Circuits Split on Validity of Conservation Easement "Proceeds" Regulation

(Parker Tax Publishing March 2022)

The Sixth Circuit affirmed a Tax Court decision and denied a taxpayer a charitable deduction for the contribution of a conservation easement because the deed at issue did not satisfy the protected-in-perpetuity requirement of Code Sec. 170(h)(5)(A). In doing so the court came to the opposite conclusion as the Eleventh Circuit and, by upholding the validity of Reg. Sec. 1.170A-14(g)(6) as a permissible interpretation of Code Sec. 170(h)(5)(A), and the Sixth Circuit's decision paves the way for an eventual resolution by the Supreme Court. Oakbrook Land Holdings, LLC v. Comm'r, 2022 PTC 70 (6th Cir. 2022).

Background

Under Code Sec. 170(h)(5)(A), taxpayers who donate an easement in land to a conservation organization can take a charitable deduction as long as the easement's conservation purpose is guaranteed to extend in perpetuity. However, in some cases, unexpected developments may make this impossible long after the donor has deeded the easement away. Contemplating such scenarios, the IRS issued Reg. Sec. 1.170A-14(g)(6), which governs in the event of an "extinguishment" of an easement. When a subsequent unexpected change in the conditions surrounding the property subject to an easement makes impossible or impractical the continued use of the property for conservation purposes, the perpetuity requirement of Code Sec. 170(h)(5)(A) can still be satisfied if two conditions are met. First, Reg. Sec. 1.170A-14(g)(6)(i) provides that the restriction must be extinguished by a judicial proceeding and second, Reg. Sec. 1.170A-14(g)(6)(ii) provides that all of the donee's proceeds from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution. Upon extinguishment, Reg. Sec. 1.170A-14(g)(6)(ii) also provides that a donee organization must receive as proceeds a fair market value 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. This regulation is referred to as the "proceeds regulation."

In 2020, in Oakbrook Land Holdings, LLC v. Comm'r, T.C. Memo. 2020-54 and Oakbrook Land Holdings, LLC v. Comm'r, 154 T.C. No. 10 (2020), the Tax Court held that a conservation easement did not satisfy the protected-in-perpetuity requirement in Code Sec. 170(h)(5)(A) and Reg. Sec. 1.170A-14(g)(6) because the easement deed provided that, in the event the properties at issue were sold following a judicial extinguishment of the easement (1) the donee organization would be entitled to proceeds based on a fixed historical value of the conservation area rather than a proportionate share of the proceeds, and (2) the donee's proceeds would be reduced by the value of any improvements made by the donor. The Tax Court thus denied the taxpayers a charitable contribution deduction and upheld the validity of Reg. Sec. 1.170A-14(g)(6) as a permissible interpretation of Code Sec. 170(h)(5)(A).

In December of 2021, in Hewitt v. Comm'r, 2021 PTC 410 (11th Cir. 2021), the Eleventh Circuit reversed a Tax Court decision involving a conservation easement donation after concluding that the IRS's interpretation of Reg. Sec. 1.170A-14(g)(6)(ii) is arbitrary and capricious and violates the procedural requirements of the Administrative Procedures Act (APA). The court concluded that an easement deed's subtraction of the value of post-donation improvements from the extinguishment proceeds allocated to the donee did not violate Code Sec. 170(h)(5)'s protected-in-perpetuity requirement and the taxpayers were thus entitled to a deduction for their conservation easement donation.

Against this backdrop, Oakbrook Land Holdings, LLC (Oakbrook) appealed its Tax Court decision to the Sixth Circuit. Like the taxpayers in Hewitt, Oakbrook challenged the validity of the proceeds regulation. According to Oakbrook, in issuing the regulation, the Treasury Department inadequately explained the rationale for the regulation in its concise general statement of basis and purpose and failed to respond to certain comments about the regulation which raised significant issues. Oakbrook argued that, in violating the notice-and-comment requirements of the APA, the Treasury Department's interpretation of Code Sec. 170(h) - the statute that the rule implements - is unreasonable and the proceeds regulation is arbitrary or capricious.

Analysis

The Sixth Circuit affirmed the Tax Court and upheld the validity of Reg. Sec. 1.170A-14(g)(6) as a permissible interpretation of Code Sec. 170(h)(5)(A). The court began by noting that perpetuity is vital to the statutory scheme allowing deductions for qualified conservation contributions. This type of gift, the court said, may qualify for a deduction if it is "of a qualified real property interest," "to a qualified organization," and is "exclusively for conservation purposes." While easements can qualify as such contributions, the court stated, perpetuity is vital to the statutory scheme. The court noted that, under Code Sec. 170(h)(2)(C), an easement is a qualified real property interest only if its deed creates a restriction (granted in perpetuity) on the use which may be made of the real property. Driving home how important the parenthetical phrase in Code Sec. 170(h)(2)(C) is, the court said, is the provision in Code Sec. 170(h)(5)(A) which explains that a contribution is not treated as having been made exclusively for conservation purposes unless the conservation purpose is protected in perpetuity. In other words, the court observed, the donation of an easement does not qualify for a charitable deduction unless the taxpayer can guarantee that both the grant of the interest and the conservation goals which it serves will endure for quite a long time - forever, to be exact.

The court then looked at the crux of the proceeds regulation which provides that, upon extinguishment, a donee organization must receive as proceeds a fair market value 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. The court cited the Fifth Circuit's decision in PBBM-Rose Hill, Ltd. v. Comm'r, 2018 PTC 269 (5th Cir. 2018) which found that, to determine the "proportionate value" of an easement, the fair market "value of the conservation easement at the time of the gift [must be] divided by the value of the property as a whole at that time." For example, the court said, if at the time of the donation the fair market value of an easement was $25,000 and the value of the land was $100,000, then the easement would be assessed at 25 percent of the value of the property. Next, Reg. Sec. 1.170A-14(g)(6)(ii) provides that, if a judicial extinguishment occurs, the donee must receive proceeds equal to the proportionate value from any subsequent sale, exchange, or involuntary conversion. The court noted that the donee in this example would therefore receive 25 percent of any proceeds of a sale, exchange, or involuntary conversion that followed judicial extinguishment of the easement. And, the court observed, as the Fifth Circuit held in PBBM-Rose Hill, no "amount, including that attributable to improvements, may be subtracted out" of this percentage.

The court rejected the taxpayer's argument that the Treasury Department violated the notice-and-comment requirements of the APA. The court noted that 90 organizations submitted over 700 pages of commentary that addressed various aspects of the regulations prior to them being finalized. The Treasury Department also held a public hearing on the proposed regulation, the court observed, and also revised the proceeds regulation, although the changes were editorial in nature and aimed at clarifying the rule, not altering its meaning.

With respect to the argument that the Treasury Department inadequately explained the rationale for the regulation in its concise general statement of basis and purpose, the court observed that what an agency must include in a concise general statement of basis and purpose is dictated by competing considerations. Agencies, the court noted, operate with scarce time and limited resources and these limitations mean that an agency cannot discuss every item of fact or opinion included in the submissions made to it in informal rule making. Juxtaposing the final version of Reg. Sec. 1.170A-14(g)(6)(ii) with the notice of proposed rulemaking, the court found that the basis and purpose of the rule was apparent.

The court addressed the Eleventh Circuit's decision in Hewitt and said it found the decision's reasoning to be unpersuasive. The Eleventh Circuit, the court observed, stressed that one of the aims of Code Sec. 170 is to allow deductions for the donation of conservation easements to encourage donation for such easements. According to the Sixth Circuit, although encouraging the donation of conservation easements is undeniably a goal of the statute, by highlighting this point the Eleventh Circuit overlooked a crucial condition that Congress demanded be met by donors seeking deductions: an easement's conservation purpose must be "protected in perpetuity."

The Sixth Circuit concluded that Code Sec. 170(h)(5)(A) embodies a particular policy that restricts deductions to where an easement's conservation purpose can be protected forever, and Reg. Sec. 1.170A-14(g)(6)(ii) interprets how to implement that policy.

For a discussion of the perpetuity requirement for conservation easement donations, see Parker Tax ¶84,155.

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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