A Pair of Conservation Easement Deduction Cases From the Tax Court Reflect Continued IRS Attack

Originally published by Jason B. Freeman.

Red Oak Estates, LLC v. Commissioner, T.C. Memo. 2020-116 | August 4, 2020 | Kerrigan, J. | Dkt. No. 13659-17L

• Opinion

Short Summary:  The IRS moved for partial summary judgment, which was ultimately granted by the court.

The IRS issued a notice of final partnership administrative adjustment (FPAA) for tax year 2009 to Effingham Managers, LLC, as the tax matters partner for Red Oak Estates, LLC (Red Oak). In the FPAA respondent disallowed a $4,110,500 deduction for a noncash charitable contribution for the donation of a conservation easement and asserted in the FPAA a gross valuation misstatement penalty pursuant to section 6662(h), or in the alternative, a penalty pursuant to section 6662(a).

On December 31, 2009, Red Oak granted a conservation easement of approximately 150.02 acres of the property to the Georgia Land Trust, Inc., by deed recorded in Effingham County. Red Oak claimed a $4,343,000 charitable deduction for its contribution of the conservation easement on its 2009 Form 1065, U.S. Return of Partnership Income. It attached Form 8283, Noncash Charitable Contributions, to its partnership return and included an attachment stating that the appraised fair market value (FMV) of the unencumbered property was $4,651,000 and the net value of the contribution was $4,343,000.

The deed addressed the possibility that circumstances might arise in the future to render the purpose of the conservation easement impossible to accomplish, such as condemnation or certain judicial proceedings.  Paragraphs 17 and 18 of the deed provided that if the conservation easement is terminated or extinguished by judicial proceedings or condemnation, “[t]he amount of the proceeds to which Grantee shall be entitled, after the satisfaction of any and all prior claims, shall be determined, unless otherwise provided by Georgia law at the time, in accordance with the Proceeds paragraph below.”

Paragraph 19 of the deed, referred to as the proceeds paragraph, provides that the conservation easement grants a real property interest immediately vested in the grantee. The proceeds paragraph stated in pertinent part:

[T]he parties stipulate to have a current fair market value 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) by the ratio of the value of the Conservation Easement at the time of this conveyance to the value of the Property at the time of this conveyance without deduction for the value of the Conservation Easement. The value of this Conservation Easement at the time of this conveyance, and the value of the Property at the time of this conveyance without deduction for the value of the Conservation Easement, shall be determined according to that certain Property Appraisal Report, on file at the office of the Grantee, prepared on behalf of Grantor to establish the value of the gift of this Conservation Easement. The values at the time of this Conservation Easement shall be those values used to calculate the deduction for federal income tax purposes pursuant to § 170(h) of the Code.

The IRS contends that the deed violates the proceeds regulation because it provides that the portion of proceeds required to be allocated to the donee in the event of an extinguishment shall be reduced by the value of improvements to the land made by Red Oak after the grant of the easement.

Key Issues:

• Whether the charitable contribution deductions related to conservation easements should be recognized.
• Whether the extinguishment clause in Red Oak’s deed of conservation easement violates the requirements of section 1.170A-14(g)(6)(ii), Income Tax Regs.

Primary Holdings: 

• The Court granted the IRS’s Motion for Summary Judgment, holding, that the deed failed to satisfy the “protected in perpetuity” requirement.
• Substantial compliance is not a defense available to a taxpayer in this context; instead, strict compliance is necessary.

Key Points of Law:

• The Code generally restricts a taxpayer’s charitable contribution deduction for the donation of “an interest in property which consists of less than the taxpayer’s entire interest in such property.” Sec. 170(f)(3)(A). But there is an exception for a “qualified conservation contribution.” Sec. 170(f)(3)(B)(iii), (h)(1). For the donation of an easement to be a “qualified conservation contribution,” the conservation purpose must be “protected in perpetuity.” Sec. 170(h)(5)(A).
• The regulations recognize that “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.” Id. subdiv. (i). Despite that possibility, “the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding” and the easement deed ensures that the charitable donee, following sale of the property, will receive a proportionate share of the proceeds and use those proceeds consistently with the conservation purposes underlying the original gift. Ibid. In effect, the “perpetuity” requirement is deemed satisfied be- cause the sale proceeds replace the easement as an asset deployed by the donee “exclusively for conservation purposes.” Sec. 170(h)(5)(A).
• To meet the requirements of section 1.170A-14(g)(6)(ii), Income Tax Regs. (proceeds regulation), the deed must guarantee that the donee will receive “a proportionate share of extinguishment proceeds”.
• Deductions are a matter of legislative grace, and a taxpayer must prove its entitlement to the deductions it claims. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). To be entitled to a deduction for the donation of a conservation easement, the donor must ensure that the donation “gives rise to a property right, immediately vested in the donee organization,” to receive a proportionate share of the proceeds of any post-extinguishment sale. Sec. 1.170A- 14(g)(6)(ii), Income Tax Regs.
• A donor must show strict, and not substantial, compliance with the perpetuity requirements of the regulation.

Insight: The IRS has continued an attack on conservation easement deductions.  While the IRS typically attacks several aspects of conservation easement deductions, the case above is an example of a string of cases from the Tax Court that have sided with the IRS on technical grounds relating to the requirements under Treasury Regulations with respect to the deed granting the conservation easement.  Expect to see continued pressure and legal challenges from the IRS in this area.

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Cottonwood Place, LLC v. Commissioner, T.C. Memo. 2020-115 | August 4, 2020 | Kerrigan, J. | Dkt. No. 14076-17

• Opinion 

Short Summary: The IRS moved for partial summary judgment, which was ultimately granted by the court.

The IRS issued a notice of final partnership administrative adjustment (FPAA) for tax year 2009 to Hugh F. Smisson III, as tax matters partner for Cottonwood Place, LLC (Cottonwood). In the FPAA respondent disallowed a $4,592,000 deduction for a noncash charitable contribution and asserted a gross valuation misstatement penalty pursuant to section 6662(h), or in the alternative, a penalty pursuant to section 6662(a).

On December 31, 2009, Cottonwood granted a conservation easement of 135.56 acres of the property to the Georgia Land Trust, Inc., by deed recorded in Effingham County. The deed includes provisions for the distribution of proceeds in the event of extinguishment or condemnation. If the easement is terminated or extinguished by judicial proceedings or condemnation, “[t]he amount of the proceeds to which Grantee shall be entitled, after the satisfaction of any and all prior claims, shall be determined, unless otherwise provided by Georgia law at the time, in accordance with the Proceeds paragraph below.” If the easement is taken, in whole or part, by the exercise of eminent domain, the Grantee shall be entitled to compensation in accordance with applicable law and the proceeds paragraph included in the deed.

Paragraph 19 of the deed, referred to as the proceeds paragraph, provides that the conservation easement grants a real property interest immediately vested in the grantee. The proceeds paragraph states in pertinent part:

As required under Treas. Reg. § 1.170A-14(g)(6)(ii), the parties stipulate to have a current fair market value 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) by the ratio of the value of the Conservation Easement at the time of this conveyance to the value of the Property at the time of this conveyance without deduction for the value of the Conservation Easement. The value of this Conservation Easement at the time of this conveyance, and the value of the Property at the time of this conveyance without deduction for the value of the Conservation Easement, shall be determined according to that certain Property Appraisal Report, on file at the office of the Grantee, prepared on behalf of Grantor to establish the value of the gift of this Conservation Easement. The values at the time of this Conservation Easement shall be those values used to calculate the deduction for federal income tax purposes pursuant to § 170(h) of the Code.

Key Issues:

• Whether the charitable contribution deductions related to conservation easements should be recognized.
• Whether the extinguishment clause in Red Oak’s deed of conservation easement violates the requirements of section 1.170A-14(g)(6)(ii), Income Tax Regs.

Primary Holdings: 

• The Court granted the IRS’s Motion for Summary Judgment, holding, that Belair’s deed fails to satisfy the “protected in perpetuity” requirement.
• Substantial compliance is not a defense available to a taxpayer in this context; instead, strict compliance is necessary.

Key Points of Law:

• The Code generally restricts a taxpayer’s charitable contribution deduction for the donation of “an interest in property which consists of less than the taxpayer’s entire interest in such property.” Sec. 170(f)(3)(A). But there is an exception for a “qualified conservation contribution.” Sec. 170(f)(3)(B)(iii), (h)(1). For the donation of an easement to be a “qualified conservation contribution,” the conservation purpose must be “protected in perpetuity.” Sec. 170(h)(5)(A).
• The regulations recognize that “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.” Id. subdiv. (i). Despite that possibility, “the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding” and the easement deed ensures that the charitable donee, following sale of the property, will receive a proportionate share of the proceeds and use those proceeds consistently with the conservation purposes underlying the original gift. Ibid. In effect, the “perpetuity” requirement is deemed satisfied be- cause the sale proceeds replace the easement as an asset deployed by the donee “exclusively for conservation purposes.” Sec. 170(h)(5)(A).
• To meet the requirements of section 1.170A-14(g)(6)(ii), Income Tax Regs. (proceeds regulation), the deed must guarantee that the donee will receive “a proportionate share of extinguishment proceeds”.
• Deductions are a matter of legislative grace, and a taxpayer must prove its entitlement to the deductions it claims. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). To be entitled to a deduction for the donation of a conservation easement, the donor must ensure that the donation “gives rise to a property right, immediately vested in the donee organization,” to receive a proportionate share of the proceeds of any post-extinguishment sale. Sec. 1.170A- 14(g)(6)(ii), Income Tax Regs.
• A donor must show strict, and not substantial, compliance with the perpetuity requirements of the regulation. 

Insight: The IRS has continued an attack on conservation easement deductions.  While the IRS typically attacks several aspects of conservation easement deductions, the case above is an example of a string of cases from the Tax Court that have sided with the IRS on technical grounds relating to the requirements under Treasury Regulations with respect to the deed granting the conservation easement.  Expect to see continued pressure and legal challenges from the IRS in this area.

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