Friday, April 29, 2016
In Carroll v. Comm’r, 146 T.C. No. 13 (2016), the Tax Court sustained the IRS’s disallowance of approximately $650,000 of carryover deductions claimed with regard to a 2005 donation of a conservation easement to the Maryland Environmental Trust (MET) and the Land Preservation Trust (LPT), as joint holders. The subject 21-acre property is located in the Green Spring Valley National Register Historic District of Lutherville, Maryland. MET is a quasi-public entity that the Maryland legislature established in 1967 to conserve the environment; it is both a unit of the Maryland Department of Natural Resources and governed by a private board of trustees. LPT is a charitable conservation organization.
While the Tax Court determined that the easement at issue was a "qualified real property interest" and satisfied the open space conservation purpose test, the formula included in the easement deed regarding the payment of proceeds to the holders in the event of a judicial extinguishment did not satisfy Treasury Regulation requirements.
Qualified Real Property Interest
The Tax Court determined that the conservation easement was a “qualified real property interest” as defined in IRC § 170(h)(2)(C) because the easement contained “legally enforceable restrictions that will prevent uses of the retained interest in the subject property that are inconsistent with the conservation purposes of the contribution.”
The Tax Court also determined that the easement satisfied the open space conservation purposes test under IRC § 170(h)(4)(A)(iii)(II), which requires that preservation of the property be “pursuant to a clearly delineated Federal, State, or local governmental conservation policy” and “yield a significant public benefit.”
In interpreting the governmental conservation policy requirement, Treasury Regulation § 1.170A-14(d)(4)(iii)(B) provides that
Acceptance of an easement by an agency of the Federal Government or by an agency of a state or local government (or by a commission, authority, or similar body duly constituted by the state or local government and acting on behalf of the state or local government) tends to establish the requisite clearly delineated governmental policy, although such acceptance, without more, is not sufficient. The more rigorous the review process by the governmental agency, the more the acceptance of the easement tends to establish the requisite clearly delineated governmental policy. For example, in a state where the legislature has established an Environmental Trust to accept gifts to the state which meet certain conservation purposes and to submit the gifts to a review that requires the approval of the state’s highest officials, acceptance of a gift by the Trust tends to establish the requisite clearly delineated governmental policy. However, if the Trust merely accepts such gifts without a review process, the requisite clearly delineated governmental policy is not established.
In finding that the easement in Carroll satisfied the open space conservation purpose test, the Tax Court explained that the thoroughness of MET’s easement-review process, combined with the requisite approval of the easement from Maryland’s highest officials (the Governor, the Comptroller, and the Treasurer of Maryland), established that the easement preserves open space pursuant to a clearly delineated federal, state, or local governmental conservation policy. The Tax Court also determined that preservation of the 21-acre property yielded a significant public benefit because (i) the property is in a highly desirable area under development pressure, (ii) the property is subject to a restrictive type of zoning established to foster and protect agricultural lands in certain areas, (iii) the valley in which the property is located is specifically designated in the County’s Master Plan as an agricultural preservation area, and (iv) four properties adjacent to the property are encumbered by conservation easements held by MET or a state agency.
Noncompliant “Proceeds” Clause
To be eligible for a deduction under § 170(h), the conservation purpose of the easement must be “protected in perpetuity.” IRC § 170(h)(5)(A). The Treasury Regulations interpreting § 170(h) elaborate on this protected-in-perpetuity requirement by setting forth substantive rules to safeguard the conservation purpose of a contribution. Treas. Reg. § 1.170A-14(g)(1)-(6). Most pertinent to this case is Treasury Regulation § 1.170A-14(g)(6), the “extinguishment” regulation, which provides that a conservation easement may be extinguished only (i) in a judicial proceeding, (ii) upon a finding that continued use of the property for conservation purposes has become “impossible or impractical,” and (iii) with a payment (upon a subsequent sale, exchange, or involuntary conversion of the subject property) of at least a minimum proportionate share of proceeds to the holder to be used in a manner consistent with the conservation purposes of the original contribution.
The Tax Court explained that the minimum proportionate share of proceeds that must be payable to the holder following extinguishment is equal to the percentage determined by (i) the fair market value of the conservation easement on the date of the gift (the numerator) over (ii) the fair market value of the property as a whole on the date of the gift (the denominator). For example, if the fair market value of an easement on the date of the gift was $300,000, and the fair market value of the property as a whole on the date of the gift was $1,000,000, the easement represented 30% of the value of the property on the date of the gift, and the holder must be entitled to at least 30% of the proceeds following the easement’s extinguishment. The Tax Court noted that the requirements of the extinguishment regulation “are strictly construed; if a grantee is not absolutely entitled to a proportionate share of extinguishment proceeds, then the conservation purpose of the contribution is not protected in perpetuity.”
The extinguishment clause in the conservation easement deed at issue in Carroll did not comply with the proceeds requirement described above. The deed provided that, upon extinguishment, the holders would be entitled to a share of proceeds equal to the percentage determined by (i) "the deduction for federal income tax purposes allowable" by reason of the donation over (2) the fair market value of the property as a whole on the date of the gift. The court explained that, if the IRS were to disallow the deduction for reasons other than valuation and the easement were later extinguished in a judicial proceeding, the numerator in this formula would be zero and MET and LPT would not receive the minimum proportionate share of proceeds as is required. The court also noted that deductions are denied for many reasons unrelated to valuation, and, in fact, the IRS made many arguments for disallowance of the taxpayers’ claimed deductions in Carroll that were not based on valuation.
The Tax Court also distinguished its holding in Carroll from the First Circuit’s holding in Kaufman. In Kaufman, the First Circuit held that donors of a facade easement had satisfied the proceeds requirement because the easement deed correctly stated the proceeds formula and the donee organization had an absolute right as against the donors for its share of proceeds upon extinguishment. In Carroll, in contrast, the donee organizations would not be entitled to any proceeds in certain circumstances based on the formula included in the easement deed. Consistent with the First Circuit’s reasoning in Kaufman, failing to guarantee that the donees would be entitled to at least the required minimum proportionate share of proceeds upon extinguishment, and providing a potential windfall to the donor or the donor’s successors as a result, was fatal to the deduction.
The Tax Court also found that the donors’ deductions were not saved by the last sentence in Treasury Regulation § 1.170A-14(g)(6)(ii), which provides an exception to the requirement that the holder must receive at least a minimum proportionate share of proceeds upon extinguishment if “state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the [easement].” Maryland has an unusual provision in its state code. Pursuant to this provision, if land subject to an easement held by MET or the Maryland Historical Trust is condemned, damages shall be awarded “to the fee owner ... and shall be the fair market value of the land or interest in it, computed as though the easement ... did not exist.” This presumably means the holder would receive nothing unless the parties agreed that the fee owner would give some of the proceeds to the holder. The Tax Court held that this state law provision did not save the deductions in Carroll because (i) the provision only applies to easements held by MET and, thus, the proceeds formula in the deed still violated the proceeds requirement with regard to LPT, and (ii) the provision applies only to condemnations and, thus, the proceeds formula in the deed still violated the proceeds requirement with regard to judicial extinguishments not based on condemnation (e.g., where changes in the neighborhood have made continuing to protect the property for conservation purposes impossible or impractical).
The Tax Court explained that requirements set forth in the extinguishment regulation “are designed to protect the conservation purpose of a conservation contribution and must be satisfied at the outset for a contribution to be deductible.” The Tax Court further explained that, although the extinguishment regulation “imposes a technical requirement, it is a requirement intended to preserve the conservation purpose, and [the taxpayers] could have avoided this adverse outcome by strictly following the proportionality formula set forth in the regulation.”
The Tax Court also dismissed the taxpayers’ argument that noncompliance with the proceeds requirement should be forgiven because the probability of extinguishment of the easement was “so remote as to be negligible.” Citing Kaufman v. Schulman, 687 F.3d 21 (1st Cir. 2012), the Tax Court explained that easement donors cannot satisfy the requirements of the extinguishment regulation by merely establishing that the possibility of a change in conditions triggering judicial extinguishment is unexpected. To accept such an argument, explained the Tax Court, would nullify the requirements because the extinguishment regulation, by its terms, applies only to “unexpected” conditions, which likely encompass events that are so remote as to be negligible.
The Tax Court found that the taxpayers in Carroll were liable for 20% accuracy-related penalties and did not qualify for the “reasonable cause” exception to those penalties. The Tax Court explained that one of the taxpayers is a highly educated medical school graduate who had previous experience with conservation easements; although the taxpayers had hired an attorney to draft a related gift deed for the subject property, that attorney was not a tax attorney and “d[id] not answer tax-related questions or give tax advice;” the taxpayers offered no evidence that would explain why the terms of the easement varied from the proceeds requirement in the Treasury Regulation; and the taxpayers did not explain why they failed to seek competent advice from a tax attorney or other adviser to ensure that the easement complied with the pertinent regulations. The Tax Court concluded that, in the light of the high level of sophistication of one of the taxpayer's and his experience with conservation easements, the taxpayers did not demonstrate that they acted with reasonable cause and in good faith in not seeking competent tax advice regarding the donation.
The Tax Court declined to impose substantial or gross valuation misstatement penalties on the taxpayers, however, because the IRS did not assert those penalties on a timely basis.
There are a number of takeaways from Carroll.
First, conservation easement donations generally involve high-dollar deductions and the requirements of § 170(h) and the regulations are numerous, complex, and often strictly construed. Accordingly, prospective easement donors should hire tax counsel with significant expertise in the easement donation context to assist them with their donations. If they do not, they run the risk of not only having their deductions denied, but also being subject to penalties for failure to seek tax advice.
Second, donors of conservation easements should not rely on a donee organization or its template or model easement to satisfy the requirements for the deduction. The risks of noncompliance (audit, litigation, denial of deductions, and interest and penalties) fall solely on the shoulders of the donor, and it is the responsibility of the donor and the donor’s legal counsel to ensure that all requirements are satisfied. Most donees are careful to instruct donors that they cannot and do not provide legal advice, and donors need to take that warning to heart.
Finally, the amount of litigation in this context could be significantly reduced if the IRS developed safe harbor or “sample” conservation easement provisions to satisfy the key perpetuity requirements of § 170(h). While many provisions of an easement must be tailored to the specific property and situation, most of the perpetuity requirements, including those addressing judicial extinguishment and proceeds, could be satisfied with provisions that generally should not vary from easement to easement. Safe harbor provisions would facilitate both donor compliance and IRS review, and would help to ensure that the public investment in easements is actually “protected in perpetuity” as Congress intended. Moreover, developing sample provisions would not be a novel approach to addressing noncompliance and abuse. The Treasury developed sample trust provisions with annotations in the charitable remainder trust and charitable lead trust contexts and those provisions, which are widely used, have greatly facilitated compliance and significantly reduced abuses.
Nancy A. McLaughlin, Robert W. Swenson Professor of Law, University of Utah S.J. Quinney College of Law