Tax Court Upholds Denial of $5.4 Million Deduction for Conservation Easement

(Parker Tax Publishing February 2021)

The Tax Court held that the partners of a partnership that granted a conservation easement to a land trust could not deduct the value of the easement because the deed provided that, in the event of a condemnation, the value of any improvements would be subtracted from the condemnation award before calculating the percentage of proceeds that would go to the land trust, thus violating Reg. Sec. 1.170A-14(g)(6). Additionally, while the court upheld a penalty on one partner's disallowed deduction for timber chopped down in violation of the conservation deed, it (1) rejected the accuracy-related penalties asserted against the partners because it found that they had reasonable cause and acted in good faith in claiming the conservation easement deduction, and (2) rejected the application of gross misstatement of value penalties because it found that the value of the property claimed by the taxpayers was not 400 percent or more of the correct value. Sells, et al v. Comm'r, T.C. Memo. 2021-12.

Background

In 1999, Steven and Janine Moses bought a 398-acre piece of land in Calhoun County, Alabama for $2.4 million. They planned to build a house and hippotherapy center on the land. However, after Mr. Moses suffered losses in the stock market, the couple decided to divide the property and sell it. They sold 161.5 acres for $1.4 million. In 2002, Mr. Moses formed Burning Bush Farms, LLC, with seven other members -- Kevin Sells, Charlie Williams, Freddy Welch, Jay Pumroy, John Davis, Lori Brown-James, and Stephen Whatley. Each member was an equal 12.5 percent owner of Burning Bush. The Moseses sold the remaining 236.5 acres to Burning Bush for $1.4 million, the amount of Mr. Moses's existing debt, in a distress sale.

In 2003, Burning Bush deeded a conservation easement on the land to Chattoawah Open Land Trust, Inc. (COLT). Burning Bush and its members relied on Katherine Ebbins, the executive director of COLT and a licensed attorney, to ensure that the conservation easement was properly put into place and complied with the regulations. Burning Bush reported the donation on its tax return as a noncash charitable contribution with a value of just under $5.4 million. Burning Bush also reported a second noncash charitable contribution of timber on the donated property, which it valued at $275,340. Burning Bush sent Schedules K-1 to the members reflecting the flowthrough charitable contributions of the land and the timber.

The IRS sent notices of deficiency to each member denying any deduction for the donation of either the conservation easement or the timber. The IRS also applied penalties for both the conservation and the timber donation. The notices asserted 20 percent accuracy-related penalties under Code Sec. 6662(a) for negligence, substantial understatement, or substantial misvaluation against all the members except for Sells. None of the notices asserted a gross-misvaluation penalty under Code Sec. 6662(h), even though penalty approval forms for the Moseses and Pumroys showed supervisory approval for Code Sec. 6662(h) penalties against them. All eight members of Burning Bush filed petitions with the Tax Court challenging the denial of the deductions and the imposition of the penalties.

Under Code Sec. 170(f)(3)(B)(iii), a deduction is allowed for a qualified conservation contribution. A qualified conservation contribution is defined in Code Sec. 170(h)(1) as a contribution (1) of a qualified real property interest, (2) to a qualified organization, (3) exclusively for conservation purposes. Under Code Sec. 170(h)(5), the conservation purpose of the easement must be protected in perpetuity. Reg. Sec. 1.170A-14(g)(6)(i) provides that, if a subsequent unexpected change in the conditions surrounding the property makes the it impossible or impractical to use the property for conservation purposes, the conservation purpose will be nonetheless treated as protected in perpetuity if the restrictions are extinguished a judicial proceeding and all of the donee's proceeds, as determined under Reg. Sec. 1.170A-14(g)(6)(ii), from a subsequent sale are used by the donee organization consistently with the conservation purposes of the original contribution. Reg. Sec. 1.170A-14(g)(6)(ii) provides that the donation of the perpetual conservation restriction "gives rise to a property right, immediately vested in the donee organization, with a FMV that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time." In Oakbrook Land Holdings, LLC v. Comm'r, T.C. Memo. 2020-54, the Tax Court held that under Reg. Sec. 1.170A-14(g)(6), the donee must be entitled to receive the proportionate value of (1) the FMV of the easement divided by (2) the FMV of the contributed property unburdened by the easement, multiplied by the gross proceeds of any extinguishment. This means that the donee is entitled to a share of proceeds attributable to fluctuations in the property's value or to the value of post-donation improvements.

The Burning Bush partners argued that there is language in Reg. Sec. 1.170A-14(g)(6)(ii) that nullifies the "proportionate value" requirement. The regulation states that its formula for determining the proceeds to which the donee is entitled upon extinguishment applies "unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction." The partners argued that under Alabama law, the owner of a conservation easement is not entitled to proceeds where the land is "taken for and devoted to a public purpose." According to the partners, since Alabama law prevents the easement holder from being entitled to any proceeds, the proportionate-value-with-no-allowance-for-improvements clause of the regulation did not apply.

Analysis

The Tax Court upheld the denial of the deduction for the conservation easement contribution. The court noted that Reg. Sec. 1.170A-14(g0(6)(ii) speaks of the involuntary conversion of a "perpetual conservation restriction." However, the court found that the Alabama caselaw cited by the partners arose from the more traditional easements appurtenant that often apply to homeowners in a subdivision. The court agreed that in that context, the condemnation of a property subject to an easement results in condemnation awards only to the property owner, not the easement owner. The court found that Alabama law treats the interest of the donee of a conservation easement as a nonpossessory interest of a holder of real property, thus distinguishing conservation easements from mutual easements, which are treated as contractual rights. The court held that the easement Burning Bush donated was not a contract right but an interest in property whose holder had to be compensated for its condemnation or destruction or other conversion and therefore, the general rule of Reg. Sec. 1.170A-14(g)(6)(ii) applied.

Next, the court found that the timber donation was not a donation of a conservation easement but rather a separate noncash donation to which Code Sec. 170(h) did not apply. The court found that under Alabama law, timber that has not been severed from the land is the property of the land owner, and generally not even a life tenant has the right to cut it and sell it. The court reasoned that, since the cutting of timber and its conversion into lumber and other wood products is not a conservation purpose, Burning Bush's donation of the timber was either a nondeductible gift of a partial interest in real estate other than a conservation easement, or a future interest in tangible personal property. The court found that the former would never be deductible under Code Sec. 170(f)(3)(A), and that under Code Sec. 170(a)(3), the latter would not be deductible until the timber is severed from the real property.

On the issue of penalties, the Tax Court found that the only penalties for which the written supervisory approval requirement under Code Sec. 6751(b)(1) was met were (1) a Code Sec. 6662(b)(2) penalty for the conservation easement donation deducted by the Moseses, (2) Code Sec. 6662(b)(1) and (2) penalties for both the conservation easement and timber donations deducted by the Pumroys, and (3) increased penalties for gross valuation misstatements under Code Sec. 6662(h) for both the Moseses and the Pumroys. The court found that Burning Bush's position on the conservation easement was reasonable and therefore neither the Moseses nor the Pumroys were liable for Code Sec. 6662(b) penalties for the donation of the conservation easement. The court noted that in PLR 200836014, the IRS ruled that a clause like the one in the deed here would satisfy the regulation. The court explained that although the partners could not rely on a private letter ruling, the ruling was an objective indication of the reasonableness of the position they took. In addition, the court found that both Pumroy and Moses, like all the Burning Bush partners, reasonably relied on Ebbins, the executive director of COLT, who had experience in this area of tax law and was not a promoter or otherwise tainted in providing the advice. However, the court found that the reasonable cause defense did not apply to the Pumroys' timber donation. The court noted that Pumroy is an attorney whose practice focuses on real estate and reasoned that he should have been aware that if Burning Bush donated a conservation easement then it could not simultaneously donate timber whose value was based on chopping trees down in violation of the conservation deed. Finally, the court found that the gross valuation misstatement penalty did not apply because Burning Bush's valuation of the conservation easement was not 400 percent of the value of the easement as determined by the court.

For a discussion of the rules for deduction contributions of conservation easements, see Parker Tax ¶84,155. For a discussion of accuracy-related penalties on underpayments of tax, see Parker Tax ¶262,120. For a discussion of abatement of penalties due to reasonable cause, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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