Court Nixes $155 Million Conservation Easement Deduction Due to Faulty Deed Provisions

(Parker Tax Publishing November 2019)

The Tax Court held that the IRS properly disallowed a partnership's deduction for the donation of a conservation easement because the easement deed improperly allowed a portion of the proceeds to which the donee organization would be entitled on the judicial extinguishment of the easement to be reduced by (1) amounts paid in satisfaction of prior claims against the donor, and (2) amounts attributable to appreciation in the value of improvements on the donated property. The Tax Court further held that a deed provision providing for an alternative calculation of the proceeds of a sale following judicial extinguishment, which applied only if the deed's formula was determined to be different from that required by regulations, constituted a "condition subsequent" saving clause that the court would not enforce. Coal Property Holdings, LLC v. Comm'r, 153 T.C. No. 7 (2019).

Background

Coal Property Holdings, LLC (Coal Holdings) was formed in December 2012. In September 2013, Coal Holdings acquired 3,713 acres of land in Tennessee (i.e., the property). Although not actively mined within the last 25 years, the property had been periodically subject to surface mining for coal during the last century. In October 2013, an entity owned by an investor acquired a 99 percent interest in Coal Holdings for $32.5 million. Three days after that, Coal Holdings conveyed an open space conservation easement over the property to Foothills Land Conservancy (Conservancy), a tax-exempt organization. When the easement was granted, the improvements on the property included 20 natural gas wells, two cell phone towers, roads, and electricity installations.

The easement deed contained a judicial extinguishment provision stating that if circumstances arose in the future that rendered the conservation purposes impossible to accomplish and the property were sold following the extinguishment of the easement by judicial proceedings, then Conservancy would receive a share of the proceeds, after the satisfaction of prior claims, pursuant to a formula. Under the formula, Conservancy's share was equal to the property's fair market value at the time of sale, minus any increase in value after the date of the grant attributable to improvements, multiplied by a fraction specified in Reg. Sec. 1.170A-14(g)(6)(ii). The deed stated that if this formula produced a result different from that required by the regulation, Conservancy would receive a share of the proceeds as determined under the regulation. Another deed provision specified that Conservancy's proceeds would be determined after the satisfaction of all prior claims against Coal Holdings.

On its 2013 tax return, Coal Holdings claimed a charitable contribution deduction of $155.5 million for its donation of the easement. The IRS disallowed the deduction in full. Coal Holdings took its case to the Tax Court.

In general, no deduction is allowed for a charitable donation of a partial interest in property, but an exception applies for a qualified conservation easement. Under Code Sec. 170(h)(1), a deduction is allowed if (1) the taxpayer contributes a qualified real property interest, (2) the donee is a qualified organization, and (3) the contribution is exclusively for conservation purposes. Under Code Sec. 170(h)(5)(A), the contribution is not made exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.

If an unexpected change in the conditions surrounding the donated property makes impossible or impractical the continued use of the property for conservation purposes, Reg. Sec. 1.170A-14(g)(6)(i) allows the judicial extinguishment of the easement. The conservation purpose is treated as protected in perpetuity if the restrictions are extinguished in a judicial proceeding and the easement deed ensures that, following the sale of the property, the donee organization will receive a share of the proceeds and use those proceeds consistently with the original conservation purposes. Under Reg. Sec. 1.170A-14(g)(6)(ii), the donee organization must be entitled to a proportionate share of the proceeds at least equal to the value of the perpetual easement restriction.

The IRS argued that the easement did not meet the requirements for a charitable deduction because the conservation purpose was not protected in perpetuity. According to the IRS, Conservancy was not absolutely entitled to a proportionate share of the proceeds in the event of a sale following judicial extinguishment. Coal Holdings recognized that the deed's judicial extinguishment provisions were problematic under Reg. Sec. 1.170A-14(g)(6), but it contended that the deed contained an "override" mandating that the provisions be interpreted to conform to the regulatory requirements as they have been construed by the Tax Court. According to Coal Holdings, Reg. Sec. 1.170A-14(g)(6) was ambiguous when the easement was executed in 2013 because a 2008 private letter ruling, PLR 200836014, appeared to permit adjustment of post-judicial extinguishment proceeds to reflect appreciation in the value of improvements. Coal Holdings argued that the deed took account of this regulatory ambiguity and supplied an "interpretation directive" designed to ensure that, in all events, Conservancy would receive whatever proceeds the regulation was ultimately interpreted to mandate.

Tax Court's Analysis

The Tax Court upheld the IRS's denial of the deduction in full after finding that the easement deed failed to protect the conservation purpose in perpetuity. The court found that, if the conservation purposes underlying the easement became impossible to achieve and the property were sold following judicial extinguishment, Conservancy would not be entitled to the full proportionate value of the easement restriction because Coal Holdings could subtract from the proceeds the increase in value attributable to the improvements on the property. In addition, the proceeds to Conservancy would be determined only after the satisfaction of prior claims (for example, claims against Coal Holdings by the oil and gas lessees or cell tower operators), even if the easement's fair value were determined exactly as required under the regulation. Thus, the conservation purpose would not be protected in perpetuity because Conservancy would receive less than the full proportionate value of the easement.

Observation: Regarding the prior claims provision, the court explained that a deed may provide for prior claims to be paid from sale proceeds, but what violated the judicial extinguishment regulation in this case was the requirement that all prior claims be paid out of Conservancy's share of the proceeds, even if the claims represented liabilities of Coal Holdings.

The Tax Court further held that the deed provision requiring the easement to be interpreted to conform to the regulatory requirements constituted a condition subsequent which courts have consistently declined to enforce. The court cited PBBM-Rose Hill, Ltd. v. Comm'r, 2018 PTC 269 (5th Cir. 2018), and Belk v. Comm'r, 2014 PTC 614 (4th Cir. 2014), in which the taxpayers' efforts to characterize similar savings clauses as interpretative provisions were rejected. The Tax Court concluded that the regulation is unambiguous, and there was therefore no interpretative question for the savings clause to clarify. Rather, in the court's view, the provision was a classic "condition subsequent" savings clause which purported to countermand the effect of an unambiguous provision, but only in the event of an adverse future occurrence, and the court declined to enforce it.

For a discussion of the rules for contributions of partial interests in property, 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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