In each of the cases, the partnership-taxpayer acquired a tract of land and donated a conservation easement over that land to a tax-exempt entity. Each of the easement deeds at issue reserved certain rights for the taxpayer, including the "right to construct within the conserved area a limited number of improvements and buildings."
The easement deeds also contained an 'extinguishment' clause, which addressed how the proceeds of a judicial extinguishment of the easement would be allocated. In general, these clauses provided "[t]he amount of the proceeds to which Grantee shall be entitled, after the satisfaction of any and all prior claims, shall be determined . . . in accordance with the Proceeds paragraph." The proceeds paragraph in each of the easement deeds established that the grantee's share of the extinguishment proceeds would be determined "by multiplying the fair market value of the Property unencumbered by this Conservation Easement (minus any increase in value after the date of this Conservation Easement attributable to improvements)."
On their tax returns, the partnerships claimed charitable contribution deductions for the donations of the easements. The IRS disallowed all of these deductions, on the basis that the 'conservation purpose' underlying each of the easements was not 'protected in perpetuity' because the easement deeds failed to comply with the requirements in Treas. Reg. § 1.170A-14(g)(6) governing judicial extinguishments.
Primer on conservation easement donations
A taxpayer who donates a conservation easement deduction may receive a charitable contribution deduction under section 170(a) and (h). To be entitled to this deduction, taxpayers must meet numerous requirements, including that the easement contribution be made 'exclusively for conservation purposes,' Section 170(h)(1)(C). An easement contribution is not treated as exclusively for conservation purposes unless those purposes are 'protected in perpetuity,' Section 170(h)(5)(A).
The perpetuity requirement of section 170(h)(5)(A) and the corresponding regulations have been the subject of much litigation between taxpayers and the IRS. Over the last five years alone, the IRS has disallowed dozens of easement contribution deductions for failing to meet this requirement. More recently, the IRS has asserted that the perpetuity requirement of section 170(h)(5)(A) is not satisfied where the easement deed does not allocate judicial extinguishment proceeds in exact accordance with Treas. Reg. § 1.170A-14(g)(6), which provides operative rules for allocating the proceeds. Broadly speaking, this provision requires the easement deed to ensure that the donee, following a judicial sale or condemnation of the property, receives a proportionate share of the proceeds and uses those proceeds consistently with the conservation purposes underlying the original donation. This has the effect of deeming the perpetuity requirement of section 170(h)(5)(A) to be satisfied, even where the easement itself no longer legally exists.
The court's rulings
The Tax Court's rulings followed on the heels of several other precedential rulings on the issue of judicial extinguishment proceedings, most notably Oakbrook Land Holdings, LLC v. Commissioner, 154 T.C. (12 May 2020) and Coal Prop. Holdings, LLC v. Commissioner, 153 T.C. 126 (2019). In both cases, the Tax Court sustained the IRS's disallowance of the deductions where the easement deeds reduced the amount of donee's proceeds first by any 'increase in value' attributable to donor's improvements to the land and then by any 'prior claims' brought by third parties against the donor-taxpayer. The taxpayers argued that the easement deeds at issue in Oakbrook and Coal Properties were distinguishable because the 'improvements' allowed by the easement deed were less substantial than those allowed in Oakbrook and Coal Properties.
The IRS disagreed, contending that the easement deeds were not distinguishable and improperly allowed the taxpayers to reduce the grantees' shares of the judicial extinguishment proceeds to account for any donor improvements to the easement property and for any claims made by third parties against the taxpayers.
The Tax Court agreed with the IRS, noting (as it did in prior cases) that the Treasury Regulations do not permit payment of prior claims to be made entirely out of the grantee's share of the proceeds or for the grantee's share to be reduced by donor improvements. The court also rejected the taxpayers' argument that Treas. Reg. § 1.170A-14(g)(6) was invalid under the 'arbitrary and capricious' rule in section 706(2)(A) of the Administrative Procedure Act and under the test in Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). The Tax Court also rejected the taxpayers' challenge of the validity of Treas. Reg. § 1.170A-14(g)(6) under the APA and Chevron and declined to treat a 2008 private letter ruling that tacitly accepted a judicial extinguishment proceeds clause similar to the one above as binding on the IRS under Auer v. Robbins, 519 U.S. 452, 461 (1997). Alternatively, the Tax Court held that the taxpayers had failed to attach proper 'appraisal summaries,' as required by section 170(f)(11)(C), because the summaries that taxpayers provided did not include their cost basis in the acquired easement properties.
In light of the holdings in these and other easement cases at the Tax Court, the IRS has begun offering settlements to taxpayers with docketed cases involving syndicated conservation easement structures. The terms of these settlements are discussed below.
Tax Court settlement
On 23 December 2016, the IRS published Notice 2017-10, which identified a specific type of conservation easement, a 'syndicated' easement transaction, as a 'listed transaction.' This type of conservation easement allows investors to obtain charitable contribution deductions that significantly exceed the value of their original investment in the entity that donates the easement, typically a partnership. Since the publication of Notice 2017-10, the IRS has audited numerous syndicated conservation easements, with dozens of these cases being docketed in the Tax Court.
On 25 June 2020, the IRS announced a time-limited settlement offer to certain taxpayers with docketed Tax Court cases involving syndicated conservation easement transactions. As a condition of the settlement, the deduction for the easement contribution is disallowed in full. Except in limited circumstances, all partners must agree to settle the case, and the partnership must pay the full amount of tax, penalties and interest before settlement. 'Investor' partners are allowed to deduct their cost of acquiring their partnership interests and pay a reduced penalty of 10 to 20%, depending on the ratio of the deduction claimed to the partnership investment amount. However, partners who provided services in connection with any syndicated conservation easement transaction must pay the maximum penalty asserted by IRS (typically 40%) with no deduction for costs.
Additionally, the partnership is required to provide evidence, through either documents or affidavits, that the partnership and all of the partners timely disclosed all transactions covered by Notice 2017-10. The IRS announced the first settlement under this program on 31 August 2020 in the Coal Property Holdings, LLC v. Commissioner case, T.C. Dkt No. 27778-16 (stipulated decision entered on 1 September 2020). In connection with this settlement, IRS Commissioner Chuck Rettig issued a statement that "The IRS is pleased that the partnership in the Coal Property transaction has agreed to this settlement, and we encourage other participants in qualifying easement cases to accept the terms of the Chief Counsel's initiative" (see 'Settlements Begin in Syndicated Conservation Easement Transaction Initiative').
One open question is how the settlement offer will work under the new partnership audit regime. Under the Bipartisan Budget Act (BBA) of 2015, the partnership representative has sole authority to make all decisions on behalf of the partnership. In contrast, under the Tax Equity and Fiscal Responsibility Act (TEFRA), partners would, but for the terms of this settlement offer, be allowed to assert partner-level defenses to deficiencies and penalties. This issue has not yet arisen because the Tax Court has not yet decided any partnership tax cases under the BBA regime. Another point that is unclear from the terms of the settlement offer is how the IRS would propose to treat a mismatch between the outside basis and inside basis resulting from the taxpayer's deduction for the capital contribution and the subsequent addition of the disallowed easement deduction, after adjusting for other transactions and flow-through items that affect the outside basis.
The IRS and state taxing authorities have repeatedly challenged some of the arguments that the taxpayers raised above with respect to extinguishment clauses in easement deeds. Similarly, the IRS has challenged the perpetuity of easement donations under Section 170(h)(5)(A) on other bases. Taxpayers facing challenges from the IRS or another taxing authority on Section 170(h)(5)(A) perpetuity issues should seek counsel to determine the merits of their positions and to determine whether entering into the IRS's Tax Court settlement offer is the best course of action for docketed cases.
A Baker McKenzie contributed article