The much criticized syndicated conservation easement (SCE) industry is chalking up a victory this month, but there are probably other ways to look at it.
Judge Cary Douglas Pugh of the United States Tax Court has allowed $7,834,091 of a $10,427,435 charitable deduction claimed by Champions Retreat Golf Founders LLC on its 2010 tax return. Given that the IRS wanted to allow $20,000 that seems like a pretty good result for the partners in the Kiokee Creek partnership who seem to have most of the dogs in this fight. (The current owners of the Champions Retreat, 3 nine-hole golf courses and related facilities in Evans GA, have nothing at all to do with the case.) A closer look indicates that maybe they did not fare all that well.
2010 is ancient history when it comes to the syndicated conservation easement (SCE) industry. And Champions is pretty tame compared to a deal like TOT Property Holdings LLC, where, in 2013, a partnership claimed a nearly $7 million deduction on property that it had acquired weeks before for just over a million. In 2017 the IRS made certain SCEs listed transactions which has engendered a bruising political fight as well funded lobbyists have resisted reform legislation that has bipartisan support on a good day.
Dawn Of The Syndicated Easements
According to Judge Pugh’s earlier opinion in this case, the inspiration for this deal came from Douglas Cates, the accountant for the then owners of Champions Retreat. What inspired him was the opinion by Judge Wells in Kiva Dunes Conservation LLC. The situation was very similar. A golf course with apparent residential development potential raises capital by allocating a conservation easement deduction to a special class of limited partners. In this case fifteen partners, mostly clients of Mr. Cates, contributed $2,705,000 to form Kiowa Partners. Kiowa Partners contributed $2.7 million for a 15% interest in Champions. Kiowa was allocated 98.9% of the charitable deduction.
Presumably the Kiowa partners were able to use the deduction. At the top federal rate it would have saved them in the aggregate $3,649.602 roughly 1.35 times their investment.
Kiva Dunes and Champions are different from what SCEs have become. Recent aggressive deals involve a much shorter gap between the acquisition of land and the creation of the easement. The Senate Finance Committee launched a major investigation of the SCE industry in 2020. The biggest takeaway was that “the engine of every syndicated conservation-easement transaction” was an inflated appraisal.
Robert Ramsay, President of the Partnership For Conservation, the industry trade group for syndicated conservation easements, calls the case a win:
This decision validates the appraisal methodology that was used in valuing the donation and highlights the fundamental flaw with any blanket attempt to deny the value of conservation easements simply based on the class of land ownership. As P4C has said from the beginning, the core issue at the heart of upholding the integrity of all conservation easements is valuation. This case provides the latest validation that lands conserved by partnerships are just as valuable for protecting critical habitats and working lands for the next generation of Americans as lands conserved by individuals or any other class of landowner.
One way of looking at the decision is that the IRS did not fight that hard on valuation. Comments by Judge Pugh seems to indicate that. For example in a footnote she mentions that Claud Clark III, the primary appraiser for Champions (and not coincidentally Kiva Dunes), is caught up along with other defendants in litigation with DOJ. You can read about that here. His name comes up a lot in the Senate report also.
The Long And Winding Road
Initially the IRS denied the deduction entirely on the grounds that there was not enough public benefit going on. There was something called denseflower knotweed being protected, but it occupied a very small area. There was some discussion of squirrels, but given that it is legal to shoot squirrels during hunting season in Georgia, they weren’t viewed as endangered enough. As far as scenic enjoyment of the public goes, the courses are in a gated community and not visible from the road. So Judge Pugh agreed with the IRS and denied the deduction entirely, as I discussed here. That was in 2018 – some seven years after the return on which the deduction was claimed.
Champions appealed. The Eleventh Circuit saw things differently. Just because Georgia doesn’t want to protect the squirrels so much does not mean that they shouldn’t get federal benefits. And even though you can’t see the area from the road, kayakers and canoers, who are part of the public I guess, can see it from the river. So there was enough of a conservation purpose going on. That was in 2020. The case goes back to the Tax Court.
The Appraisals
Judge Pugh offers us a brief course in appraisals as she discusses the case. You get the impression that she is not all that pleased with Claud Clark III.
When you give something to charity your deduction, generally, is the fair market value of what you gave away. Since there is not a lot of buying and selling of easements, the regulations allow you to value them based on the difference between the fair market value of the property prior to the easement versus the fair market value of the property encumbered by the easement. The latter “after” value can often be the property as it is currently being used. The “before” value is an alternative “highest and best use”. That is where the controversy tends to arise.
The appraisers for Champions – Claud Clark III and Thomas F. Wingard – opined that the highest and best use for the 27-hole golf course was an 18-hole golf course and a residential subdivision. David G. Pope, the appraiser for the IRS, thought that the highest and best use of the 27-hole golf course was as a 27-hole golf course. He assigned a nominal $20,000 value to the easement. That was pretty generous. I would probably be willing to renounce my superpowers for five grand. All three appraisers agreed that the highest and best use after the easement was as a 27-hole golf course. It can be confusing, at least to me, because the after value will often be what the property is now, while they “before” value is something that might have been.
Champions Retreat is actually 3 nine-hole courses each designed by a champion – Arnold Palmer, Jack Nicklaus or Gay Player. In the dystopian nightmare that Claud Clark III lays out the course called “The Bluff” designed by Jack Nicklaus would become a residential subdivision.
There is a pretty deep dive in the highest and best use which involves several factors including legal permissibility and financial feasibility. Judge Pugh, as you would expect from the bottom line went with Mr. Clark’s obliteration of Jack Nicklaus’s masterpiece.
There are three methods to value property – sale comparison, income method and replacement cost. For a case like this you use a variation of the income method called the “subdivision development method”. There are six steps. Basically you are going to take the land and spend a bunch of money doing stuff to it and selling the pieces which will give you a pile of money left over. You then value that future pile of money taking into account not only the time value of money, but also risk factors and entrepreneurial factors. It seems like hypothetical developments run a lot smoother than real ones where it is one GD thing after another, but that might just be me.
The IRS argued that the subdivision method is “susceptible to manipulation” because of all the assumptions making the comparable sales method better. They note that Clark mentioned two sales but did not explain why they were not comparable. This is where Judge Pugh lays into the IRS (i.e. the respondent):
Respondent criticizes Mr. Clark for mentioning two sales in his expert report but failing to explain why those two sales could not have formed the basis for a valuation under the comparable sales method. But respondent failed to offer his own analysis of those sales using the comparable sales method. Without more in the record, we cannot determine whether the lots sold were comparable, how they might have been similar or different, and whether (or what) adjustments were necessary to make those lots comparable to the property at issue in this case.
Judge Pugh’s Bottom Line
Judge Pugh was not well pleased with Mr. Clark’s appraisal, but the IRS had not given her an alternative to work with, once she agreed that a residential subdivision could be the highest and best use. She worked with his numbers adjusting the “absorption rate” i.e. how long it would take to sell all the lots. Clark had it at 2.5 years. The Judge said 5. That modification knocked his before valuation down to $10,762,856 from $13,306,170.
There was also a significant difference of opinion on the after value with Clark at $1,436,176 and the IRS appraiser, Pope, at $4,280,000. Judge Pugh noted that the actual sale of the course in 2014 was much more supportive of Clark’s valuation and she weighed it in at $1,942,560. She opined that Mr. Pope’s numbers were very far off – “indeed, they were not even playable, much less close to the pin”. Her final value of the easement was $7,834,091.
Attorney Vivian Hoard who represented Champions wrote me:
For the past decade the taxpayer has been confident that it structured and valued the easement appropriately.
How Big A Win Is This?
The people I think about are those fifteen Kiowa partners, mostly clients of Douglas Cates. They put in $2.7 million and were rewarded with a deduction that should have yielded them almost $3.6 million in tax savings. Presumably they would not have jumped in if they could not use the deduction at the top bracket. If they are really lucky, the IRS will not be able to put through the adjustment to their individual returns. According to a 2015 TIGTA report that does sometimes happen.
Still let’s assume that in their case the system works as it is supposed to. The aggregate adjustment of $2,593,344 will hit their 2010 returns which at the top 2010 rate of 35% creates an aggregate deficiency of $907,670. So they are giving back most of their 2010 winnings of $949,602 (the excess of tax savings over investment). And then there is the interest bill which according to the calculator comes in at $539,804. Of course if they brilliantly invested their tax savings back in 2011, they are still way ahead, but to the simple minded, there is no way that this result is a win for them. Of course, we don’t know the exact terms of the deal. And it gives me a headache to try to figure out what happened to their basis.
When you consider that the IRS did not try very hard to fight on valuation and we end up with a result which appears to wipe out any gains that went to the investors, I think I feel OK about discouraging people from going into these deals.