Monday, July 29, 2013

Carpenter v. Commissioner Revisited - Federally-Deductible Conservation Easements Must be Extinguishable Only in a Judicial Proceeding

Teller county copy
In Carpenter v. Commissioner, T.C. Memo 2013-172 (Carpenter II), the Tax Court denied the taxpayer’s motion for reconsideration and supplemented its opinion in Carpenter v. Commissioner, T.C. Memo. 2012-1 (Carpenter I). The court clarified that Treasury Regulation § 1.170A-14(g)(6)(i)—the "extinguishment" regulation—sets forth the conditions under which federally–deductible conservation easements can be permissibly extinguished, namely, in a judicial proceeding upon a finding that continued use of the property for conservation purposes has become impossible or impractical. The court specifically rejected the argument that the extinguishment regulation is merely a safe harbor, explaining: "To make our position clear, extinguishment by judicial proceedings is mandatory. Therefore, we reject petitioners’ argument that [the extinguishment regulation] contemplates any alternative to judicial extinguishment."

The Tax Court also rejected the taxpayers’ argument that the First Circuit’s opinion in Kaufman v. Commissioner, 687 F.3d 21 (1st Cir. 2012) (Kaufman III), was an intervening change in law that required the Tax Court to reconsider its holding in Carpenter I that conservation easements extinguishable by mutual agreement of the parties do not satisfy the extinguishment regulation. The Tax Court explained that Carpenter is appealable to the Tenth Circuit rather than the First Circuit and Kaufman III addressed legal issues different from the one present in Carpenter in any event. In particular, Kaufman III addressed the proper interpretation of Treasury Regulation § 1.170A-14(g)(1) (the "general enforceability in perpetuity" regulation) and Treasury Regulation § 1.170A-14(g)(6)(ii) (the "proceeds" regulation), neither of which were at issue in Carpenter.

The Tax Court’s holdings in Carpenter I and II are consistent with IRS General Information Letter dated September 18, 2012, in which the agency advised that, while state law may provide a means for extinguishing a conservation easement for state law purposes, the requirements of IRC § 170(h) and the extinguishment and proceeds regulations must nevertheless be satisfied for a contribution to be deductible for federal income tax purposes.

The Tax Court’s holdings in Carpenter I and II are also consistent with public policy. To ensure consistent protection of the federal investment in conservation easements and the conservation values they are intended to “protect in perpetuity” for the benefit of the public, the high threshold for extinguishment set forth in Treasury Regulation § 1.170A-14(g)(6)(i) must apply uniformly to all federally-deductible easements, regardless of the parties to the easements or the states in which the easements are created. Uniform application of the extinguishment requirements also ensures that taxpayers will be treated equitably—that easement donors benefiting from sizable deductions will not be able to more easily escape the perpetual restrictions placed on their property in some states than in others. Requiring that the decision to extinguish a federally-deductible perpetual conservation easement be made by a court as opposed to the parties to the easement ensures that the decision will not be made solely by the parties who stand to benefit, financially or otherwise, from the extinguishment. And requiring that the extinguishment decision be made by a court as opposed to a state or local official, agency, committee, or administrative board helps to ensure that the decision to terminate federally-deductible easements will not be influenced by the short-term and often short-sighted political, economic, and development pressures to which state and local actors can be subject. Finally, the already substantial complexities associated with valuing federally-deductible conservation easements would be greatly exacerbated if the easements were subject to extinguishment pursuant to different processes and procedures, which, even if tied to state and local laws or ordinances, would vary over time as local politics and priorities change.

The easiest and most prudent way to comply with the extinguishment requirement appears to be to include a provision in the conservation easement stating that the easement can be extinguished in whole or in part only (a) in a judicial proceeding, (b) upon a finding by the court that a subsequent unexpected change in the conditions surrounding the property has made impossible or impractical the continued use of the property for conservation purposes, and (c) with a payment of proceeds to the holder as provided in Treasury Regulation § 1.170A-14(g)(6)(ii) to be used by the holder in a manner consistent with the conservation purposes of the original contribution (i.e., the easement should carefully track the provisions of both Treasury Regulation § 1.170A-14(g)(6)(i) and -14(g)(6)(ii)). The easement should also comply with the related "restriction on transfer" regulation, Treasury Regulation § 1.170A-14(c)(2), which mandates that the instrument of conveyance limit the holder's ability to transfer the easement, whether or not for consideration, except in carefully prescribed circumstances. As an added precaution and to avoid any possible confusion, the easement might further provide that its provisions apply notwithstanding and in addition to any conditions that may or may not be imposed on the transfer or release or other extinguishment of a conservation easement under state law.

Nancy A. McLaughlin, 

Robert W. Swenson Professof of Law

University of Utah SJ Quinney College of Law

http://lawprofessors.typepad.com/nonprofit/2013/07/carpenter-v-commissioner-revisited-federally-deductible-conservation-easements-must-be-extinguishabl.html

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Comments

Carpenter II is a significant problem in states like Massachusetts that have a clearly legislated path to extinguishment that doesn’t require judicial process. The Carpenter II requirements for extinguishment should be changed.

The Massachusetts statute that enables conservation easements to be perpetually enforceable (MGL c. 184, ss. 31-33) says they may be “released, in whole or in part” only after a public process and approvals by the same governmental authorities whose approval was required for the easements to be perpetually enforceable in the first place. No easement can be released simply by agreement of the land owner and easement holder, but court approval is not required. That’s been the law here since at least 1969. The process requires the approval authorities to take into consideration the public interest in conservation, any national, state, regional and local program in furtherance of conservation, any public state, regional or local comprehensive land use or development plan affecting the land, and any proposal by a governmental body for use of the land.

The Treas. Regs. on extinguishment should be read only as creating a safe harbor for extinguishment by judicial process. For some reason, it’s good enough for public policy if an administrative process can grant the imprimatur that magically makes a conservation easement enforceable in perpetuity, but a decision by the same process to allow extinguishment of the same easement is somehow not good enough. Granted, an extinguishment process by impartial, informed decision makers is the goal, but judicial process does not guaranty impartiality or the protection of conservation values when the easement parties agree to request extinguishment. Certainly judicial extinguishment process is no more impartial than administrative process in states where judges are elected. When a state legislature establishes an administrative process that is impartial, in the sense it requires independent judgment by a governmental official, and that requires consideration of the public interest in conservation, the IRS ought to accept that process, or at least be able to evaluate that process for protection of the conservation values that merited favorable tax treatment. There isn’t national uniformity regarding how a perpetually enforceable conservation easement may be created, and national uniformity is no more desirable or necessary when it comes to extinguishment. It’s not good policy to single out extinguishment as one aspect of state law on perpetuity that must be ignored to satisfy the tax deduction requirements.

Posted by: Jonathan Bockian | Sep 16, 2013 12:44:37 PM

Many thanks to Mr. Bockian for posting his comments on Carpenter II as it gives me a chance to address a misconception some have regarding Internal Revenue Code § 170(h) and the interaction between federal and state law.

The decision in Carpenter II should not be a problem for conservation easement donors in Massachusetts. Property owners wishing to benefit from the federal charitable income tax deduction under IRC § 170(h) need merely to draft their conservation easements to comply with federal tax law requirements in addition to any state law conditions and requirements, as attorneys have been advising their clients to do for decades. See, e.g., the checklist of federal requirements in the Conservation Easement Handbook, first and second editions.

The assertion that “[t]here isn’t national uniformity regarding how a perpetually enforceable conservation easement may be created….” is not correct. Section 170(h) and the Treasury Regulations interpreting that section contain an elaborate set of uniform threshold requirements that must be met upon the donation (i.e., creation) of a conservation easement to be eligible for a federal deduction.

Section 170(h) provides that a federally deductible conservation easement must be:

(1) “granted in perpetuity”

(2) for one or more of the four qualifying “conservation purposes” enumerated in § 170(h) and described in detail in the regulations,

(3) to a “qualified holder” (generally a government entity or a publicly-supported charity or satellite thereof),
and

(4) the conservation purpose of the easement must be “protected in perpetuity,” which requires, among other things, that surface mining on the subject property be prohibited or, if the mineral and surface estates are separated, that the probability of surface mining is demonstrated to be “so remote as to be negligible.”

The Treasury Regulations, which are based on the extensive instructions regarding § 170(h) that Congress provided in the legislative history, mandate that the following additional requirements must be met at the time of the donation of a federally deductible conservation easement.

(1) Eligible Donee Requirement. The easement must be granted to an “eligible donee,” defined as a qualified organization that has “a commitment to protect the conservation purposes of the donation” and “the resources to enforce the restrictions.” See Treasury Regulation § 1.170A-14(c)(1).

(2) Restriction on Transfer Requirement. The easement must prohibit the donee organization from transferring the easement, whether or not for consideration, except for transfers to other “eligible donees” that agree to continue to carry out the conservation purposes of the easement. See Treasury Regulation § 1.170A-14(c)(2).

(3) No Inconsistent Use Requirement. Subject to a limited exception, the easement must not permit “inconsistent uses,” defined as uses that would injure or destroy “significant conservation interests.” See Treasury Regulation § 1.170A-14(e)(2) and (3).

(4) General Enforceability in Perpetuity Requirement. The easement must impose “legally enforceable restrictions [generally through recordation of the easement] … that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation.” See Treasury Regulation § 1.170A-14(g)(1).

(5) Mortgage Subordination Requirement. If there is an outstanding mortgage on the subject property at the time of the donation, the lender must subordinate its rights in the subject property to the right of the donee “to enforce the conservation purposes of the gift in perpetuity.” See Treasury Regulation § 1.170A-14(g)(2).

(6) Baseline Documentation Requirement. If the donor reserves rights in the easement, the exercise of which might impair the conservation interests associated with the property (which generally will be the case), “the donor must make available to the donee, prior to the time the donation is made, documentation sufficient to establish the condition of the property at the time of the gift.” This “baseline” documentation is “designed to protect the conservation interests associated with the property, which although protected in perpetuity by the easement, could be adversely affected by the exercise of reserved rights.” See Treasury Regulation § 1.170A- 14(g)(5)(i).

(7) Donee Notice Requirement. If the donor reserves rights in the easement as described in subparagraph (6) above, the donor must agree to notify the donee, in writing, before exercising any reserved right that may have an adverse impact on the conservation interests associated with the property. See Treasury Regulation § 1.170A-14(g)(5)(ii).

(8) Donee Access Requirement. If the donor reserves rights in the easement as described in subparagraph (6) above, the easement must provide the donee with the right to enter the property at reasonable times to inspect the property to determine compliance with the terms of the donation. See Treasury Regulation § 1.170A-14(g)(5)(ii).

(9) Donee Enforcement Requirement. If the donor reserves rights in the easement as described in subparagraph (6) above, the easement must provide the donee with the right to enforce the easement by appropriate legal proceedings, including, but not limited to, the right to require restoration of the property to its condition at the time of the donation. See Treasury Regulation § 1.170A-14(g)(5)(ii).

(10) Extinguishment Requirements. If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation can make impossible or impractical the continued use of the property for conservation purposes (which will be a possibility in virtually all cases), the conservation purpose can nonetheless be treated as “protected in perpetuity” if (i) the restrictions are extinguished by judicial proceeding and (ii) all of the donee’s proceeds (determined as described in subparagraph (11) below) from a subsequent sale or exchange of the property are used by the donee “in a manner consistent with the conservation purposes of the original contribution.” See Treasury Regulation § 1.170A-14(g)(6)(i).

(11) Division of Proceeds Requirement. At the time of the gift the donor must agree that the donation of the easement gives rise to a property right, immediately vested in the donee, with a fair market value that is at least equal to the proportionate value that the easement, at the time of the gift, bears to the value of the property as a whole at that time. That minimum proportionate value representing the donee’s property right, which is generally expressed as a percentage, must remain constant. When a change in conditions gives rise to the extinguishment of the easement as described in subparagraph (10) above, the donee, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a percentage of the proceeds at least equal to that minimum proportionate value, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior easement. See Treasury Regulation § 1.170A-14(g)(6)(ii).

The extinguishment and division of proceeds requirements set forth in subparagraphs (10) and (11) above consist of four distinct requirements, none of which are satisfied by the state statutory conditions imposed on extinguishment under Massachusetts law:
(i) a judicial proceeding,
(ii) a finding of "impossibility or impracticality,"
(iii) payment of at least a the designated minimum proportionate share of proceeds to the holder following extinguishment, and
(iv) the holder's use of such proceeds “in a manner consistent with the conservation purposes of the original contribution” (i.e., to replace lost conservation values on behalf of the public).

Government entities and charitable organizations in Massachusetts and other states are free to raise funds and use state appropriated funds to purchase conservation easements that are extinguishable pursuant to whatever process might be set forth in the state code. If they wish to benefit from the federal subsidy provided by § 170(h), however, they must comply with all of the requirements for the federal deduction listed above, each of which plays an important role in protecting the federal investment in conservation easements and in ensuring that the conservation purposes of such easements are “protected in perpetuity” as Congress intended.

It is not surprising that Congress and the Treasury Department declined to defer to potentially 50 different state procedures for the extinguishment of federally deductible conservation easements. Like-situated taxpayers should be treated alike, and it should be no easier for easement donors (or their successors) in Massachusetts to have the perpetual restrictions encumbering their lands extinguished than for easement donors (or their successors) in the other 49 states. Moreover, state law is subject to change at any time. Billions of dollars (in the form of lost federal revenues) are being invested in conservation easements intended to protect unique or otherwise significant land areas or structures in perpetuity for the benefit of the public. There would be little protection of this federal investment in perpetual conservation if the easements were subject to extinguishment under state processes and procedures that vary over time with changes in state legislatures and state and local political, economic, and development priorities.

For additional posts regarding federal tax law requirements, see:

http://lawprofessors.typepad.com/nonprofit/2013/08/mitchell-v-commissioner-revisited-170h-requires-perpetuation-of-conservation-easement-itself-not-jus.html

http://lawprofessors.typepad.com/nonprofit/2013/06/belk-v-commissioner-tax-court-reaffirms-its-holding-that-floating-conservation-easements-are-not-ded.html

Posted by: Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah SJ Quinney College of Law | Sep 23, 2013 11:20:25 AM

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