Tax Court Invalidates Conservation Easement Regulation
By Christopher Johnson, JD, LLM, CPA, MBA and John P. Kavanaugh, CPA
In a recent decision regarding conservation easements, the Tax Court determined that an IRS Treasury Regulation was invalid and, therefore, the taxpayer’s charitable deduction was allowed. The case adds to a growing and conflicting body of case law surrounding such deductions. The contribution of a conservation easement, known as a “qualified conservation contribution” under the federal tax code, involves an agreement with a nonprofit organization to permanently limit the use of real property for conservation or historical preservation purposes. Concern has grown in recent years about the abuse of such rules, in which otherwise unused land was being purchased cheap, appraised at a high value and then donated subject to a conservation easement to generate significant tax write deductions.
IRS and Congressional scrutiny of conservation easements has been increasing for a number of years. In 2016, the IRS classified certain conservation easement transactions involving pass-through entities as subject to harsh disclosure and penalty provisions if the claimed deduction was greater than 2.5 times the partner’s investment. Congress later effectively codified the IRS’ earlier rule by denying any conservation easement deduction for such transactions after December 29, 2022.
While the changes to the conservation easement rules are limiting new transactions, the IRS is simultaneously focused on reviewing and denying deductions for prior transactions under the pre-existing rules. Active cases in the Tax Court jumped from 425 in 2022 to over 750 last year, and the IRS plans to increase its audit rates of partnerships claiming conservation easement deductions to 80%.
Regulation Ruled Invalid
Last month, the Tax Court in Valley Park Ranch LLC v. Commissioner (March 28, 2024) ruled against the government, allowing the taxpayer’s deduction after determining that a specific regulatory requirement was invalid.
The taxpayer in 2016 conveyed a conservation easement to a qualified nonprofit organization of over 45 acres of land in Oklahoma. The taxpayer claimed a $14.8 million conservation easement deduction in its 2016 partnership tax return on the land, for which its claimed tax basis was approximately $90,000. The IRS audited the return and ultimately disallowed the deduction for failure to satisfy the requirement that the property be “protected in perpetuity” under the statute and the regulations. The taxpayer appealed to the Tax Court for review, claiming that the property was “protected in perpetuity” as required by the statute and regulations but also that the regulation in question was invalid and should, therefore, be ignored.
The relevant regulation in question [Treas. Reg. 1.170A-14(g)(6)(ii)] concerns extinguishment, the termination of easement restrictions due to a later change in conditions, which makes the continued use of the property for conservation purposes impossible or impractical. The regulation requires that, in order to claim as a tax deduction, the conservation easement may only be extinguished under judicial proceedings and with a specified allocation of the residual proceeds to the nonprofit organization.
The regulation was proposed as part of a large package of rules concerning conservation easements in May 1983. The IRS received over 700 pages of comments during the comment period. The final regulation was issued in January 1986 without any substantive changes and without any discussion of the relevant comments received and how they were or were not addressed.
The Tax Court pointed to specific comments made during the IRS’ comment period, which either urged removal of the regulation entirely or the revision of the proposed allocation of proceeds calculations. Because the IRS did not respond to a significant comment, the Tax Court held that the regulation was procedurally invalid and should be ignored. As the taxpayer had satisfied the statutory requirements, the taxpayer’s deduction was allowed in full. This current decision actually reverses two prior holdings by the Tax Court in 2020 that this regulation was valid. Appeals of those 2020 decisions resulted in one court finding that the regulation was invalid (Eleventh Circuit in 2021) and a second court ruling that the regulation was valid (Sixth Circuit in 2022). The Supreme Court declined to hear the case to reconcile the conflict, and no other Courts of Appeals have ruled on this issue to date.
Conservation Easements Now
Although the taxpayer may have prevailed in this particular decision, the federal government continues to successfully pursue cases against fraudulent conservation easement claims, both in civil and criminal courts. Earlier this year, two accountants were each sentenced to more than 20 years in prison for marketing and promoting fraudulent conservation easement claims.
The law change at the end of 2022 to deny most excess conservation easement deductions for passthrough entities has likely put a stop to the most abusive transactions, as they will simply not be as lucrative now as they were previously. No deduction would be permitted for Valley Park Ranch under current law.
Conclusion
Conservation easements remain a useful charitable tool to provide a benefit to the environment as well as the donor. Proper contemporaneous documentation, particularly a thorough valuation report prepared by a qualified appraiser, is key to substantiating your deduction.
Contact Us
If you may be considering making a charitable conservation easement donation or have previously participated in a conservation easement transaction and think you may be affected by the conservation easement regulations, consider consulting with experienced professionals to assist in navigating the requirements and assessing the impact. Our experts are actively following the updates, including recent court decisions. If you would like more information on the conservation easements, contact your client service team at PKF O’Connor Davies or:
Christopher Johnson, JD, LLM, CPA, MBA
Partner
cjohnson@pkfod.com | 646.449.6305
John P. Kavanaugh, CPA
Partner
jkavanaugh@pkfod.com | 646.449.6394