Carroll V. Commissioner

U.S. Tax Court, 146 T.C. 13, April 27, 2016: Formula for sharing post-extinguishment proceeds must conform exactly to IRS Regs.

Despite the federal Tax Code and Treasury Regulations’ requirement that to be eligible for a tax deduction a donated conservation easement must be enforceable in forever and always (“in perpetuity”), the law recognizes the possibility that even a qualified conservation easement could be extinguished by a court in unusual circumstances. When a conservation or preservation easement is extinguished, that presumably increases the fair market value of the property because it could be sold without the burden of the easement. To assure that the property owner will never recoup the value of the gift that gave rise to a tax benefit (and reduced Treasury revenue) and that the value of that easement will always be used for conservation purposes, the Tax Code and Regulations require that to be eligible for the deduction, a donated conservation easement must spell out a certain formula for how the property owner and the conservation organization that holds the easement (various called the “grantee,” “donee” or “holder”) will divide the proceeds of the first sale of the property after extinguishment. The holder will then continue to have the cash value of the easement, to use for conservation purposes.

At issue in this case, which the Tax Court described as its first on this question, was how closely the formula for sharing post-extinguishment proceeds must conform to the text of the IRS regulations. The court’s answer was the formula must guarantee that the holder will get exactly what it would get using the precise words of the regulations; i.e., the court rejected the Carroll formula and therefore said the Carroll Easement did not qualify for a federal tax deduction.

Sec. 1.170A-14(g)(6)(ii) of the Income Tax Regs. says that the holder’s share of post-extinguishment proceeds must be “at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift [the numerator] bears to the value of the property as a whole at that time [the denominator].” These values are determined by an appraisal closely contemporaneous with the gift. Even as these dollar values might change over time, this fraction (the numerator divided by the denominator as determined by this formula at the time of the gift) never changes; it remains the same in perpetuity.

The conservation easement in this case (the Carroll Easement) used a different numerator.  Instead of the “value [of] the perpetual conservation restriction at the time of the gift,” the Carroll Easement used the amount allowable as a deduction for Federal income tax. In other words, regardless of what the donor’s appraisal might have said at the time of the gift, the Carroll Easement said that the value of the easement was what the IRS said the value was. This presumably reflects the fact that the IRS has often contested the donor’s appraised value and the Tax Court has sometimes agreed that the value of the easement at the time of the gift was some number lower than the donor’s appraised value, sometimes down to zero value.  The Carroll Easement also said that once there was a final determination of value by the IRS or a court of competent jurisdiction, the holder’s share of post-extinguishment proceeds would remain constant.

In disqualifying the Carroll Easement, the court relied on the federal Third Circuit Court of Appeals and district court decisions in the Kaufman cases. Kaufman v. Commissioner (Kaufman I), 134 T.C. 182 (2010), reconsideration denied by Kaufman v. Commissioner (Kaufman II), 136 T.C. 294 (2011), aff’d in part, vacated in part and remanded in part sub nom, Kaufman v. Shulman (Kaufman III), 687 F.3d 21 (1st Cir. 2012).  Although the facts in Kaufman were different, the principle cited by the court was that the nonprofit easement holder must be absolutely guaranteed its proportionate share of post-extinguishment proceeds. Kaufman I, 134 T.C. at 187.

The court understood this principle to mean that the holder’s proportionate share of post-extinguishment proceeds must be determinable exactly as the IRS Regulations state at the time of the gift (or perhaps when the deduction is claimed). The Carroll Easement left open the possibility that the holder’s proportionate share would appear to be one thing at the time of the gift and another thing by the time the IRS could no longer challenge the deduction claim or the IRS challenge was finally resolved.

(The court noted that if the Carroll case were appealed, the appeal would be heard by different Court of Appeals Circuit than the circuit which decided Kaufman, and so might reach a conclusion different from Kaufman’s, “the Court of Appeals for the First Circuit’s opinion in Kaufman III is instructive on several points.”)

Not surprisingly, Carroll objected that the court’s reasoning was circular:  was it logical to say that the Carroll Easement was disqualified for a charitable deduction because it might be disqualified for a charitable deduction for a reason other than the reason for which the court wanted to disqualify it? The Carroll Easement either would or would not be disqualified for a reason other than the post-extinguishment proceeds clause (indeed, the court rejected other IRS objections to the Easement; see below). If the Carroll Easement were disqualified for a reason other than the post-extinguishment proceeds clause, what possible difference could it make what the proceeds clause said? And if it were not disqualified on other grounds, then didn’t the Carroll Easement’s proceeds clause have the effect of guaranteeing the holder a certain share of proceeds that, once determined, would remain constant in perpetuity?

The court found this argument “unpersuasive. The regulatory requirements set forth in section 1.170A-14(g), Income Tax Regs., are designed to protect the conservation purpose of a conservation contribution and must be satisfied at the outset for a contribution to be deductible.”

The court also upheld the IRS decision to hold the taxpayer liable for accuracy-related penalties under I.R.C. sec. 6662. Although Tax Code Section 6664(c)(1) provides that the penalty under section 6662(a) do not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith, the taxpayer in this case did not consult with an attorney or other adviser in the drafting of the easement, and therefore could not claim reasonable cause and good faith.

The IRS also challenged the deduction on the basis that easement the did not constitute a qualified real property interest under section 170(h)(1)(A), and was not contributed exclusively for conservation purposes under section 170(h)(1)(C) because it did not preserves open space pursuant to a clearly delineated Federal, State, or local government conservation policy and yield a significant public benefit. The court found the Carroll Easement met these requirements.

The opinion is available at http://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10767.

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