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Eleventh Circuit Invalidates Extinguishment Proceeds Regulation

(Parker Tax Publishing January 2022)

The Eleventh Circuit reversed a Tax Court decision disallowing a couple's carryover deduction for a conservation easement donation after concluding that the IRS's interpretation of Reg. Sec. 1.170A-14(g)(6)(ii), known as the extinguishment proceeds regulation, is arbitrary and capricious and violates the procedural requirements of the Administrative Procedures Act. As a result, the 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 couple is thus entitled to a carryover deduction for their conservation easement donation. Hewitt v. Comm'r, 2021 PTC 410 (11th Cir. 2021).


In the 1990s, David Hewitt and his sister acquired several hundred acres of land in Randolph County, Alabama. The cumulative property owned between the two siblings had no zoning ordinances at that time and consisted of pastureland along a county road and wooded areas with steep topography, rough terrain, and limited road access. David has used, and continues to use, portions of the property as a cattle ranch. On December 28, 2012, David donated an easement on the property to and for the benefit of Pelican Coast Conservancy, Inc (the Conservancy). The easement deed provides that the easement's purpose is "to assure that the Property will be retained forever predominately in its natural condition and to prevent any use of the Property that will impair or interfere with the Conservation Values as set forth in this Easement." The easement deed sets forth a list of "prohibited uses" and permits the Conservancy the right to enter upon the property at reasonable times to preserve and protect the conservation features. The deed also contains a "permitted uses" section, which reserved to the Hewitts the right to build certain types of improvements on certain areas of the property.

Additionally, Section 15 of the deed governs judicial extinguishment of the easement and provides that if circumstances arise in the future that render the purpose of the easement impossible to accomplish, the easement can only be terminated or extinguished, whether in whole or in part, by judicial proceedings in a court of competent jurisdiction, and the amount of the proceeds to which the Conservancy would be entitled, after the satisfaction or prior claims, from any sale, exchange, or involuntary conversion of all or any portion of the property subsequent to such termination or extinguishment would be determined to be at least equal to the perpetual conservation restriction's proportionate value unless otherwise provided by Alabama law at the time. Under this provision, the parties stipulated that the easement would have, at the time of extinguishment, a fair market value determined by multiplying the then fair market value of the property unencumbered by the easement (minus any increase in value after the date of the grant attributable to improvements) by the ratio of the value of the easement at the time of the grant to the value of the property, without deduction for the value of the easement, at the time of the grant. The provision also stated that the ratio of the value of the easement to the value of the property unencumbered by the easement would remain constant.

On a 2012 joint tax return filed by David and his wife, the couple reported a noncash, charitable contribution for the donation of the easement in the amount of $2,788,000. An appraisal of the easement was attached to their return. Due to limitations on charitable contribution deductions, the deduction for the easement contribution was $57,738. The Hewitts timely filed their federal income tax returns for the 2013 and 2014 tax years. The 2013 return claimed a noncash, charitable contribution carryforward deduction from the 2012 charitable contribution deduction for the easement in the amount of $1,868,782, and the 2014 return carried the same deduction in the amount of $861,480.

The IRS denied the deduction because the deed subtracted the value of post-easement improvements before determining the Conservancy's share of the extinguishment proceeds. Thus, the IRS said, the easement did not protect the conservation purposes of the contribution in perpetuity as required by Code Sec. 170(h)(5) and in violation of Reg. Sec. 1.170A-14(g)(6)(ii) (i.e., the extinguishment proceeds regulation). The Hewitts filed a petition with the Tax Court challenging the disallowance of the easement donation. The IRS argued that the easement deed failed to comply with Reg. Sec. 1.170A-14(g)(6) due to the "improvements clause" included therein. Reg. Sec. 1.170A-14(g)(6)(ii) prohibits the subtraction of the value of post-donation improvements to the property on which a conservation easement exists from the proceeds in the event of judicial extinguishment. The Hewitts contended, among other things, that Reg. Sec. 1.170A-14(g)(6)(ii), as interpreted by the IRS, was not a valid exercise of the Treasury Department's rulemaking authority and violated the Administrative Procedures Act (APA).

In Hewitt v. Comm'r, T.C. Memo. 2020-89, the Tax Court held that the easement did not satisfy the "protected-in-perpetuity" requirement in Code Sec. 170(h)(5) because the easement deed violated the judicial extinguishment proceeds formula set forth in Reg. Sec. 1.170A-14(g)(6)(ii). The Tax Court also concluded that the proceeds regulation as to the post-donation improvements was procedurally valid under the APA. However, the court did not uphold the IRS's assessment of the 40 percent accuracy-related penalty for gross valuation misstatements and the 20 percent accuracy-related penalty for negligence or disregard of rules and regulations or substantial understatements of income tax under Code Sec. 6662(a) and (b)(1) and (2) for 2013 and 2014. The Hewitts appealed to the Eleventh Circuit.

On appeal, the Hewitts made several arguments as to why the Tax Court erred. They contended that the IRS's interpretation of Reg. Sec. 1.170A-14(g)(6)(ii) was incorrect, as subtraction of the value of post-donation improvements from the proceeds allocated to the donee was the "better reading" of the regulation. Specifically, the Hewitts argued that the IRS's interpretation is arbitrary and capricious because it violates the procedural requirements of the APA. This is so, they contended, because the Treasury Department failed to respond to significant comments as to the improvements issue in issuing the regulation. The Hewitts further argued that the regulation is substantively invalid under Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) as an unreasonable interpretation of the statute.


The Eleventh Circuit reversed the Tax Court and held that the IRS's interpretation of Reg. Sec. 1.170A-14(g)(6)(ii), the extinguishment proceeds regulation, is arbitrary and capricious and violates the APA's procedural requirements. As a result, the court said, the 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 Hewitts were entitled to the carryover charitable deduction for the conservation easement. Because the court found that Reg. Sec. 1.170A-14(g)(6)(ii) is procedurally invalid, it did not address the Hewitts' Chevron-related argument.

The court noted that Reg. Sec. 1.170A-14(g)(6) requires that the donee of an easement be granted a vested right to the value of judicial sale proceeds (e.g., in condemnation) multiplied by a fraction equal to the value of the conservation easement at the time of the gift, divided by the value of the property as a whole at that time. And, in TOT Property Holdings, LLC v. Comm'r, 2021 PTC 178 (11th Cir. 2021), the court observed that it found that Reg. Sec. 1.170A-14(g)(6)(ii)'s proceeds formula does not allow for any increase in value after the date of the grant attributable to improvements to be subtracted from the extinguishment proceeds before the fraction is applied to the proceeds. However, the Eleventh Circuit said, while it agreed with the IRS's interpretation of the proceeds regulation in TOT, it expressly did not consider the validity of the regulation under the APA, as the taxpayers there did not make such a challenge.

In the instant case, the court cited various detailed comments made in response to the proposed regulations issued prior to the final extinguishment proceeds regulation in Reg. Sec. 1.170A-14(g)(6) and noted that there were significant comments that warranted a response from the Treasury Department in issuing the final regulation. The court found that the Treasury's failure to respond to these significant comments was in violation of the procedural requirements of the APA.

For a discussion of the charitable contribution deduction requirements relating to donations of easements, 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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