A string of taxpayer victories in Conservation Easement cases has many taxpayers who have sponsored or invested in these transactions re-thinking whether settling pending tax court litigation is a good idea, after all. The Eleventh Circuit’s decision in Pine Mountain Preserve, LLLP v. Commissioner, coupled with recent Tax Court decisions in Kissling v. Commissioner and Rajagopalan v. Commissioner have the conservation easement community feeling confident about litigation prospects. But taxpayers who want to litigate these cases should not look at their prospects through rose colored glasses. The IRS could not be more clear: it intends to litigate and fight against these transactions with every resource available.
The IRS is aggresively pursuing taxpayers who participate in conservation easements. (Photo By Bill … [+]
CQ-Roll Call, Inc via Getty Images
I have and do advise anyone who is considering entering into a syndicated conservation easement transaction today: do not even think about it. The litigation costs – let alone the time and energy – of a battle with the IRS simply cannot be understated. As a tax controversy and tax litigation attorney, I represent clients who have involvement with conservation easements. Because of that, while I’ve had no involvement with any of the cases discussed in this article, my assessment can’t possibly be completely impartial. It is because of that representation, however, that no matter how much I think a particular conservation easement case has a very good chance of being decided in favor of the taxpayer, I know that such a victory may be Pyrrhic at best. Anyone considering whether to settle or fight in a conservation easement case should carefully consider the financial and emotional cost of litigation when evaluating a possible settlement. As I’ve said before, fighting the IRS can take an emotional and physical toll on a person.
A Public-Private Partnership to Conserve Land
As I explained in an earlier article, a conservation easement is a collaborative effort between the federal government and landowners to protect land from development and conserve it for future generations. The landowner enters into a voluntary and binding legal agreement encumbering property that she owns, restricting its use exclusively for specified conservation purposes. The agreement must run with the property and in favor of a qualified donee organization—a governmental unit or a publicly supported non-profit organization with a commitment to protect the donation’s conservation purposes. These purposes can include preserving land for outdoor recreation, preserving the natural habitat of wildlife and plants, preserving open space for scenic enjoyment, and preserving the façade of historic structures. In return, the federal government, through the tax code, grants the landowner a tax deduction in the amount of the diminution in her property’s value resulting from the restriction placed on it. The National Conservation Easement Database has documented about 32.7 million acres nationwide preserved to date by almost 200,000 distinct conservation easements. According to one study, the Treasury lost about $600 million a year between 2003 and 2008 on account of these donation deductions claimed by individuals.
Congress first enacted a tax deduction for charitable contributions of conservation easements as a temporary provision in 1976, and then made that deduction permanent in 1980. When enacting the permanent deduction provision, Congress specified two separate perpetuity requirements, the so-called perpetual-grant and perpetual-protection requirements. Specifically, Congress provided that the restriction constituting the easement should be “granted in perpetuity,” and the “conservation purpose” sought to be achieved by that grant should be “protected in perpetuity.” As I explain below, after years of inactivity, the IRS abruptly and without explanation began wielding both these perpetuity requirements as cudgels in an effort to deprive taxpayers of any tax benefits from their charitable contributions of conservation easements.
During the intervening time, there was apparent consensus on what the perpetuity requirements entailed. In particular, the Senate Finance Committee report accompanying the 1980 legislation explained the perpetual-protection requirement thus: “By requiring that the conservation purpose be protected in perpetuity, the committee intends that the perpetual restrictions must be enforceable by the donee organization (and successors in interest) against all other parties in interest (including successors in interest).”
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An implementing Treasury regulation finalized in 1986 states that “any interest in the property retained by the donor . . . must be subject to legally enforceable restrictions. . . that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation.” Harmonizing that regulation with the 1980 Senate Finance Committee Report, it is clear that it is the donee organization that is envisaged as preventing inconsistent uses. Therefore, the regulation quoted above would more faithfully track congressional intent if it were read as follows: “that any interest retained by the donor must be subject to legally enforceable restrictions that will enable the donee organization to prevent uses of the retained interest inconsistent with the conservation purposes of the donation.” And that is exactly how that regulation implementing the perpetual-protection requirement has been understood by taxpayers and those advising them, at least initially with apparent tacit consent of the IRS.
The IRS’ Strained Reading of the Perpetuity Requirements
But after almost two decades, during which both the statutory and regulatory schemes remained largely unchanged, the IRS seemed to precipitately indicate a ramp-up in audit and litigation activity, issuing Notice 2004-41. Issued without an opportunity for public participation through notice-and-comment procedures that generally precede promulgation of regulations, this notice cautioned taxpayers engaging in conservation easement transactions of the Service’s intention to disallow “improper deductions” and impose penalties “in appropriate cases.” The notice focused on valuation of conservation easements, reminding taxpayers that availability of a deduction required that the easement be “substantiated in accordance with regulations prescribed by the Secretary,” and highlighting the constraint “that the amount of the deduction may not exceed the fair market value of the . . . contributed easement. . . reduced by the fair market value of any consideration received by the taxpayer.” Other than a passing reference to the perpetual-grant requirement, the notice was silent on the two perpetuity requirements.
The other shoe dropped with Notice 2017-10, again issued without notice-and-comment procedures, in which the Service identified conservation easements granted through partnerships or other pass-thru entities, so-called syndicated easement transactions, as listed transactions and notified taxpayers that the “IRS intends to challenge the purported tax benefits from this transaction based on overvaluation of the conservation easement.” Like Notice 2004-41, Notice 2017-10 only briefly mentioned the perpetual-grant requirement and made no reference to the perpetual-protection requirement. Unlike Notice 2004-41, however, Notice 2017-10 imposes draconian and burdensome reporting requirements, as well as strict and heavy penalties for the failure to comply with those requirements.
Belying its proclaimed intention in both notices to train its enforcement guns on the valuation of conservation easements, however, the IRS has been engaged ever since in an exercise in revisionist history, rearticulating the two perpetuity requirements in a manner that would trip up almost any grant of a conservation easement. Instead of challenging the taxpayer’s claimed valuation of a conservation easement, the Service has typically been hunting through the grant instrument, looking for provisions that it argues run afoul of its strained reading of one or both perpetuity requirements. The upshot? The IRS disallows the entire charitable contribution deduction on the grounds that the taxpayer failed to comply with the threshold prerequisites for a valid conservation easement.
For example, the IRS points to the amendment clause typically found in most easement deeds, contending that such a clause opens the door to the parties’ amending the easement in ways violative of the perpetual-protection requirement, notwithstanding language in the clause precluding amendments inconsistent with the conservation purpose of the grant. In effect, then, the Service seems to be arguing that the donee organization is not to be trusted in the exercise of its contractual consent power.
That argument flies in the face of congressional intent to charge the donee organization, as holder of the easement, with enforcement of the perpetual-protection requirement. It has also been consistently rejected by the Tax Court and every Court of Appeals to have considered it. In rejecting it, the reviewing courts have refrained from delving into the legislative history of the perpetual-protection requirement. They have, however, found a donee organization’s tax-exempt status adequate reason for respecting that organization’s discretion.
Observing that “[a]ny donee might fail to enforce a conservation easement,” the D.C. Circuit has pointed out that “a tax-exempt organization would do so at its peril.” Simmons v. Commissioner, 646 F.3d 6, 10 (D.C. Cir. 2011), aff’g T.C. Memo. 2009-20. The Sixth Circuit, too, rebuffed a similar IRS challenge, focusing on the absence of any evidence suggesting that the donee organization “is unwilling or unable to monitor and enforce compliance so as to maintain the stated conservation purpose in perpetuity.”
The IRS Tumbles Down Pine Mountain
Undeterred, the IRS has pressed ahead, seeking to strike down the grant of a conservation easement for allegedly violating not just the perpetual-protection but also the perpetual-grant requirement. It tasted partial success with the latter argument in the Tax Court in Pine Mountain Preserve LLLP v. Commissioner, 151 T.C. 247 (2018), a case involving three separate easements granted in 2005, 2006, and 2007, respectively, over some 6,224 acres of land in Shelby County, Alabama, about 20 miles south-east of Birmingham.
The Tax Court allowed a deduction for the 2007 easement covering “a specific, identifiable piece of real property,” rejecting the Service’s contention that a general amendment clause in the easement deed could enable the parties to amend the easement in ways that might violate the perpetual-grant requirement, “e.g., by reducing the size of the . . . [c]onservation [a]rea or by permitting residential construction within it.” Drawing inspiration from the rationale expressed by the D.C. Circuit in Simmons v. Commissioner, in denying an IRS challenge to the perpetual-protection requirement, the Tax Court extended that rationale to the perpetual-grant requirement. Finding it “hard to imagine” how the donee organization “could conscientiously find such amendments to be ‘consistent with the conservation purposes’ set forth in the easement,” the Tax Court noted that the IRS’ argument “would apparently prevent the donor of any easement from qualifying for a charitable contribution deduction,” as long as “the easement permitted amendments,” a result it deemed untenable. Consequently, the Tax Court concluded that the amendment clause in the 2007 easement deed did not violate either the perpetual-grant or the perpetual-protection requirement.
Nevertheless, with only a single dissenting vote, the Tax Court in that case sustained disallowing deductions for the remaining two easements at issue, those granted in 2005 and 2006, because the property owner retained certain development rights over the conservation area.
Invoking a “Swiss-cheese” metaphor, the Tax Court majority “imagine[d] the entire easement-related area as a large slice of Emmenthaler cheese.” The majority worried about the property owner making “new holes” in this cheese. “The holes represent the zones reserved for commercial or residential development.” The majority reasoned that the property owner “could put new holes in the cheese and make up for it by adding an equal amount of previously unprotected land to the conservation area.” Alternatively, argued the majority, “he could put new holes in the cheese and make up for it by plugging the same number of holes elsewhere in the conservation area.” Claiming that the “statute thus bars the developer from putting any new holes in the cheese,” the Tax Court majority concluded that the 2005 and 2006 easements “did not restrict a specific, identifiable piece of real property,” and therefore, violated the perpetual-grant requirement.
On appeal, the Eleventh Circuit reversed the Tax Court’s holdings with respect to the 2005 and 2006 easements, eschewing the Swiss-cheese metaphor and declaring “that the better cheese analogy is to Pepper Jack.” The Court of Appeals explained that “the reserved rights don’t introduce holes into the conservation-easement slice, because the entire slice remains subject to ‘a restriction’—i.e., the conservation easement.” Therefore, concluded the court, “the reserved rights are embedded pepper flakes, and, so long as they don’t alter the actual boundaries of the easement,” the perpetual-grant requirement is satisfied.
Making clear that its opinion wasn’t giving “the Pine Mountains of the world a free pass,” the Eleventh Circuit pointed out that even “after passing through the granted-in-perpetuity gateway, a conservation easement must still satisfy . . . [the] protected-in-perpetuity requirement.” To make that determination for the 2005 and 2006 easements, the Eleventh Circuit remanded the case back to the Tax Court. Even as it did so, the Court of Appeals remarked that the donee organization, the North American Land Trust (NALT), “has extensive advance-approval rights under these easement contracts. NALT is a sophisticated land-conservation organization, and we have little doubt that when it comes to negotiating conservation easements, it is well positioned and equipped to look after conservation interests.”
In doing so, the Eleventh Circuit appeared to be echoing the sentiments of an amicus brief filed by Land Trust Alliance, Inc. in the case, arguing that when deciding whether an easement has been granted in perpetuity, a court should presume “as a matter of law that easement holders will faithfully comply with their obligations under the conservation easement and under Code §501(c)(3),” which provision governs nonprofit organizations in general.
By entrusting the donee organizing to police the dual perpetuity requirements, the Eleventh Circuit’s Pine Mountain opinion thus forces the IRS not only to read those requirements consistent with legislative intent but also to live up to its own word in the two notices the agency has issued in this area, Notice 2004-41 and Notice 2017-10, and litigate the merits of the value of a conservation easement claimed by a taxpayer instead of trying to ensnare him with novel theories that would seek to deny the obvious fact of his having granted a valid conservation easement in the first instance.
The Battle of Experts
A couple of Tax Court cases that followed right after the Eleventh Circuit decided Pine Mountain signaled why the IRS may have been so keen to fight this battle so far away from the promised battleground of valuations: On both occasions, the Service came up second-best in the valuation race.
The value of a conservation easement is its fair market value (FMV) at the time of the contribution, with Treasury regulations defining FMV as the “price at which the property would change hands between a willing buyer and a willing seller.” These regulations prefer using sale records of properties with easements comparable to the contributed easement at issue, provided a substantial record of such sales exists. That, however, is seldom the case. Recognizing that, the same regulation provision allows looking to the difference between the FMV of the property encumbered by the easement before and after the grant of the easement, the so-called before-and-after test. For purposes of this test, the regulations provide considering not only the property’s current use, but also the property’s highest and best use both before and after the easement grant. In computing “before” and “after” values for the test, courts generally use the comparable-sales and income methods. Regardless of the method used, the before-and-after test usually boils down to a duel between the IRS’ and taxpayer’s economic experts, each side marshaling assumptions and projections about the larger economy and the specific piece of property at issue to answer an imponderable: what might the property have been worth had it been put to its highest and best use—both with and without the easement on it.
In both the post-Pine Mountain cases I examine here, the IRS drew attention to provisions in the respective easement deeds to argue that the perpetual-grant requirement had been violated. And in each case, the Tax Court put a stop to those arguments by pointing to its own Pine Mountain opinion regarding the 2007 easement at issue in that case. “Once we decided in Pine Mountain that the power of parties to amend a deed of easement did not ipso facto render all donations of such easements nondeductible, this case became one of the apparently rare instances in which the only dispute is about the proper value of an easement,” the Tax Court wrote in the first of these cases, Kissling v. Commissioner . Similarly, in the second case, Rajagopalan v. Commissioner, the Tax Court, while acknowledging the presence of “an amendment clause that allows the parties to modify certain restrictions in the deed of easement,” nonetheless rejected the IRS’ argument “that this deprives the easement of the required perpetuity,” stating that the court “expressly rejected this argument” in its Pine Mountain opinion.
The duel of the experts then ensued in each case. Kissling involved façade easements on three commercial buildings in Buffalo, New York, contributed to the National Architectural Trust in 2004 by individual taxpayers through a partnership. The IRS fielded a solitary valuation expert against three for the taxpayer. The court expressed “some serious concerns” about the IRS expert’s methodology. Cherry-picking its way among the several components of the before-and-after test based on the reports of the different experts, the court “determined that the correct total value of the easements” was only slightly lower than what the individual taxpayers had claimed on their returns; $ 672,512 rather than $770,310, for a total difference of $97,798, a difference too small to attract any accuracy-related penalties.
The second case, Rajagopalan, turned out to be an even bigger rout for the IRS. At issue was an easement on almost 90 acres of land in Haywood County, North Carolina, granted to NALT in November 2006, “at what turned out to be very nearly the frothiest point on a local real-estate bubble that was even bubblier than it was in most parts of the nation.” Once again, the easement had been granted through a partnership. Each side fielded a single expert. The IRS’ expert determined a “before value” of $1,280,000 and an “after value” of $560,000, for an FMV for the conservation easement of $720,000. The taxpayers’ expert determined a “before value” of $4,150,000 and an “after value” of $1,250,000, for an FMV for the conservation easement of $2,900,000. The partnership had claimed on its return an FMV for the easement of $4,879,000, and the individual taxpayers, on whose returns the deduction had “flowed through,” urged the Tax Court to disregard their own expert and conclude “that the FMV of the conservation easement is at least the amount claimed by” the partnership.
The Tax Court acceded and reached that very conclusion, even though it admitted that “[t]his is an exceptionally unusual conclusion to reach in a conservation-easement case.” But the court felt compelled, given “plenty of credible evidence that land prices per acre were booming in the years before the easement’s creation.” Looking “at it from within the market bubble that existed at that time,” the court found the claimed deduction “entirely reasonable.” Justifying its decision to settle on a number outside the range provided by “the experts who battled it out at trial,” the court noted that while the taxpayer’s expert had relied primarily on transactional data of other properties,” the court itself “relied on transactional data of the specific property at issue.” Of course, the court had to do so, because that transaction was the only transaction before the court.
A third case in which the Tax Court decided against the IRS expert is Glade Creek Partners, LLC v. Commissioner. In Glade Creek, the Tax Court held that the charitable donation deduction was invalid because the deed making the conservation easement donation improperly subtracted posteasement improvements from the extinguishment proceeds before determining the share to donate to the conservancy receiving the donation. In other words, Tax Court held the deed did not properly allocate extinguishment proceeds as required by the applicable Treasury Regulation. Although the deduction was disallowed, the court still considered expert testimony on the question of value to determine if the IRS penalty proposed applied.
Glade Creek’s attorneys made quick work of the IRS appraiser, who relied on several incorrect and misguided assumptions in rejecting the taxpayer’s experts conclusion that residential real estate development was the highest and best use of the property (HBU). And even once the court determined that the HBU was in fact residential real estate, the Tax Court disregarded several other portions of the IRS’s expert testimony, including his comparable price properties and sales history analysis. Taken together, the court found the IRS appraiser’s conclusions were so flawed that his testimony was disregarded entirely for determining the before value of the easement. However, the IRS did not accept the taxpayer’s conclusions whole cloth, either. The taxpayer claimed a deduction of $17.5 million, and the IRS argued that the entire deduction should be disallowed and a 40% penalty applied. While the entire deduction was disallowed due to the issue with the deed discussed above, after considering both the taxpayer’s expert and discounting the IRS’s expert, the Tax Court held that the proper value of the easement deduction was closer to $8.6 million and applied a 20% penalty to that reduced amount.
Challenging Notice 2017-10
In my earlier article, I discussed an IRS settlement program for such syndicated easement grants made through partnerships. Pine Mountain, Kissling, and Rajagopalan all seem to indicate that taxpayers with large amounts of claimed contribution deductions at stake who have made good-faith efforts to comply with substantiation and other requirements governing conservation easements may well spurn this offer and litigate their valuation disputes. If any of these taxpayers need stiffening of their resolves, the Supreme Court may soon provide it.
On December 1, the Court heard oral argument in CIC Services, LLC v. IRS, a case in which the taxpayer is asking the Court to allow a pre-enforcement challenge to an IRS notice impacting captive insurers, a notice issued without notice-and-comment rulemaking and one imposing onerous reporting requirements, huge potential tax penalties, and possible criminal penalties. What does this case have to do with conservative easements? Recall that both of the IRS’ recent pronouncements on conservation easements—Notice 2004-41 and Notice 2017-10—were issued without notice-and-comment rulemaking. And more importantly, analogous to the notice at issue in CIC Services, Notice 2017-10 imposes burdensome reporting requirements on donors making conservation easements through partnerships or other pass-thru entities as well as their material advisors with failure-to-comply penalties of as high as $200,000 for an entity and $100,000 for an individual. Civil and criminal penalty possibilities abound in both captive insurance and conservation easements. During the CIC Services oral argument, a clear majority of the Supreme Court justices seemed inclined to allow the taxpayer to challenge the notice without first paying the penalty. If, as expected, the Court allows a pre-enforcement challenge in CIC Services, a similar pre-enforcement challenge to Notice 2017-10 should get underway almost immediately. Prior to the Supreme Court taking up CIC Services, I argued in Tax Notes that Notice 2017-10 (subscription required) is problematic for these very reasons.
It has been more than 15 years since the IRS threatened in Notice 2004-41 to crack down on what it characterized as abusive transactions involving exaggerated valuations of conservation easements. But instead of a front-on challenge to these valuations, the Service seems to have been engaged in two-pronged asymmetric warfare. First, it has largely confined its litigation strategy to taking “sniper shots” at the easement grants themselves, claiming that they violate one or both perpetuity requirements. And second, through Notice 2017-10, it has sought to strong-arm participants in syndicated conservation easement transactions to settle. But the Eleventh Circuit’s Pine Mountain opinion appears to have stymied the first prong. And a taxpayer-friendly result in CIC Services may well defang Notice 2017-10. If so, the IRS may soon run out of cover and be forced to litigate the merits of conservation easement valuations, a development that good-faith donors of such easements should welcome.
It Seems Like Taxpayers are Winning – What’s the Downside of Participating in a Conservation Easement?
Yes, some taxpayers are winning, and there have been some key taxpayer victories lately. But there are a few things about these victories that investors should keep in mind. The process of battling the IRS takes a lot of time, a lot of money, and a lot of nerve.
Time: For those taxpayers who are encouraged by the Pine Mountain win in the Eleventh Circuit, consider this: the tax years at issue in that case are 2006, 2006, and 2007. You read that right. It has been over ten years since the tax returns at issue were filed, and the case is not over yet. It is heading back to Tax Court.
Money: The IRS knows right where to look to see if the partnership or LLC fighting the battle has enough capital to fight the good fight – the balance sheet. Is this partnership well capitalized or not? If not, then there won’t be sufficient funds to fight the IRS at the IRS Exam, IRS Appeals levels, then in Tax Court, if necessary in Appeals Court, and if necessary back in Tax Court. The IRS is taking an aggressive approach and is auditing every single syndicated Conservation Easement Deduction, and likely will issue notices of deficiency for all. Legal fees can easily exceed what partnerships have in reserves, and if so, partners will have to infuse additional capital into the partnership in order to keep fighting the IRS.
Moreover, even if a partnership does keep up the fight, in light of these recent taxpayer victories, does it mean that all conservation easement cases will be decided in favor of taxpayers? Not even close. It is therefore critical that partners consider that a deduction today may very well turn into a tax bill later, plus interest. The IRS is entitled to interest at 3% above Prime on tax, which is due from the date the tax was due. Looking back to Pine Mountain, if the partners in that entity end up owing tax, they will owe interest since 2005.
Nerve: Fighting the IRS is no easy task, even with a good lawyer by your side. It is important to consider whether you are the kind of person who can sleep at night knowing that the IRS may literally come knocking on your door. Taxpayers who participate in conservation easements can expect to have the deduction disallowed until they are proven right – and this is not an emotional place that many taxpayers are comfortable in.
Conclusion
In light of these recent taxpayer wins in Tax Court and at the Eleventh Circuit, those who have a stake in the conservation easement world have good reason to take heart. But as any attorney who has actually tried tax cases will tell you, trials are unpredictable and expensive. Indeed, fighting with the IRS even before getting to trial is expensive and takes a toll on those who are forced to do so. One client of mine put it this way: “when the battle with the IRS first began, whenever I went out to the mailbox, my hands would start trembling.” Taxpayers who are considering whether or not to settle should be encouraged by the recent hard-won taxpayer victories, but take care not to discount the cost of a trial and appeal, both from a financial and emotional perspective.