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A Split in the Circuits: Will Supreme Court Take Up Easement Challenge?

April 5, 2022, 8:45 AM

Oakbrook Land Holdings LLC is a charitable conservation easement case in which the U.S. Court of Appeals for the Sixth Circuit affirmed the U.S. Tax Court’s decision in favor of the IRS. The validity of a Treasury Regulation was at issue, and the Sixth Circuit found the regulation to be valid. Finding a Treasury Regulation to be valid is not terribly newsworthy; it is very difficult for a taxpayer to prevail when challenging the validity of Treasury Regulations due to deference to the agency by the courts.

However, the Eleventh Circuit recently ruled in favor of a taxpayer and found the very same regulation to be invalid in Hewitt v. Commissioner. The panel of judges decided that Treasury failed to satisfy the requirements of the Administrative Procedures Act during its review process prior to the finalization of Treasury Regulation §1.170A-14(g)(6)(ii), the proceeds regulation.

As a quick recap of the impact of this developing law on charitable easements, the proceeds regulation requires that an easement deed contain language detailing how to allocate proceeds in the very unlikely event of judicial extinguishment of a perpetual easement. An extinguishment can occur through court order in an eminent domain proceeding or in a situation where the environmental purpose is no longer viable. The proceeds regulation, as interpreted by the IRS, requires the easement deed to specify that upon extinguishment, the proceeds are distributed through a percentage allocation established at the time of the initial easement donation. This percentage is determined without regard to whether the donor or the donee might subsequently make improvements to the property. The IRS and Tax Court have attempted to shut down conservation easements by focusing on their interpretation of the proceeds regulation, with early success.

The tax court opinions in Oakbrook Land Holdings and Hewitt v. Commissioner focused on the Administrative Procedures Act, or APA, and whether that particular provision was properly promulgated following a public comment period. In both cases, the Tax Court upheld the validity of the proceeds regulation. As is to be expected, the appellate courts similarly focused on the APA. The Sixth Circuit agreed with the Tax Court’s assessment and gave credence to the fact that the regulation was promulgated in January 1986 and, although IRC §170 has been amended more than 30 times, the proceeds regulation has not changed. The Eleventh Circuit did not agree and reversed the decision.

The taxpayers in both cases focused, in part, on the unfairness of the proceeds regulation in that a large percentage of a donor’s subsequent improvement to the property is essentially also donated to the easement holder. In response, the Sixth Circuit held: “Erring on the side of providing the donee with higher rather than lower proceeds...buoys the donee’s ability to ensure that the conservation purpose of the easement continues upon extinguishment. With additional funds at its disposal the conservation organization will likely have more options available to further the original conservation purpose in line with §170(h)(5)(A)...[the Proceeds Regulation] does just that and is thus a reasonable interpretation of the section.”

However, this does not address a situation in which the charitable donee improves the property. If the charity provides funding for improvements, the donor benefits if the easement is extinguished. This could result in private benefit or inurement to the donor, thereby threatening the charitable status of the easement holder.

On the other hand, the Eleventh Circuit in Hewitt reviewed Treasury’s compliance with the APA and concluded the agency’s interpretation of the proceeds regulation is “arbitrary and capricious and violated the APA’s procedural requirements.” The Eleventh Circuit relied extensively on the concurring/dissenting opinions of U.S. Tax Court judges Emin Toro and Mark V. Holmes in Oakbrook and their separate opinions that the proceeds regulation is invalid. In doing so, it highlighted the comment from New York Landmarks Conservancy, or NYLC. The NYLC commented on the unfairness of the extinguishment provisions and the inequities that could result in the ultimate distribution of proceeds after extinguishment. The Eleventh Circuit found this argument to be persuasive and worthy of Treasury’s acknowledgment and discussion as required by the APA. Treasury did not acknowledge or address NYLC’s comments. The Eleventh Circuit reversed the tax court’s opinion and held that the proceeds regulation was procedurally invalid under the APA.

How can two separate panels of appellate judges come to such different conclusions? It appears that the judges interpreted very similar facts and the same law differently, which does not bode well for establishing legal precedent that taxpayers can rely on.

One interesting argument that has not gotten much attention is the dichotomy of the practical application of the proceeds regulation as compared to the theoretical application of the proceeds regulation. It is probable that this arcane provision will rarely become relevant in the perpetual life of an easement. However, it is being used by the IRS to disallow the charitable deductions claimed by hundreds, if not thousands, of taxpayers who have made easement donations to charities. Congress specifically provided this incentive to taxpayers to encourage conservation easements.

Indeed, none of the conservation easement court opinions I have reviewed—91 and counting—involve actual implementation of this provision of the proceeds regulation. There is no evidence that any proceeds have actually been distributed utilizing the proceeds regulation’s formula or the taxpayers’ easement deeds’ formulas. None of the perpetual easements I have reviewed have been judicially extinguished to date. It is not a common occurrence, as the easements are required to be perpetual. There is no discussion about the possibility of allowing taxpayers to amend their easement deeds to comply with the IRS’ interpretation of the proceeds regulation. The option of amending the easement deed would cure the problem raised by the IRS while preserving environmental protections of easements and the tax benefits granted by Congress to incentivize such easements. Many easement deeds include a “savings clause” that allows amendments to protect the interests of both donor and donee, especially on the occasion of punitive government action. Amendments would eliminate the “gotcha” quality of the IRS’ current position, and the parties could focus on substantive issues.

The key question is whether the Supreme Court will take up this issue. The split in the circuits is undeniable, and millions, if not billions, of tax dollars are at stake. Also at stake are millions of acres of land and species of birds and animals that may or may not be protected pending the outcome of this issue. Therefore, the Supreme Court should be interested in reviewing and resolving the issue for conservation purposes and for tax purposes.

Another angle is that former President Donald Trump is being investigated for his investment in conservation easements and his large charitable deductions that resulted from said contributions. In fact, Judge Barbara Lagoa, a December 2019 Trump appointee to the Eleventh Circuit, was the author of the Hewitt opinion in favor of taxpayers. There is no indication that the outcome in the Eleventh Circuit was politically motivated, but there is speculation that some influence may have been present. It is possible the Supreme Court may want to steer clear of the issue due to its political implications, although the Eleventh Circuit did not seem to be conflicted by the political overtones.

It has been quite a journey to get to this point, and hundreds if not thousands of taxpayers and their financial well-being hang in the balance. I, for one, hope that the Supreme Court agrees to take up the case and provides more certainty for taxpayers and conservationists. If the proceeds regulation is upheld, the proceeds clauses will need to be carefully crafted to avoid giving the IRS an easy route to deny the corresponding charitable deductions. Donors should carefully structure the easements so as not to include land that may be subsequently improved by the donor or donee. These factors may discourage future easements. On the other hand, if the Treasury Regulation is struck down, conservation easements will be saved from extinction, and the focus should turn to valuation and fulfillment of the conservation purpose.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Nancy Ortmeyer Kuhn is a director at Jackson & Campbell, P.C. in Washington, D.C., and is chair of the Tax Group. Her legal practice focuses on litigation and federal tax matters.

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