Tax Court in Brief | Cattail Holdings, LLC v. Comm’r | Conservation Easement “Protected in Perpetuity” and Supervisory Approval of Penalty

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The Tax Court in Brief – February 13th – February 17th, 2023

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Tax Litigation:  The Week of February 13th, 2022, through February 17th, 2023

Cattail Holdings, LLC v. Comm’r, T.C. Memo. 2023-17| February 14, 2023 | Lauber, J. | Dkt. No. 27209-21

Summary: In September 2016 Dolomite Holdings 251, LLC (Dolomite), acquired a 723-acre tract of land in Virginia. On November 28, 2017, Dolomite contributed 207 acres of this tract (Property) to Cattail in exchange for a 100% interest in Cattail. Dolomite later sold interests in Cattail to investors. In December 2017 Cattail granted an open-space conservation easement over the Property to the Foothills Land Conservancy (Foothills), a “qualified organization” for purposes of section 170(h)(3). The easement deed recites the parties’ intent that the land “be retained forever in its undeveloped, natural, scenic, farm land, forested and/or open land condition.” The deed generally prohibits commercial, industrial, or residential development. But, it reserved certain recreational rights to Cattail as grantor. Cattail also reserved the right to construct barns, sheds, and facilities “for the generation of renewable electrical power.” Cattail was required to seek Foothills’ consent for exercising any of the activities reserved to Cattail. The deed also prohibited:

The exploration for, or development and extraction of, minerals and hydrocarbons by any surface or subsurface mining method, by drilling, or by any other method, or transportation of the same via new pipelines or similar facilities, that would impair or interfere with the Conservation Purposes and Conservation Values of the Property in any material respect in the discretion of the Grantee.

Cattail timely filed Form 1065, U.S. Return of Partnership Income, for its 2017 tax year. Cattail claimed a charitable contribution deduction of $40,675,000 for its donation of the easement and based on Cattail’s appraisal of the easement. The IRS examined the return and assigned the case to a Revenue Agent (RA). An IRS appraiser concluded that the fair market value (FMV) of the donated easement was $3,563,000. The RA then recommended assertion against Cattail of the 40% penalty for gross valuation misstatement. See 26 U.S.C. § 6662(h). In the alternative, the RA recommended assertion of a 20% penalty for substantial valuation misstatement, reportable transactions understatement, negligence, and/or substantial understatement of income tax. See id. at §§ 6662(b)(1)–(3), (c)–(e), 6662A(b). The RA’s recommendations were set forth in a penalty consideration lead sheet, and RA’s team manager and immediate supervisor digitally signed and approved the penalty lead sheet. The RA mailed Cattail a Form 5701, Notice of Proposed Adjustment, and Form 886–A, Explanation of Items, and later notified Cattail that the IRS disallowed the charitable contribution deduction in full and determined penalties. The FPAA alternatively determined that, if any deduction were allowable, Cattail had not established the value of the easement. Cattail petitioned the Tax Court for readjustment of the partnership items.

Key Issues:

Whether, as a matter of law, the IRS properly disallowed the charitable contribution deduction based on the reservation of rights-of-use in Cattail with respect to mining such that the conservation purpose was not “protected in perpetuity” as required by 26 U.S.C. § 170(h)(5)(A)?

Whether the IRS complied with the requirements of section 6751(b)(1) by securing timely supervisory approval of all penalties at issue?

Primary Holdings:

No. The deed did not indicate that Cattail retained the right to exploit any “qualified mineral interest.” And, the deed expressly prohibited mineral exploration and “[a]ny activity or use of the Property inconsistent with the purpose of this Easement.” The IRS’s assertion that Foothills might be faithless to its charitable mission by permitting Cattail to engage in activity explicitly barred by the statute and the deed “is not a proposition that can plausibly be advanced in a motion for summary judgment.”

Yes. All of the penalties at issue in this case were approved by the RA’s immediate supervisor, and the Notice of Proposed Adjustment was mailed to Cattail before the notice of determination was issued and otherwise at a stage where the supervisor had discretion to approve or disapprove the penalty determinations. The IRS complied with section 6751(b)(1).

Key Points of Law:

“Protected in Perpetuity.” The Internal Revenue Code generally restricts a taxpayer’s charitable contribution deduction for the donation of “an interest in property which consists of less than the taxpayer’s entire interest in such property.” 26 U.S.C. § 170(f)(3)(A). But there is an exception for a “qualified conservation contribution.” Id. at § 170(f)(3)(B)(iii), (h)(1). For the donation of an easement to be a “qualified conservation contribution,” the conservation purpose must be “protected in perpetuity.” Id. at § 170(h)(1)(C), (5)(A). The conservation purpose will not be treated as protected in perpetuity if “there is a retention of a qualified mineral interest [and] if at any time there may be extraction or removal of minerals by any surface mining method.” Id. at § 170(h)(5)(B)(i).

Respondent contends that the easement deed “permits surface mining” in violation of this provision. According to respondent, paragraph 3(h) of the deed endows Cattail with a “contingent right to engage in surface mining,” subject to Foothills’ approval. Paragraph 3(h) assertedly allows surface mining unless, “in the discretion of the Grantee,” such activity “would impair or interfere with the Conservation Purposes and Conservation values of the Property in any material respect.”

Penalty Approval. Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination.” The “initial determination of [a penalty] assessment” is a formal action by the Examination Division directed to a particular taxpayer. See Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020); Frost v. Commissioner, 154 T.C. 23, 32 (2020).

The IRS satisfies section 6751(b) so long as a supervisor approves an initial determination of a penalty assessment before the IRS assesses those penalties to the taxpayer. Kroner v. Commissioner, 48 F.4th 1272, 1276 (11th Cir. 2022), rev’g in part T.C. Memo. 2020-73. The phrase “initial determination of [the] assessment” refers to the “ministerial” process by which the IRS formally records the tax debt. See id. at 1278; but see Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 29 F.4th 1066, 1074 (9th Cir. 2022) (treating supervisory approval as timely if secured before the penalty is assessed or “before the relevant supervisor loses discretion whether to approve the penalty assessment”), rev’g and remanding 154 T.C. 68 (2020); Chai v. Commissioner, 851 F.3d 190, 220 (2d Cir. 2017) (concluding that supervisory approval must be obtained at a time when “the supervisor has the discretion to give or withhold it”), aff’g in part, rev’g in part T.C. Memo. 2015-42. The “immediate supervisor” is the person who supervises the revenue agent’s substantive work on an examination. See Sand Inv. Co. v. Commissioner, 157 T.C. 136, 142 (2021).

IRS Appraisers and Duty of Examination. In-house IRS appraisers do not have the authority to “determine” penalties; they simply offer an opinion as to value. During an IRS examination it is the duty of a revenue agent to determine penalties, taking into account (among other things) the value of the property contributed and possible defenses the taxpayer may have. The word “determination” has “an established meaning in the tax context and denotes a communication with a high degree of concreteness and formality.” Belair Woods, 154 T.C. at 15. An “initial determination” thus signifies a “consequential moment” of IRS action. Id. A preliminary recommendation offered by an appraiser to a revenue agent is not a “determination” within the meaning of section 6751(b)(1). The Tax Court does not second-guess the extent of the RA’s or the supervisor’s deliberations about whether penalties should be imposed. The Court confines its review to seeking evidence of written supervisory approval.

Insights: The Tax Court denied the IRS’s motion for summary judgment on the issue of denying the charitable contribution for the deeded conservation easement. Presumably, the issue of whether the conservation easement is “protected in perpetuity” will be presented at trial along with differing appraisal expert testimony and evidence about the value of the easement contributed, given that Cattail and the IRS are about $37 million apart on their respective ideas of the easement’s FMV.