Conservation has been in the tax news yet again recently. Really, ever since Notice 2017-10, conservation easements, especially those of the syndicated variety, have been caught in the cross hairs of the IRS as well as the Department of Justice while also drawing the ire of a few of those in power in Congress. 1 Most recently, the Tax Court ruled in several new cases, including Railroad Holdings, LLC v. Comm’r, TC Memo 2020-22 and Rock Creek Holdings, LLC v. Comm’r, Tax Court Order, 2/10/2020.
Conservation Easement Litigation in a Nutshell
The battles currently waged with respect to conservation easements can be broken down into two categories, technical faults (TKOs) and valuation. Unsurprisingly, the former yields a simple yet effective strategy for attacking conservation easements on a strict compliance basis. This strategy seems to be a favorite of the IRS recently and appears to be creating the chilling effect the Service apparently desires.2 TKOs have come about in a couple different ways.
TKO Issues
Failure to Disclose Basis on Form 8283
First, we saw issues surrounding Form 8283 requirements in RERI Holdings I, LLC v. Comm’r, 149 T.C. 1 (Jul 3, 2017). (“RERI 1”).3 In RERI I, the taxpayer failed to include “cost or adjusted basis” of the property donated on Form 8283. The Tax Court found this figure to be required by Treasury regulations and that, as a result of its omission, the charitable deduction would be completely disallowed. On the heels of RERI I came Belair Woods LLC et al. v. Comm’r, TC Memo 2018-159. There, the taxpayer again failed to report basis on Form 8283. Instead, the taxpayer stated in an explanation that the basis was unnecessary for the calculation of the charitable deduction. The Tax Court wholly disagreed, citing RERI I, and opened the door for an easy TKO for the IRS in striking down conservation easements.4
Failure for Satisfy Perpetuity Requirement
Another argument the IRS has used with incredible efficiency is strict compliance with the extinguishment regulations relating to protecting a qualified conservation contribution in perpetuity. In the world of real property, things do not last forever. However, IRC § 170(h)(2)(C) requires that conservation easements be protected in perpetuity. The law generally does not like perpetual control of property and it is not unreasonable to believe that a judicial extinguishment of an easement in some form or fashion may come about. Enter the extinguishment regulations.5 Essentially, a conservation deed must provide that upon extinguishment of the easement, the donee should at least receive the proportionate value that the perpetual conservation restriction, at the time of the gift, bears to the value of the property as a whole and such proportionate value must remain constant.
Over time, people insist on being creative in the conservation easement world (terrible idea) and unfortunately for many, the results have not been good. A few of illustrative cases are described below:
- The taxpayer tried to recoup value of subsequent improvements in extinguishment proceeds provision with a priority allocation resulting in possibility done would receive less than the required proportional amount.6
- The taxpayer failed to include proper extinguishment language resulting in possibility that grantee would not receive the proportionate share required, but included savings language citing to regulation which the Court refused to enforce. Inclusion of savings language was held to be insufficient to satisfy extinguishment requirements.7
- The taxpayers’ conservation deed allowed mortgagee a first in line spot to collect from extinguishment proceeds resulting in possibility that grantee might not receive the requisite proportionate funds.8
Recently, we have seen some new cases in the form of TKO-type cases.
Railroad Holdings, LLC and Rock Creek Holdings, LLC
In Railroad Holdings, the Tax Court struck down a $16 million deduction holding that the conservation deed was not compliant with the extinguishment regulations and failed to provide the grantee the requisite proceeds in the event of extinguishment of the easement. In a sister case, a deduction of $7.9 million was set aside. The Tax Court noted that its rulings in these cases were similar to that in Coal Property Holdings, LLC and that the deeds in issue illustrated the same problems, albeit with different language.
The pertinent language in both deeds read to say “For purposes of this Conservation Easement, the fair market value of SERLC’s right and interest (which value shall remain constant) shall be equal to the difference between (a) the fair market value of the Conservation Area as if not burdened by this Conservation Easement and (b) the fair market value of the Conservation Area burdened by this Conservation Easement, as such values are determined as of the date of this Conservation Easement.”
Based on the above, the deeds did not give a proportionate value based upon the time of gift. Instead, the value was fixed as of the time of the gift. Therefore, with respect to each contribution, the donee organization would not receive the proportional increase in any appreciation of the property. Like most TKO cases, this one was disposed of on summary judgment.
Carter v. Comm’r, TC Memo 2020-21 (Bonus Case)
In another recent case of creativity gone wrong,the taxpayer reserved the right in its conservation deed to build a single-family dwelling on each of the 11 “building areas” of no more than two acres, to be determined later, subject to the donee’s approval. After a semi-lengthy opinion, the Tax Court held that the easement given did not meet the perpetuity requirements and was not a qualified conservation contribution, within the meaning of IRC 170(h)(1) as the donor retained rights with respect to the property contrary to the easement. Specifically, while a certain number of acres may have been protected, the structure of the contribution did not allow for an identifiable piece of property to be protected since certain lots could be carved out in the future. Therefore, no deduction allowed.
In short, TKO battles are quick and easy and seem to be often decided on summary judgment.
Valuation Issues
If you, as a taxpayer, want to fight over a conservation easement in Tax Court, you want to fight over valuation. Valuation is a quantitative determination of the value of the easement granted and a loss with respect to valuation does not result in a total loss for a taxpayer. In fact, out of many of the recent and semi-recent cases, the approximate average adjustment landed at around 15%.9
Conclusion
In short, the cases released so far this year, in conjunction with last years cases, show the IRS’ attack pattern in their aggressive scrutiny of conservation easements. It is easy to understand why this pattern exists and that the IRS is can much more efficiently challenge these contributions on a technical basis rather than a substantive value basis. While a policy discussion of whether the IRS should attack and scrutinize as aggressively as it has is a subject beyond the scope of this article. However, it is worthwhile to consider Congress’ track record of legislatively incentivizing conservation through IRC § 170(h) and maintaining a trajectory or making the provisions more expansive and favorable for taxpayers. While the IRS may take the position that many of the transactions may be abusive, is the IRS going too far and potentially hindering some of the Congressional intent behind these provisions enacted by Congress by creating a sweeping chilling effect? It will certainly be interesting to see how this plays out.
Footnotes
- See United States v. Zak, No. 1:18-cv-05774 (N.D. Ga. 2018), Grassley, Wyden Launch Probe of Conservation Tax Benefit Abuse, IR-2019-213, and Letter to Senator Grassley from Charles Rettig.
- See IR-2019-213.
- See also S. Gray Edmondson, J.D., LL.M., RERI Revisited on Appeal, $33M Deduction Denial Upheld (June 5, 2019). RERI I was not a conservation case, but raised the issue of basis reporting in Form 8283
- See Oakhill Woods, LLC v. Comm’r, TC Memo 2020-24
- Treas. Reg. § 1.170A-14(g)
- See PBBM-Rose Hill, Limited v. Comm’r, 900 F.3d. 193 (5th Cir. 2018).
- See Coal Property Holdings, LLC v. Comm’r, 153 TC 7 (2019) and Joshua W. Sage, J.D., LL.M., IRS Leaves $155.5 Million Lump of Coal for Faulty Easement Deed, (Nov. 13, 2019).
- Frederick M. Wall v. Comm’r, (TC Memo 2012-169)
- Jenny L. Johnson Ware, Valuing Conservation Easements: An Empirical Analysis of Decided Cases, Tax Notes Federal (July 22, 2019).