Eleventh Circuit: Judicial extinguishment proceeds formula invalid

The Eleventh Circuit found the IRS’s interpretation of the judicial extinguishment proceeds formula for conservation easements to be procedurally invalid under the Administrative Procedure Act (APA).

Facts: In 2012, David Hewitt made a conservation easement contribution to the Pelican Coast Conservancy Inc. The recorded deed of conservation easement reserved Hewitt’s and his wife’s right to build certain improvements on their property subject to the deed. The deed also provided that, in the event of a judicial extinguishment of the easement, any increase in value after the date of the grant due to property improvements would be subtracted from the fair market value when determining the portion of proceeds due the conservancy.

The Hewitts reported charitable contribution deductions for tax years 2012, 2013, and 2014 related to the easement. In 2017, the IRS sent a notice of deficiency to the Hewitts disallowing the charitable contribution carryover deductions claimed in 2013 and 2014 from the easement, claiming that the easement deed did not meet the requirements for a qualified conservation contribution deduction. The Hewitts petitioned the Tax Court for a redetermination.

The Tax Court, in Hewitt, T.C. Memo. 2020-89, sided with the IRS due to the deed’s wording regarding judicial extinguishment. Subtracting the value of post-easement property improvements before determining the donee’s share of proceeds is not permitted under Regs. Sec. 1.170A-14(g)(6)(ii), the Tax Court held. The Hewitts appealed to the Eleventh Circuit.

Issues: Sec. 170 permits a charitable contribution deduction for contributions of qualified conservation easements. The contribution must be exclusively for conservation purposes (Sec. 170(h)(1)(C)), which must be protected in perpetuity (Sec. 170(h)(5)(A)).

Regs. Sec. 1.170A-14(g) provides rules for establishing that conservation purposes are protected by enforceable restrictions in perpetuity. Among them is a special rule for when a subsequent, unexpected change in conditions surrounding the property makes its continued use for conservation purposes impractical or impossible. In this case, the conservation purpose can be treated as protected in perpetuity if the restrictions are extinguished by a judicial proceeding and all the donee’s proceeds from a sale or exchange of the property are used in a manner consistent with the original contribution’s conservation purposes (Regs. Sec. 1.170A-14(g)(6)(i)). In addition, under Regs. Sec. 1.170A(g)(6)(ii), the donee must be entitled to a portion of the proceeds at least equal to the restriction’s value, which must be at least equal to the proportion that the value of the restriction bore to the value of the property as a whole at the time of the gift and have remained constant from that time.

The Eleventh Circuit noted that it had recently rejected arguments that “any amount, including that attributable to improvements, may be subtracted out” from the constant proportionate value of a perpetual conservation restriction under the regulation (TOT Property Holdings, LLC, 1 F.4th 1354 (11th Cir. 2021)). However, the court noted, it had not in the earlier case addressed whether Regs. Sec. 1.170A(g)(6)(ii) is procedurally valid under the APA.

Besides arguing that the regulation is procedurally invalid under the APA, the Hewitts contended that the IRS’s interpretation of the regulations was arbitrary and capricious.

In determining the regulation’s validity under the APA, the Eleventh Circuit examined whether the IRS had followed the APA’s three-step procedure for notice-and-comment rulemaking, that agencies must: (1) issue a notice of proposed rulemaking, (2) give interested parties the opportunity to participate and voice concerns, and (3) consider and respond to any significant comments received.

During the comment period for the proposed regulations that included the regulation at issue, the IRS received more than 90 comments. Thirteen of these specifically addressed the proposed extinguishment proceeds regulation, with one specifically commenting on whether the value of post-easement improvements should be included in the extinguishment proceeds formula. In the preamble to the Treasury Decision adopting the regulations as final, this comment was not specifically addressed; rather, the IRS stated that it had “consider[ed] … all comments regarding the proposed amendments.” The IRS also stated in the preamble that, since the regulations were interpretative, although it had solicited comments, the APA’s procedural requirement of notice and public comment had not applied.

Before the Eleventh Circuit, the IRS contended that none of the 13 comments on the regulation at issue were sufficiently significant to require a response because they did not cast doubt on its reasonableness.

Holding: The Eleventh Circuit sided with the Hewitts and held that the IRS had violated the APA’s procedural requirements, finding that the comments regarding the extinguishment proceeds calculation were significant and the IRS had failed to respond to the comments. Consequently, the court held that the IRS’s interpretation of Regs. Sec. 1.170A-14(g)(6)(ii) to disallow the subtraction of the value of post-donation improvements to the easement property in the extinguishment proceeds allocated to the donee was arbitrary and capricious and was thus invalid. Because the interpretation was invalid, the court also reversed the Tax Court’s disallowance of the Hewitts’ carryover charitable deductions related to the conservation easement and remanded the case to the Tax Court.

• Hewitt, 21 F.4th 1336 (11th Cir. 2021)

— Shannon Veyon Jemiolo, CPA, Ph.D., is an assistant professor of accounting, and Ian Redpath, J.D., LL.M., is a professor of accounting, both at Canisius College in Buffalo, N.Y.