U.S. Tax Court, 140 T.C. 17, June 24, 2013: Side letter promising termination of conservation easement disqualifies tax deduction.
Before petitioner Graev donated a historic preservation easement and a cash stewardship contribution to National Architectural Trust (NAT) he requested and received from NAT a letter promising that if the IRS disallowed Graev’s charitable contribution deductions for a qualified conservation contribution, NAT would refund the cash and “join with you to immediately remove the facade conservation easement from the property’s title”.
The tax court agreed with the IRS that this side letter made those contributions “conditional gifts,” that the likelihood that the cash would be returned and the preservation terminated was not negligible, and therefore the contributions are not deductible under Internal Revenue Code section 170.
The court, reviewing the relevant Code provisions, said the Code does not allow a deduction for a gift that is not completely given, in that there is a condition subsequent or precedent to the gift being fully irretrievably made. An exception to the rule is that the deduction may be considered “made” notwithstanding a possibility that the contribution will be defeated by a subsequent event, but only if on the date of the contribution that possibility is “so remote as to be negligible”. (Treasury Regulations sec. 170A-1(e), 1.170A-7(a)(3) and 1.170A-14(g)(3).) A failure of a conservation easement to satisfy the “so remote as to be negligible” test would mean that the conservation easement also fails the perpetuity requirement for qualified conservation contributions.
The court found that there was at least a non-negligible possibility, if the IRS successfully disallowed Graev’s easement contribution deduction, that NAT would join with Graev to terminate the easement. The court said the precedent of 885 Inv. Co. v. Commissioner, 95 T.C. 156, 161 (1990) (quoting United States v. Dean, 224 F.2d 26, 29 (1st Cir. 1955)), defines “so remote as to be negligible” as “‘a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.’” The court cited Graev’s own request for and reliance on the side letter as evidencing that to Graev the chance of terminating the easement pursuant to the side letter was not highly improbable and, when he granted the easement after receipt of the side letter, he made the judgment not to ignore that chance of termination. The IRS’ announced policy (in IRS Notice 2004-41) to scrutinize charitable contribution deductions for facade easement contributions created a non-negligible risk of disallowance by the IRS, and Graev’s evaluation of that risk as non-negligible is evident from Graev’s request for the side letter, the court said.
The court distinguished the ruling in another case, O’Brien v. Commissioner, 46 T.C. 583 (1966), also a charitable contribution with a contingent subsequent. It said that O’Brien “did not analyze the tax contingency issue under the section 170 regulations, and we did not hold that a tax-treatment contingency can never be a subsequent event that will defeat a contribution and a deduction. We simply did not address that issue.”
Graev tried to argue that under applicable State (New York) law, NAT could not be held to the promises it made in its side letter, so that there was in fact no possibility that the property would be returned. Graev claimed that New York’s environmental conservation statutes, N.Y. Envtl. Conserv. Law secs. 49-0301 to 49-0311, made the side letter unenforceable and the common law doctrine of merger extinguished the side letter upon NAT’s recording the easement deed. The court accepted the premise that the easement is enforceable only under New York’s Environmental Conservation Law and is subject to that law’s restrictions on how an easement can be extinguished. Although the court said that “NAT’s promise in the side letter to remove the easement, standing alone, does not appear to comply with any of the … permissible modification or extinguishment methods” of the statute, the combination of the side letter and the easement provisions gave NAT the power of extinguishment. The court also held that even assuming the doctrine of merger applies to the side letter, the provisions in the side letter would fall within an exceptions to that doctrine and survive the deed.
(Regardless of the merits of the court’s reasoning, its Opinion also includes what appears to be a classic Catch-22 statement by the court: “If we had upheld the deductions, the condition in the side letter would never have been met, the gift would be complete, the contribution would be deductible (assuming other qualifications are met), and we would enter decision in favor of the Graevs to overturn the IRS’s deficiency determination. Because instead we disallow the deductions and enter decision in the IRS’s favor, upholding the deficiency determination, the condition in the side letter is triggered and the gift presumably reverts to the donor.”)
Decision available at http://www.ustaxcourt.gov/InOpHistoric/GraevDiv.Gustafson.TC.WPD.pdf.