Federal Income Taxation
Andrew Todd
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In 2021, the United States Court of Appeals for the Eleventh Circuit handed down several opinions involving U.S. federal income tax issues.1 Two of the court's published opinions address federal income taxation of conservation easements.2 Conservation easements have been under significant scrutiny by the Internal Revenue Service (IRS), having earned a spot on the "Dirty Dozen" list of tax scams in 2019.3 This Article surveys the two published opinions issued in 2021 involving the U.S. federal income taxation of conservation easements.
Section 170 of the Internal Revenue Code of 1986 (the Code), was amended in 1980 to provide tax benefits in the form of a charitable contribution deduction for property owners who enter conservation easements.4 Congress established this tax benefit to aid in preserving the nation's rich cultural heritage and vast natural resources at the risk of providing an opportunity for taxpayer abuse.5
A taxpayer is entitled to a charitable contribution deduction upon making a qualified conservation contribution.6 A qualified conservation contribution is the donation (1) of a "qualified real property interest"; (2) to a "qualified organization"; (3) that is made exclusively for a
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conservation purpose; and (4) for which the conservation purpose is protected in perpetuity.7
First, a "qualified real property interest" may be an entire interest in real property—excluding mineral rights, a remainder interest in real property, or a restriction on the use of real property granted in perpetuity.8 For a real property restriction to be enforceable in perpetuity, the donor must have a legally enforceable vested right in the property and the restriction must prevent the donor from using the property in a manner inconsistent with the restriction's conservation purpose.9 Restrictions that expire are insufficient and will disqualify the conservation contribution as a charitable deduction.10 However, restrictions which can only be defeated by remote contingencies unlikely to occur are considered to be "granted in perpetuity."11
Second, under section 170(h) of the Code, a qualified organization may be a governmental unit,12 an entity receiving substantially all of its support from a governmental unit,13 certain organizations described in section 501(c)(3) of the Code,14 or organizations controlled by certain organizations described in section 501(c)(3) of the Code.15 An organization described in section 501(c)(3) of the Code is a qualified organization if (1) more than one-third of such organization's annual revenue normally consists of more than one-third of its annual support from contributions, grants, charitable gifts, membership fees, and revenues from the performance of its exempt purposes;16 and (2) not
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more than one-third of such organization's annual support comes from investment income and unrelated business taxable income.17
Next, a qualifying conservation contribution must be made exclusively for conservation purposes. Conservation purposes may include: preservation of land for recreational or educational use by the general public; protection of habitats for wildlife; protection of ecosystems; preservation of open space for the scenic enjoyment of the public pursuant to government conservation plans; or the preservation of certain historically important land or structures.18
Finally, the property's conservation purpose must be "protected in perpetuity" for a contribution to be deemed exclusively for conservation purposes.19 The statute does not define what it means for a conservation purpose to be protected in perpetuity.20 In the absence of statutory guidance, the IRS issued regulations outlining what may meet this requirement. Generally, taxpayers may satisfy this requirement by providing the donee with a legally enforceable right to prohibit the use of the property in a manner inconsistent with the conservation purpose.21
In its regulations, the IRS recognized that circumstances could arise that may justify extinguishment of a restriction, or that parties may simply change their mind and wish to terminate the restriction.22 To address this concern, the regulations allow a restriction to be terminated by a judicial proceeding and to still be treated as protected in perpetuity if: (1) the proceeds of any subsequent sale, exchange, or condemnation "of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution";23 and (2) the parties agree at the time the restriction is granted that the donee will be entitled to a portion of any proceeds from the eventual sale, exchange, or conversion of the property.24 The amount owed to the donee is the same proportion that the restriction's fair market value bears to the unencumbered fair market value of the
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property.25 This regulation is the subject of the cases examined in the Article below.
A. Factual Background
George R. Dixon purchased 2,602 acres of undeveloped real estate in rural Van Buren County, Tennessee, for approximately $1.9 million in 2005.26 Three years later, Dixon transferred 652 of those acres to two limited liability companies that he controlled. The transferred acreage accounted for approximately $486,000 of the original purchase. In November 2013, the same 652 acres were transferred from Dixon's two limited liability companies to TOT Property Holdings, LLC (Taxpayer).27
After the November 2013 transfer, Taxpayer's total assets included the 652 acres of real property and $100 cash.28 On December 10, 2013, PES Fund VI, LLC purchased a 98.99% ownership interest in Taxpayer in exchange for $717,200 in cash and assumed the seller's obligations to make $322,000 in capital contributions to the Taxpayer, for a total purchase price of $1,039,200 (the PES Transaction).29
A few weeks later, on December 27, 2013, Taxpayer executed a deed (the Deed) that granted a conservation easement on nearly the entire property to Foothills Land Conservancy (Foothills).30 Section 9.1 of the Deed contained a provision concerning extinguishment of the easement, providing that the easement could only be terminated by appropriate judicial proceedings. If the easement was terminated, Foothills would be entitled to a portion of the proceeds from any termination proceeding "as determined in accordance with Section 9.2 [of the Deed] or 26 C.F.R. Section 1.170A-14, if different."31
Section 9.2 of the Deed prescribed a formula for valuation of the easement in the event of termination.32 The formula provides that the value of the easement at the time of extinguishment is calculated by:
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[M]ultiplying (a) the fair market value of the Property unencumbered by this Easement (minus any increase in value after the date of this grant attributable to improvements) by (b) a fraction, the numerator of which is the value of this Easement at the time of the grant and the denominator of which is the value of the Property without deduction of the value of this Easement at the time of this grant.33
Section 9.2 of the Deed concluded with a statement that the parties "intended that this Section 9.2 be interpreted to adhere to and be consistent with 26 C.F.R. Section 1.170A-14(g)(6)(ii)."34 In effect, this formula subtracts any increase in value attributable to improvements from any extinguishment proceeds. The reduced value would then be multiplied by the defined fraction. As a result, the portion of the extinguishment proceeds that Foothills would receive equals the easement's proportionate value of the unencumbered property at the time of the grant.35
On its partnership tax return for the taxable period ending on December 31, 2013, Taxpayer reported a charitable contribution via conservation easement of $6.9 million.36 Upon examination, the IRS determined that the easement did not qualify for the claimed charitable contribution deduction and assessed accuracy-related penalties. The IRS sent the Taxpayer a copy of the revenue agent's report and a transmittal letter signed by the examining agent's immediate supervisor, an IRS group manager. That letter stated that the "[revenue agent's] report explains all proposed adjustments including facts, law, and conclusion."37 Approximately two months later, the IRS group manager who signed the transmittal letter signed a form approving the civil penalties recommended in the revenue agent's report.38
The "IRS issued a notice of final partnership administrative adjustment" (FPAA) to Taxpayer in January 2017, disallowing the conservation easement deduction and assessing accuracy-related penalties under section 6662 of the Code.39 The deduction was disallowed due to Taxpayer's failure to establish that the deduction met the statutory requirements or that the value of the deduction was correct as claimed.40 Taxpayer timely challenged the FPAA by filing a
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petition in the tax court (the tax court case name is the same as the Eleventh Circuit case name).41 The tax court decided three main issues, holding for the IRS on all three.42
B. Did the Conservation Easement Protect the Conservation Purpose in Perpetuity?
First, the tax court determined that the valuation formula in section 9.2 of the Deed was inconsistent with regulatory requirements and that the language in the deed attempting to substitute the preferred formula with regulatory language was an unenforceable "condition subsequent savings clause."43 Thus, according to the tax court, the IRS properly denied the deduction for charitable contribution of the conservation easement because the Deed did not protect the conservation purpose in perpetuity, as required by section 170(h)(5) of the Code.44
The Eleventh Circuit began by considering whether the tax court properly determined...
