coal Property Holdings, LLC granted a substantial qualified conservation easement to a qualified organization. The deed itself provided that the donee organization would receive a share of the proceeds in the event of a judicial extinguishment of the charitable conservation easement. Under the easement deed in at issue, the formula to allocate the proceeds contained the language, “after satisfaction of prior claims” prior to the allocation formula. Further, the formula stated that donee’s share was equal to the property’s fair market value at the time of sale, “minus any increase in value after the date of the grant attributable to improvements,” multiplied by a fraction specified in the regulations, Treas. Reg. Section 1.170A-14(g)(6)(ii). Alternatively, in the event the formula produced a result different from the amount required under regulation, the deed contained savings language that the donee would receive a share of proceeds per the regulation.
Ownership and the Numbers
Property Company (Coal Property Holdings, LLC)
At the time of the subject transactions, Coal Property Holdings, LLC (taxed as a partnership) owned a parcel of land with a holding period of one year or more. In this case, the parcel of land was a 3,713 acre tract of land in Campbell County, Tennessee, contributed to Coal Property Holdings, LLC on September 20, 2013, by Lindsay Land, LLC.
Investment Company (LCV Fund XII, LLC)
In September 2012, Green Zone Investments, LLC acquired an interest in LCV Fund XII, LLC, a Georgia limited liability company in exchange for a contribution of $40.3 million.
Sale of Coal Property Holdings, LLC Interests to LCV Fund XII, LLC
On October 14, 2013, LCV Fund XII, LLC entered into an agreement with Lindsay Land, LLC to purchase a 98.99% interest in the capital and profits of Coal Property Holdings, LLC in exchange for $32.5 million.
Grant of Easement and the Charitable Deduction
Three days later, on October 17, 2013, Coal Property Holdings, LLC granted an easement on the property to Foothills Land Conservancy, a qualified organization for the purposes of Section 170(h)(3). The deed was recorded immediately following. The taxpayer claimed a deduction in the amount of $155 million.
Cash Contributions to LCV Fund XII, LLC: $40.3 million
Cash Paid for Coal Property Holdings, LLC: $32.5 million
Residual Cash in LCV Fund XII, LLC: $7.8 million
Charitable Deduction Claimed: $155.5 million
Calculation of the Charitable Deduction
The charitable deduction was computed by determining the easement value using the “before and after method.” Per an appraisal, the highest and best use for the 3,713 acres in question would be as a coal mine. The before value was concluded to be $160.5 million. The after value was determined to be $5 million. The difference, and thus the deduction amount, equaled $155.5 million.
Issues Raised by the IRS
Failure to Attach Fully Completed Appraisal Summary (IRS Form 8283)
The IRS raised some commonly heard issues (each of which technical). First, the IRS argued that the deduction should be disallowed as a result a failure to attach a fully completed appraisal summary with the return as required by regulations. 4
In support of this position, the IRS noted that Coal Property Holdings, LLC did not complete the box for the “date acquired by donor” and gave a misleading statement regarding acquisition of the property. Additionally, the IRS stated Coal Property Holdings, LLC did not adequately disclose cost or adjusted basis in the property.
As the case was disposed as a result of the extinguishment issue (see below), these arguments are noted but not discussed.
Erroneous Assumption of All Mining Prohibited
Next, the IRS argued that the $155.5 million valuation was based on an erroneous assumption that the easement prohibited all mining on the property. The IRS position was that, based on the language of the deed of easement, subsurface mining would be allowed in some cases.
Again, the case was disposed of as a result of the extinguishment issue, discussed next, thus this argument was merely noted and not discussed in the opinion.
Conservation Purposes Not Protected in Perpetuity (Extinguishment Issues)
The heart of the ruling in this case goes to what happens with the proceeds following a judicial extinguishment of the easement, as contemplated under the regulations. An example of extinguishment would be a condemnation or a taking as part of a judicial proceeding. In this case, there was a $155.5 million valuation before and a $5 million valuation after. The regulation requires that proceeds in the event of an extinguishment be allocated proportionately so as to preserve the perpetuity requirement.5 In short, in the world of real estate, perpetual restrictions or encumbrances are not always possible. Contemplating this very issue, the regulations provide a safe harbor.
In the situation presented, if the land were subject to a judicial extinguishment and the total proceeds were $200 million, the proceeds should be allocated as follows6:
Taxpayer: $6.23 million (3.12%, calculated from $5M taxpayer retained value/$160.5M total property value)
Donee: $193.77 million (96.88%, calculated from $155.5 donated value/$160.5M total property value)
Here, the issue presented was whether the form of the deed of easement provided that (1) increases in value attributable to improvements would be deducted from the sale proceeds prior to multiplying against the ratio of easement to the value of the entire parcel, and (2) the calculation would occur following satisfaction of prior claims.
The Formula Issue
The formula in the deed failed to satisfy the extinguishment regulations because the improvement values would be subtracted from the sale proceeds before determining the proceeds payable to the donee. The case illustrates (with the numbers above) that the donee should receive $193.77 million in the sale situation. However, if the value of improvements post-easement, represent $10 million of the value, then the 96.88% is multiplied against $190 million. Thus, the donee would receive less than the $193.77 million required by regulation. As a matter of fact, the donee could receive less than the required amount and therefore, on that issue alone, the deed of easement did not satisfy the perpetuity requirements.
Satisfaction of Prior Claims Language
The deed of easement allowed for satisfaction of all claims against the property from the total proceeds. The Court noted that this language could be read to allow a subtraction from the proceeds payable to the donee. Therefore, the donee might not receive its required proportion in a sale event.
What about the Savings Language?
The deed of easement did include savings language stating “It is intended that this Section 9.2 be interpreted and adhere to and be consistent with section 1.170-14(g)(6)(ii).” The Court interpreted this language to be a condition subsequent and refused to give effect to the provision. While likely a discussion for another day, the Court has historically ruled unfavorably to taxpayers with respect to “condition subsequent” language. Battlegrounds have been extinguishment clauses, self-cancelling installment notes, and Wandry-type clauses. In short, a condition subsequent acts to retroactively change the inputs in an effort to achieve the desired result. The condition precedent works similar in the sense that it achieves a similar goal, but does so without a feedback mechanism and modification.
In sum, this case is another notch in the belt for the IRS in attacking conservation easements based on technicalities. What is important to note here is that the IRS was able to succeed on the technicality issue alone. There were other arguments surrounding the appraisal summary (IRS Form 8283) and I am sure there would have been a dispute on the valuation but the IRS chose to go for the low-hanging fruit and was able to bring home a bushel in this case. No matter how you slice the facts, there is now a legally binding conservation easement on approximately 3,700 acres that someone paid $30-$40 million to acquire (assuming some fees were paid to some advisors). Value changed hands and no charitable deduction was allowed. Just because no tax deduction was allowed does not mean a binding gift was not made. Ouch.
- See Treas. Reg. § 1.170A-14(g)(1) (“[A]ny interest in the property retained by the donor (and donor’s successors in interest) must be subject to legally enforceable restrictions (for example, by recordation in the land records of the jurisdiction in which the property is locate) that will prevent uses of the retained interest inconsistent with the conservation purposes of the do nation.”); see also IRS Conservation Easement Audit Technique Guide 12 (Rev. Jan. 24 2018) (providing that an easement is not enforceable before it is recorded).
- Interstate Transit Lines v. Comm’r, 319 U.S. 590, 593 (1943); Deputy v. Du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
- See e.g. Zarlengo v. Comm’r, T.C. Memo 2014-161 (holding that deed of easement executed in 2004 was not effective as a donation until January 26, 2005, when it was recorded).
- See Treas. Reg. Section 1.170A-13(c)(2)(i)(B).
- See Treas. Reg. Section 1.170A-14(g)(6)(ii)
- This example was used in the opinion.