Appellate Court Finds Federal Conservation Easement Regulation Invalid

The Eleventh Circuit Court of Appeals recently invalidated a technical provision in the Treasury Regulations controlling conservation easement charitable contribution deductions, and reversed a Tax Court order disallowing the taxpayer’s carryover deduction. The case was remanded for further proceedings. Hewitt v. Commissioner, No. 13-700 (11th Cir. Dec. 29, 2021), opinion available here.

This is a significant opinion in the area of conservation easements. The IRS has been aggressive in attacking conservation easement deductions for many years, and has recently found success in asserting that certain conservation easements failed on a technical ground involving the perpetuity requirement. PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193 (5th Cir. 2018). To qualify as a conservation easement under the statute, the conservation purpose of the easement must be “protected in perpetuity.”  I.R.C. § 170(h)(5). However, the statute doesn’t say what “protected in perpetuity” means. That definition comes from Treasury Regulations that were proposed in 1983 and made final in 1986. Treas. Reg. § 1.170A-14(g)(6).

In defining how an easement protects a conservation purpose in perpetuity, the final regulations adopted a rule to address the hypothetical situation where an easement is extinguished in the future. Conservation easements are susceptible to extinguishment under various state laws. In California, easements may be extinguished through judicial proceedings, or in some cases, through administrative proceedings. The Treasury Regulations state that if the restrictions contained in an easement are judicially extinguished, and the proceeds from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution, the conservation purpose may nonetheless be treated as protected in perpetuity despite the extinguishment. Treas. Reg. § 1.170A-14(g)(6)(i).

This means if there is a change in the conditions surrounding a property that make it impossible or impractical to keep the conservation restrictions in place, the property can be sold and the proceeds can be used for a different, but consistent, purpose. To deal with this situation, conservation easement deeds typically establish a formula to decide who gets what in the event of a sale. The extinguishment formula can get complicated in the case of a grant or bargain sale of a conservation easement involving government funding. Easement deeds commonly provide that if there are post-donation improvements paid for by the donor, and the easement is later extinguished, the donor will receive the additional value generated by such improvements once the property is sold.

A landowner who grants a conservation easement to a charity, but plans to build a barn on the land, for example, may wish to include a provision in the easement stating that any increase in value attributable to the barn would go to the owner, and not to the charity, in the event of a judicial extinguishment. This seems sensible in that the charity would continue to share in the appreciation of the land, while additional investment by the donor into the property that is consistent with conservation purposes would be further incentivized. However, such a provision presents a problem under the current IRS interpretation of the extinguishment proceeds formula of Treas. Reg. § 1.170A-14(g)(6)(ii).

Courts have consistently found that such a provision is in contravention of the “protected in perpetuity” requirement in I.R.C. § 170(h)(5) in light of Treas. Reg. § 170A-14(g)(6), beginning with PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193 (5th Cir. 2018), and in other subsequent court opinions. This trend of completely disallowing deductions due to a technical violation has been viewed as severe, particularly in light of the fact these provisions are often boilerplate language that is neither negotiated nor well-understood by the donating taxpayers. The extinguishment provision issue is not only raised by the IRS in potentially abusive situations, but it has also been raised in cases where the underlying donation value is not in dispute.

The Hewitt opinion is therefore a very important development, because it finds that the extinguishment proceeds formula set out in Treas. Reg. § 1.170A-14(g)(6)(ii), as interpreted by the IRS, is arbitrary and capricious, and is thus invalid. The court provided a detailed analysis of this holding, but in summary, the court found that because the Treasury failed to respond to significant comments concerning post-donation improvements in the case of an extinguishment, the IRS interpretation of the regulation was invalid under the Administrative Procedure Act. The court’s holding in Hewitt is somewhat surprising given that the Eleventh Circuit recently upheld a Tax Court opinion that disallowed a taxpayer’s deduction on the same ground. TOT Property Holdings, LLC v. Commissioner, 1 F.4th 1354, 1363 (11th Cir. 2021). However, as the court in Hewitt explains, the procedural validity issue was not raised in TOT due to concessions of the parties.

Takeaways

• Hewitt opens the door to future litigation on the issue of what proceeds formulae can be utilized in extinguishment provisions.
• At present, taxpayers must continue to exercise extreme caution in drafting conservation easement deeds, including extinguishment provisions and many other provisions.
• Hewitt is highly relevant to cases pending before the IRS and in litigation.