Tax Court denies deduction for conservation easement

Two opinions issued recently by the Tax Court addressed different arguments made by a taxpayer challenging the IRS’s disallowance of a charitable conservation easement deduction. In a memorandum opinion, the Tax Court upheld the IRS’s disallowance of a partnership’s deduction for the conservation easement because the conservation purpose of the easement was not preserved “in perpetuity” under Regs. Sec. 1.170A-14(g)(6)(ii), which prescribes the relative value of a donee’s property rights and entitlement to proceeds from any extinguishment of the easement and subsequent sale or other disposition of the property. In a separate reported opinion, the Tax Court rejected the taxpayer’s argument that Regs. Sec. 1.170A-14(g)(6)(ii) was an invalid regulation. According to the court, the regulation had been properly promulgated under the Administrative Procedure Act (APA), and its substance was valid under the two-part Chevron test (Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)).

Facts: Oakbrook Land Holdings LLC, a land development company, donated a conservation easement on 106 acres outside Chattanooga, Tenn., to the Southeast Regional Land Conservancy (SRLC) in late 2008. Oakbrook relied heavily on the SRLC to draft the transfer deed, which included a provision that specified how to divide the proceeds between Oakbrook and the SRLC in the event the easement was later extinguished by a judicial proceeding due to changed circumstances or a condemnation. The provision granted the SRLC the right to receive the difference between the fair value of the property without the easement and the fair value of the property with the easement determined on the date of the donation, minus the amount of any improvements made by Oakbrook after the date of the easement.

Oakbrook had the easement appraised and used the appraisal to take a $9,545,000 charitable deduction on its 2008 Form 1065, U.S. Return of Partnership Income. In December 2012, the IRS issued a notice of final partnership administrative adjustment that disallowed the deduction and assessed an accuracy-related penalty. Oakbrook petitioned the Tax Court for relief.

Issues: Sec. 170(h)(1) allows a charitable contribution deduction for the contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. A contribution is not exclusively for conservation purposes unless that purpose is protected in perpetuity. If, after the creation of the easement, an unexpected event occurs that makes the continued use of the property for conservation purposes impossible or impractical, the conservation purpose can be treated as protected in perpetuity if the restrictions on the property are extinguished by a judicial proceeding and the donee uses all of its proceeds from any disposition of the property in a manner consistent with the original contribution.

Under Regs. Sec. 1.170A-14(g)(6)(ii)a donee must receive a minimum amount of the proceeds from a future disposition. At the date of the donation, the donor must agree that the donee has a property right that has a value 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.” That proportionate value must remain constant, and upon a subsequent disposition by judicial decree or a condemnation, the donee must be entitled to a share of the proceeds at least equal to that proportionate value.

In the portion of the case decided in the memorandum opinion, Oakbrook argued that the term “proportionate value” used in the regulation means the value of the easement on the date of the donation (reduced by any post-donation improvements) and that its deed satisfied the requirement because, under the deed, the SRLC was entitled to that amount if the easement were extinguished. The IRS argued that the term “proportionate value” means a fraction with a numerator equal to the value of the easement on the date of the gift and a denominator equal to the value of the property without the easement and that Oakbrook’s deed did not entitle the SRLC to the proportionate value of any extinguishment proceeds.

In the portion of the case decided in the reported opinion, Oakbrook also argued that even if the IRS’s reading of the regulation was correct, it was irrelevant because the regulation was procedurally and substantively invalid. A valid regulation must be properly promulgated (procedurally valid) under the APA’s requirements and be substantively valid, usually evaluated by the two-part Chevron test.

Oakbrook argued that Treasury did not comply with the APA because in the preamble to the regulation it failed to specifically discuss the basis and purpose of the judicial extinguishment provision related to the allocation of proceeds and the treatment of donor improvements. Oakbrook also argued that the regulation was unreasonable because it did not limit the donee’s share of any sale proceeds to the easement’s fair value at the date of the gift and did not consider the value of donor improvements.

Holdings: In the memorandum opinion, the court held that “proportionate value” in Regs. Sec. 1.170A-14(g)(6)(ii) means a fraction, not a fixed amount, because the regulation describes the ratio of value of the easement to the value of the entire property, which implies a fraction. Also, according to the court, when “proportionate value” is used in other places in the Code and other regulations, it indicates the use of a fraction. The court applied that interpretation to the deed, finding it violated the requirements of Regs. Sec. 1.170A-14(g)(6)(ii) because it failed to entitle the donee to a proportionate share of the proceeds from a future disposition and because the regulation does not permit any reduction of the proceeds for donor improvements.

The court did not sustain the accuracy-related penalty assessed by the IRS, finding Oakbrook’s position was reasonable.

In the reported opinion, the court’s majority held that the regulation was procedurally valid because its broad statements of purpose were adequate for the court to perform judicial review and that the APA does not require an explanation of the basis and purpose of each individual component of a regulation. However, one minority opinion found that an analysis of the regulation was unnecessary because the deed did not satisfy the statutory requirements for a deduction because it did not grant an interest in real property. But this minority opinion nonetheless found the regulation to be procedurally invalid. According to this opinion, Treasury had not responded to significant points and had not considered all relevant factors stated in the public comments. Another minority opinion, which dissented completely from the majority opinion, stated, “The IRS ignored comments that questioned the practical application of the regulation, its clarity, and special problems it would cause some donors.”

The majority held that the regulation was reasonable and thus substantively valid under Chevron because, as written, it satisfies the statutory mandate that the conservation purpose of the easement be protected in perpetuity.

• Oakbrook Land Holdings, LLC, T.C. Memo. 2020-54 and 154 T.C. No 10 (2020)

— By Charles J. Reichert, CPA.