Taxpayer Survives Summary Judgment in Conservation Easement Case

(Parker Tax Publishing March 2023)

The Tax Court denied an IRS motion for partial summary judgment arguing that a conservation easement deed failed to meet the requirement in Code Sec. 170(h)(5)(A) that the conservation purpose of an easement donation be protected in perpetuity due to language in the deed pertaining to mining activities, after finding that the deed expressly prohibited surface mining. However, the court granted summary judgment for the IRS on the issue of whether the initial determination of the penalties assessed against the taxpayer, including valuation misstatement and reportable transaction penalties, was approved in writing by the immediate supervisor of the IRS employee who made the initial penalty determination under Code Sec. 6751(b)(1). Cattail Holdings, LLC v. Comm'r, T.C. Memo. 2023-17.

Background

Cattail Holdings, LLC (Cattail) is a Delaware limited liability company (LLC) whose principal place of business is in Georgia. In 2017 Dolomite Holdings 251, LLC (Dolomite), acquired a 723-acre tract of land in Chesterfield, Virginia. Dolomite contributed roughly 207 acres of this tract (Property) to Cattail in exchange for a 100 percent interest in Cattail. Dolomite subsequently sold interests in Cattail to investors.

In December 2017, Cattail granted an open space conservation easement over the Property to the Foothills Land Conservancy, a qualified organization for purposes of Code Sec. 170(h)(3). The easement deed generally prohibits commercial, industrial, or residential development. Paragraph 3 of the deed prohibits any activity on the Property that would be inconsistent with the conservation purpose of the easement. Paragraph 4(s) similarly provides that Cattail "may not exercise any of its rights reserved under this Easement in such a manner to adversely impact the Conservation Purposes or Conversation Values of the Property."

In addition to the deed's general prohibition against any activity inconsistent with the conservation purpose, paragraph 3 of the deed lists numerous specific prohibitions. Of relevance in this case is paragraph 3(h), which bars mining activities. It expressly prohibits: "The exploration for, or development and extraction of, minerals and hydrocarbons by any surface or subsurface mining method, by drilling, or by any other method, or transportation of the same via new pipelines or similar facilities, that would impair or interfere with the Conservation Purposes and Conservation Values of the Property in any material respect in the discretion of the Grantee." Paragraph 3 states that the prohibited uses are "subject to those reserved rights set forth [in] Paragraph 4." But paragraph 4 reserves to Cattail no mining rights of any kind. Apart from paragraph 3(h), which bars surface and subsurface mining, the deed contains no reference to mineral exploration, development, or extraction.

On its Form 1065, U.S. Return of Partnership Income, for its 2017 tax year, Cattail claimed a charitable contribution deduction of $40,675,000 for its donation of the easement. In support of this supposed value Cattail relied on an appraisal prepared by Dale W. Hayter, Jr. The IRS selected Cattail's 2017 return for examination and assigned the case to Revenue Agent (RA) Kendrick Veney. An IRS senior appraiser, Kenneth Baker, prepared an appraisal review report that evaluated Hayter's appraisal. Baker's report concluded that the fair market value (FMV) of the donated easement was $3,563,000. Nowhere in his report did Baker recommend the assertion of any penalty against Cattail, for valuation misstatement or otherwise.

In an April 2021 penalty lead sheet, RA Veney recommended assertion against Cattail of the 40 percent penalty for gross valuation misstatement and, in the alternative, a 20 percent penalty for substantial valuation misstatement, reportable transactions understatement, negligence, and/or substantial understatement. RA Veney's team manager, Lee Volkmann, signed the penalty lead sheet on April 26, 2021. On May 21, 2021, RA Veney mailed Cattail a Form 5701, Notice of Proposed Adjustment, setting forth the proposed adjustments and penalty determinations. On July 23, 2021, the IRS issued Cattail a final partnership administrative adjustment (FPAA), disallowing the charitable contribution deduction in full and determining penalties. The FPAA alternatively determined that, if any deduction were allowable, Cattail had not established the value of the easement. Cattail took its case to the Tax Court.

In a motion for partial summary judgment, the IRS contended that Cattail's deduction was properly disallowed because the deed permitted surface mining and therefore violated the requirement under Code Sec. 170(h)(5)(A) that the conservation purpose of the easement be protected in perpetuity. Specifically, the IRS asserted that paragraph 3(h) allows surface mining unless, "in the discretion of the Grantee," such activity "would impair or interfere with the Conservation Purposes and Conservation values of the Property in any material respect." The IRS also argued that it complied with the requirements of Code Sec. 6751(b)(1), which requires that the initial determination of a penalty be approved in writing by the immediate supervisor of the IRS agent making the initial penalty determination.

Cattail made two arguments for why the IRS failed to comply with Code Sec. 6751(b)(1). First, with respect to the reportable transaction understatement penalty, Cattail noted that in Notice 2017-10, the IRS announced that participants in syndicated easement transactions risked certain penalties, and that in a subsequent 2019 press release (IR-2019-182), the IRS further advised that, in examining easement transactions based on inflated valuations, every available enforcement option would be considered - including civil penalties. Based on these announcements, Cattail contended that the decision to assert penalties in all transactions falling under Notice 2017-10 was made by "higher-level officials within the IRS" sometime in 2019. Therefore, Cattail contended that RA Veney had no discretion whether to recommend assertion of the penalty and Volkmann had no discretion whether to approve it. Alternatively, Cattail suggested that, at least with respect to the valuation misstatement penalties, it was Baker, not RA Veney, who made the initial determination of the penalty assessment. According to Cattail, there was no evidence showing that RA Veney made an independent determination or was permitted not to assert valuation penalties following receipt of Baker's appraisal review report.

Analysis

The Tax Court denied the IRS's motion on the Code Sec. 170(h)(5)(A) question but granted it with respect to Code Sec. 6751(b)(1).

The court found the IRS's argument that the deed permitted surface mining unconvincing for three reasons. First, the court found that nothing in the deed reserved to Cattail the right to engage in any mining-related activity. To the contrary, the court noted that paragraph 4 expressly prohibits mining by surface or any other method. Second, the court found that the IRS erred in interpreting paragraph 3(h) to allow mining "in the discretion of" Foothills. The court said that, far from permitting mining, this grant of discretionary authority gave Foothills the power to prevent any transportation of existing minerals that it viewed as problematic. Third, the court said that the IRS's contention that the deed allowed surface mining with Foothills' approval struck it as "fanciful" considering that paragraph 3 explicitly prohibited any activity inconsistent with the deed's conservation purpose. In the court's view, by assuming "a contingent right to surface mining," the IRS was suggesting that Foothills might be faithless to its charitable mission by permitting Cattail to engage in activity explicitly barred by statute. The court concluded that this was not a proposition that could plausibly be advanced in a motion for summary judgment.

Turning to the penalty approval issue, the court noted that this case is appealable to the Eleventh Circuit and that the interpretation of Code Sec. 6751(b)(1) in Kroner v. Comm'r, 2022 PTC 281 (11th Cir. 2022), was therefore controlling. In Kroner, the Eleventh Circuit held that the IRS satisfies the Code Sec. 6751(b)(1) requirement so long as a supervisor approves an initial determination of a penalty assessment before the IRS assesses the penalties. The Tax Court observed that under a literal application of the standard enunciated in Kroner, supervisory approval could seemingly be secured at any moment before actual assessment of the tax. However, the court found that the Eleventh Circuit left open the possibility that supervisory approval in some cases might need to be se-cured sooner, i.e., before the supervisor "has lost the discretion to disapprove" the penalty determination.

Applying the Kroner rule, the Tax Court noted that as of April 26, 2021, the IRS examination remained at a stage where Volkmann had discretion to approve or disapprove the penalty determinations. Therefore, the court found that under a reading of Kroner most favorable to Cattail, the IRS complied with Code Sec. 6751(b)(1) as long as Volkmann was the appropriate person to supply such approval. On that issue, the court was not persuaded by Cattail's arguments. The court found that neither Notice 2017-10 nor the 2019 press release determined any penalties against Cattail. Further, the court found that IRS announcements to the public at large cannot constitute the initial determination of a penalty assessment because such announcements are not directed at a specific taxpayer whose return is under IRS examination.

The court also rejected Cattail's argument that Baker made the initial penalty determination by preparing an appraisal review report. Baker's limited role, the court found, was to review Cattail's appraisal and provide his evaluation of it to RA Veney. The court noted that IRS appraisers do not have the authority to determine penalties they simply offer opinions as to value. In the court's view it was undisputed in this case that RA Veney prepared the penalty consideration lead sheet, recommending assertion of all the penalties at issue, and Volkmann - his immediate supervisor - timely signed this form on April 26, 2021.

For a discussion of the protected in perpetuity requirement for conservation easements, see Parker Tax ¶84,155. For a discussion of the penalty supervisory approval requirement under Code Sec. 6751(b)(1), see Parker Tax ¶262,195.

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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