IRS and Tax Court Overturned Again
The United States Court of Appeals for the First Circuit Court overruled the Tax Court’s opinion on who gets insurance or condemnation money first on conserved land. The First Circuit reversed the Tax Court’s decision that perpetuity required the subordination to give money to the land trust first. The conservation easement must still do that.
Donors still must obtain a lender subordination to the entire conservation easement, including the payment on extinguishment clause, and record it at the same time as the conservation easement despite this new ruling.
The IRS lost two significant recent cases that deal with historic preservation easements but have important implications for all conservation easements as well. United States Court of Appeals for the First Circuit handed taxpayers—and the entire preservation and conservation communities—another big victory in Kaufman v. Commissioner (US Court of Appeals 1st Circuit, Nos. 11-2017, 11-2022, July 19, 2012). Similarly in Scheidelman v. Commissioner the United States Court of Appeals for the Second Circuit overturned a controversial Tax Court decision supporting the IRS interpretation of substantiation requirements.
Follow All the Rules
But this is not a time for complacency. The IRS and the Tax Court have warned us that failure to follow all of the rules can result in very unpleasant consequences. Donors and land trusts must still pay attention to details and not hastily suspend recently adopted new practices regarding deduction substantiation or become lax or lazy in continuing to implement sound practices to help landowners understand their obligations in these highly technical transactions.
And in spite of another recent Tax Court case, Averyt v. Commissioner (see below), holding against the IRS an another issue, all land trusts should send the “gift” letter. The Alliance has sample letters and other relevant information on contemporaneous written acknowledgement (gift) letters.
The Alliance has a special collection of documents that includes information on this most recent developments in case law, as well as samples of mortgage subordination language, practical pointers and fact sheets, articles, summaries and full text versions of the cases, and a copy of the regulations regarding mortgage subordination at. Log in to The Learning Center first and then paste the address in your browser if you are not automatically directed to the collection.
Three Big Issues
The First Circuit reviewed three main points in its Kaufman opinion:
- Whether the easement met the “perpetuity” requirements of the Treasury Regulations because the mortgage subordination gave the mortgage company a priority interest to insurance and condemnation proceeds if the easement was ever extinguished
- Whether the easement holder’s discretion to give its consent to changes to the property or abandon the easement was inconsistent with the perpetuity
- Whether the appraisal summary substantially complied with regulatory requirements
The First Circuit focused on the IRS’ interpretation of the Treasury regulations and whether easement-holding organizations must have a priority interest to insurance and condemnation proceeds in the event the easement property is destroyed or condemned. The court rejected the IRS’s interpretation, finding that such an interpretation would “doom practically all donations of easements” and was contrary to the purpose of the statute that Congress intended.
The second issue related to whether the easement holder’s discretion to consent to changes to the property or abandon the easement failed to satisfy the regulatory requirement that easements must prevent uses that are inconsistent with the preservation of the property. This issue was squarely addressed in Simmons, and the court found that easement holding organizations must be allowed flexibility in the oversight of their easements, and that abandonment of the easement was a remote possibility, one that the IRS could directly control in its regulation of tax-exempt organizations.
The court stated that Treas. Reg. § 1.170A-14(g)(1) “nowhere suggests the stringent outcome that the IRS seeks to ascribe to it and the consequences of the reading would be to deprive the done organization of flexibility to deal with remote contingencies.”
The final issue addressed was the technical noncompliance of the appraisal summary submitted by the donor. By focusing on the minor deficiencies of the appraisal summary, the court stated that the IRS, in avoiding the valuation issues, was attempting to “convert an inherently factual issue into a set of violations of the procedural requirements [of the regulations] … in disregard of their language and purpose.” The court applied the substantial compliance doctrine to numerous minor omissions by the Kaufmans in their Form 8283 filing, as well as the appraisal and the appraisal summary, stating “we can hardly agree with the IRS that these defects, in no way prejudicial to it in this instance, doom the appraisal summary.”
The First Circuit’s decision overturned the Tax Court’s interpretation of the Treasury regulations in Kaufman v. Commissioner, 136 T.C. 294 (2011). However, because the Tax Court based its decision not to impose further penalties on the Kaufmans on the understanding that the deduction failed for technical reasons, the court vacated the penalties decision as well. The court returned the case to the Tax Court to address the valuation issue and reconsider the penalties.
The court specifically addressed the IRS’s concern about abusive appraisals, but said that using technicalities to deny deductions rather than addressing the legitimacy of valuation was not acceptable. The court did express skepticism about the actual valuation, as well as any significant economic difference between existing zoning and preservation laws and the façade easement restrictions, but left that to the Tax Court to determine after it reexamines the case. Following the trend of the Second Circuit Court of Appeals in the Scheidelman decision reported last month, the court said that the IRS cannot avoid litigating valuation by relying on non-prejudicial technical errors in reporting.
Nevertheless the court expressed some understanding for the IRS’s approach:
Doubtless it is the desire to avoid such trials, as well as the difficulty of detecting and investigating suspicious cases one by one, that explains the IRS's aggressive legal positions in this case. And, despite our rejection of those particular positions, we do not question the IRS's concern, transcending this case, that individuals and organizations have been abusing the conservation statute ‘to improperly shield income or assets from taxation.
Such language from the Court may have broader implications for conservation generally and IRS interpretation of at least the present Treasury regulations.
However, to reject overly aggressive IRS interpretations of existing regulations is hardly to disarm the IRS. Without stifling Congress' aim to encourage legitimate easements, one can imagine IRS regulations that require appraisers to be functionally independent of donee organizations, curtail dubious deductions in historic districts where local regulations already protect against alterations, and require more specific market-sale based information to support any deduction. Forward looking regulations also serve to give fair warning to taxpayers.
Just four days before the Second Circuit’s decision on the appeal in Scheidelman, the Tax Court decided a similar case (Rothman v. Commissioner, US Tax Court, T.C. Memo. 2012-163, June 11, 2012). In Rothman, the Tax Court rejected the appraisal for the same reasons that it rejected the appraisal in Scheidelman. The Second Circuit’s reversal of the Scheidelman decision four days after the Rothman decision caused the Rothmans to move for reconsideration of the Tax Court’s analysis. On July 31, 2012, the Tax Court issued a revised opinion that narrowly applied the Second Circuit’s holding in Scheidelman, reversing only the two points that explicitly overlapped the two cases and declining to reverse any other point.
Conservation Easement Can Be Contemporaneous Written Acknowledgement
In Averyt v. Commissioner, the Tax Court determined that, under the specific facts, the conservation easement satisfied Code Sec. 170(f)(8) and qualified as a contemporaneous written acknowledgment. This is a rare occurrence. Averyt was a taxpayer victory but we haven’t heard from the IRS what they think about it so for the foreseeable future, everyone should still send a separate gift letter and not rely on satisfying this code requirement in any other way.
But Be Careful!
Nationally respected tax attorney and conservationist Steve Small says, “these three recent decisions are very important to the land trust community. They break what has mostly been an IRS winning streak in court, and that is important by itself. Scheidelman and Kaufman deliver a message to IRS that, among other things, the Service should stop relying on ‘technicalities’ to defeat easement gifts and start arguing about valuation. In addition, these two decisions, and Averyt, may, or may not, change IRS audit strategy, and it may be easier for taxpayers to settle cases rather than fighting all the way to Tax Court. But that still remains to be seen. And don’t rely on Averyt. As our button said at Rally a few years ago, ‘Send the damn gift letter.’ These may be good cases for easement donors, but there is no excuse for not following ALL the rules, to the letter. We know what the rules are; get it right!”
It remains to be seen how the IRS will deal with these Circuit Court of Appeals decisions that directly contradict the IRS approach to easement tax code compliance.