The Art of an IRS APA Defense: Conservation Easements and Hewitt
Good tax attorneys will do whatever it ethically takes to win on behalf of their clients. Often, this means the attorney must not only have a good understanding of the substantive provisions at play, but also relevant procedural rules. And, there are many.
Take for example the recent Eleventh Circuit decision in Hewitt. In that case, the taxpayers had donated a conservation easement on property. However, they ran afoul of a Treasury Regulation, which places limitations on the amount of proceeds the Hewitts could receive in the event the conservation easement was later nullified through judicial extinguishment. Rather than simply arguing that the operative regulation did not apply to the transaction at issue, the tax attorney also contended that the regulation was void as violative of the Administrative Procedure Act (the “APA”). The taxpayer won! The Hewitt decision is discussed more fully below.
The Property and the Deed of Conservation Easement.
David Hewitt (“David”) acquired approximately 1,300 acres in Alabama from his family and other third parties (the “Property”). He used the Property for cattle ranching.
However, on December 28, 2012, David executed a Deed of Conservation Easement (the “Deed”) in favor of a conservancy. The Deed was properly recorded in the county records in Alabama.
Among other provisions, the Deed contained its purpose, prohibited uses of the Property, and permitted uses of the Property. First, it specified that David had executed the Deed to retain the Property in its natural condition. Second, the Deed limited the usage of the Property—to advance its natural state—and permitted the conservancy to enter the Property to preserve and protect the easement. Third, it contained a “permitted uses” provision, which reserved to the Hewitts the right to build certain types of improvements on the Property.
In many cases, there is an issue of which party shares in the improvement value of land when an easement is extinguished. For example, here is it David or is it the conservancy? To address this issue, the parties agreed that the Deed should contain a judicial extinguishment clause. Thus, subsection 15.1 of the Deed stated:
Extinguishment. If circumstances arise in the future such as render the purpose of this Easement impossible to accomplish, this Easement can only be terminated or extinguished, whether in whole or in part, by judicial proceedings in a court of competent jurisdiction, and the amount of the proceeds to which Conservancy shall be entitled, after the satisfaction or prior claims, from any sale, exchange, or involuntary conversion of all or any portion of the Property subsequent to such termination or extinguishment (herein collectively “Extinguishment”) shall be determined to be at least equal to the perpetual conservation restriction’s proportionate value unless otherwise provided by Alabama law at the time, in accordance with subsection 15.2 . . .
Subsection 15.2 further provided:
Proceeds. This Easement constitutes a real property interest immediately vested in Conservancy. For the purposes of this Subsection, the parties stipulate that this Easement shall have at the time of Extinguishment a fair market value determined by multiplying the then fair market value of the Property unencumbered by the Easement (minus any increase in value after the date of this grant attributable to improvements) by the ratio of the value of the Easement at the time of this grant to the value of the Property, without deduction for the value of the Easement, at the time of this grant . . . For the purposes of this paragraph, the ratio of value of the Easement to the value of the Property unencumbered by the Easement shall remain constant.
Section 170 of the Code permits taxpayers to claim a charitable contribution deduction in certain instances. Here, in this case, David and his wife filed a 2012 joint income tax return and claimed a noncash, charitable contribution deduction for the donation of the easement in the amount of $2,788,000. The Hewitts also attached an appraisal of the easement to the return.
The Code limits the amount of charitable contribution deductions any given taxpayer can take in a tax year. Due to these limitations, the Hewitts only claimed $57,378 of the charitable contribution deduction on their 2012 tax return and carried the remainder to 2013 and 2014.
IRS Examination and NOD.
Large itemized deductions such as those claimed above by the Hewitts tend to get the attention of the IRS. This case was no different. After an examination of the Hewitts’ 2013 and 2014 returns, the IRS issued a notice of deficiency to the Hewitts for those tax years (the “NOD”). The NOD disallowed the charitable contribution deductions and also asserted accuracy-related penalties for both years.
Tax Court Proceedings.
The Hewitts filed a timely petition with the United States Tax Court challenging the IRS’s disallowance of the carryover charitable contributions. During those proceedings, the Hewitts also raised the following argument: Treas. Reg. § 1.170a-14(g)(6), which relates to judicial extinguishment and proceeds, was not a valid exercise of the Treasury’s rulemaking authority under the Administrative Procedure Act (the “APA”). Conversely, the IRS argued it followed all required procedures under the APA and that under Treas. Reg. § 1.170A-14(g)(6) the taxpayers were not entitled to a charitable contribution deduction due to the judicial extinguishment provision in the Deed.
The Tax Court held in favor of the IRS, except for the penalties. More specifically, the Tax Court concluded that the Hewitts were not entitled to the claimed charitable contribution deductions under Treas. Reg. § 1.170A-14(g)(6). In addition, the Tax Court, with some dissent, contended that Treasury had followed the rulemaking requirements under the APA in issuing that regulation.
The Eleventh Circuit Reverses the Tax Court’s Decision.
The Hewitts appealed the Tax Court’s decision. For purposes of the appeal, the IRS did not challenge any other requirements under section 170 of the Code or the penalty determination. Thus, the Eleventh Circuit was required to determine whether the Tax Court had correctly interpreted Treas. Reg. § 1.170A-14(g)(6) and alternatively whether Treasury had complied with the APA in promulgating that regulation.
As to the first issue, the Eleventh Circuit held that it had already determined in a prior decision that the Tax Court’s interpretation of Treas. Reg. § 1.170A-14(g)(6) was the proper one—i.e., that the Hewitts are not entitled to a charitable contribution deduction under the regulation. However, the Eleventh Circuit continued its analysis as to whether Treasury had complied with the notice-and-comment requirements of the APA.
Section 170 and Treas. Reg. § 1.170A-14(g).
To better understand the issues in this case, it is important to have a better understanding of the applicable Code and regulatory provisions. Under section 170(a), a taxpayer may generally claim a charitable contribution deduction, provided certain requirements are met. Generally, section 170 does not permit a charitable contribution deduction for donations of less than all of the property. I.R.C. § 170(f)(3)(A). For example, a taxpayer cannot generally donate a life estate in a building he or she owns and obtain a charitable contribution deduction.
However, Congress saw fit to enact an exception to this general rule. Specifically, a taxpayer may receive a charitable contribution deduction if the donation is a “qualified conservation contribution.” I.R.C. § 170(f)(3)(B)(iii), (h).
Qualifying contributions must meet certain hurdles. Thus, the contribution must be: (1) of a qualified real property interest; (2) to a qualified organization; (3) exclusively for conservation purposes. Sec. 170(h)(1). A “qualified real property interest” includes “a restriction (granted in perpetuity) on the use which may be made of the real property.” Sec. 170(h)(2)(C). Additionally, section 170(h)(5)(A) provides that, for purposes of subsection (h), a “contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.” The statute does not define the “protected in perpetuity” requirement.
Because the statute does not speak of the definition of “protected in perpetuity,” Treasury stepped in on May 23, 1983. On that date, Treasury issued a notice of proposed rulemaking regarding “proposed regulations relating to contributions of partial interests in property for conservation purposes.” Later, on January 14, 1986, Treasury issued final regulations, including the regulation at issue in this case: Treas. Reg. § 1.170A-14(g)(6). Treas. Reg. § 1.170A-14(g)(6) governs the allocation of proceeds between the donor and donee in the event of judicial extinguishment of a donated conservation easement. Specifically, that provision provides:
- In general. If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee’s proceeds (determined under paragraph (g)(6)(ii) of this section) from a subsequent sale or exchange of the property are used by the done organization in a manner consistent with the conservation purposes of the original contribution.
- Proceeds . . . [F]or a deduction to be allowed under this section, at the time of the gift the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time . . . For purposes of this paragraph (g)(6)(ii), that proportionate value of the donee’s property rights shall remain constant. Accordingly, when a change in conditions give rise to the extinguishment of a perpetual conservation restriction under paragraph (g)(6)(i) of this section, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction.
According to the above regulation, a donee of an easement must be granted a vested right, at the time of the donation, of the value of the judicial sales proceeds multiplied by the faction equal to the value of the conservation easement at the time of the gift, divided by the value of the property as a whole at that time. Taxpayers who have failed to comply with this provision have been denied the charitable contribution deduction in its entirety.
The Administrative Procedure Act.
As indicated above, the Hewitts contended that the above interpretation of the regulation should not govern their case. This argument was quickly shot down by the Eleventh Circuit—they concluded they had already determined that the Tax Court’s reading was the proper one on another appeal. However, the Hewitts’ tax attorney raised another argument: Treas. Reg. § 1.170A-14(g)(6) was invalid under the APA’s notice-and-comment requirement.
The APA permits a reviewing court to hold unlawful and set aside agency action, findings, and conclusions if “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” See 5 U.S.C. § 706(2)(A). And although federal courts generally do not substitute their judgment for that of the agency, federal courts will also “not rubber stamp the action of the agency.” Port of Jacksonville Mar. Ad Hoc Comm., Inc. v. U.S. Coast Guard, 788 F.2d 705, 708 (11th Cir. 1986).
A challenge to the notice-and-comment requirements can relate to any one of three requirements under the APA. First, an agency is required to issue a general notice of proposed rulemaking, ordinarily by publication in the Federal Register. Second, if notice is required, the agency must give interested persons an opportunity to participate in the rulemaking through submission of information, views and arguments. In response, the agency must consider and respond to so-called “significant comments” received during the open period for public comment. Third, in promulgating a final rule, the agency must include in the rule’s text a concise general statement of its basis and purpose. Because rules issued through this notice-and-comment process often have the “force and effect of law,” these rules are often referred to as “legislative rules.” See Chrysler Corp. v. Brown, 441 U.S. 281, 302-03 (1979).
Eleventh Circuit’s Analysis.
The Eleventh Circuit conducted a deep dive of Treasury’s rulemaking of Treas. Reg. § 1.170A-14(g)(6). It noted that after Treasury issued a notice of proposed rulemaking and requested public comments, it received more than 700 pages of commentary from 90 organizations and individuals. And of these 90 persons, 13 offered comments as to the proposed extinguishment proceeds regulation discussed above.
Of the 13 comments, the Eleventh Circuit noted that one was particularly detailed. Specifically, the New York Landmarks Conservancy (“NYLC”) had urged Treasury to delete the proposed proceeds regulation because it contained pervasive “problems of policy and practical application.” NYLC noted that Congress had enacted section 170(h) to encourage the protection of the environment through conservation easement donations and that the proposed regulation would “thwart the purpose of the statute by deterring prospective donors.” NYLC made additional comments associated with the extinguishment regulation including those aimed at Treasury’s proposed allocation of the value of proceeds attributable to future improvements by the donor.
After a public hearing, Treasury adopted the proposed regulations with revisions. However, Treasury failed to discuss or address the comments above including those raised by the NYLC. And Treasury further indicated in the final regulations that although it had solicited public comments, the IRS had concluded that the regulations were interpretative and that the APA did not apply.
On these facts, the Eleventh Circuit held:
After careful consideration of the agency record before us, the several opinions in Oakbrook and precedent from the Supreme Court, and this Court’s interpretation of procedural validity under the APA, we conclude that § 1.170A-14(g)(6)(ii)—as read by the Commissioner to prohibit subtracting the value of post-donation improvements to the easement property from the proceeds allocated to the donor and donee in the event of judicial extinguishment—is arbitrary and capricious under the APA for failing to comply with the APA’s procedural requirements and is thus invalid.
In this regard, the Eleventh Circuit concluded that NYLC’s comments were “significant” and required a response by Treasury to satisfy the APA’s procedural requirements. And the fact that Treasury stated that it considered “all comments,” without more discussion, did not change the court’s analysis because it did not enable the court to review why Treasury reacted to NYLC’s specific objections to the proposed regulation.
As shown in Hewitt, procedure is important and may even carry the day when other arguments do not. Taxpayers who have valid challenges to the implementation and promulgation of regulations should consider raising procedural challenges to these regulations under the APA.
For additional articles regarding conservation easement deductions, see the below articles written by other Freeman Law attorneys.
Recent Tax Court Conservation Easement Decision Demonstrates Continued IRS Enforcement Efforts and Penalty Defenses
Recent IRS Memo Supports Use of Summonses for Syndicated Conservation Easement Transaction
IRS Fraud Penalties, TEFRA, and Conservation Easements
Conservation Easement Deductions: A Primer on Key Provisions
Senate Finance Committee Releases Conservation Easement Data