The Syndication of Conservation Easement Tax Deductions

When things seem too good to be true, they usually are...

Let’s say a man named John donates a conservation easement on his farm to a land trust. His appraiser valued the farm at $3 million before the easement and $2 million after the easement. Therefore, the easement is worth $1 million, which would be the amount of the tax deduction available for the donation. John doesn’t have sufficient income to use this deduction. He wants to sell the deduction to someone who can use it.

Federal tax law does not allow the donor of a conservation easement, or of any other property for that matter, to transfer the deduction generated by the donation to someone else. A federal tax deduction is personal to the donor. If the donor can use the deduction, fine; if not, it disappears. In other words, John can’t sell his deduction.

This is simple. However, some legitimate conservationists, and some not-so-legitimate tax shelter “facilitators,” are using limited liability companies and other so-called “pass-through” entities to try to “syndicate” tax deductions — in essence, to sell them — in ways that an individual, such as John, cannot accomplish. These deals are anything but “simple.”

This is not to say that all syndications are shams; but all syndications involving the allocation of tax deductions deserve close scrutiny. Syndications that do not comply with the extremely complex tax rules regarding the allocation of income, loss and deduction in a pass-through entity and/or involve inflated easement appraisals can undermine the viability of the tax benefits for conservation easements and the credibility of the voluntary land conservation effort. Furthermore, syndications can hurt landowners who are caught up in a promotion they do not fully understand. Note also that syndications may require compliance with securities law as well as tax law.

The focus of this article is on syndications that involve the allocation of tax deductions resulting from conservation easement donations. However, I am going to dramatically oversimplify the tax rules involved, which are some of the most complex that exist, so that those of you not steeped in partnership tax law can gain a basic understanding of what the issues are. I have included a resources box for those who want to delve deeper.

Simplified Example of a Syndication

Assume that instead of donating the conservation easement himself, John transfers his farm to a limited liability company (“John’s LLC”). Initially John is the only member. John sells four memberships to wealthy neighbors for $50,000 each. John and his neighbors agree (in an “operating agreement”) that the income and losses of John’s LLC will be allocated entirely to John and the tax deductions will be allocated entirely to the four neighbors. Upon liquidation, John will be entitled to 94% of the assets of the LLC after payment of all debts, and the neighbors will each be entitled to 1.5% of the assets. John also has the right to buy out his neighbors after three years for $3.

Thus, John gets the $200,000 paid into the LLC by the neighbors, and the neighbors each get $250,000 of the easement donation deduction. This saves each neighbor $99,000 in federal income taxes, a pretty good result for a $50,000 investment. John also gets to buy out his neighbors for a pittance and recover his ownership of the farm.

What has happened here? It is still simple: John has just sold a tax deduction that he can’t use to other taxpayers who can. The fact that he used a limited liability company to make the transfer doesn’t change what happened, or make it legitimate. It does change the applicable tax rules, however, because we are no longer dealing with an individual transferring a deduction, but the “allocation” of a deduction among members of a limited liability company.

Background

A limited liability company is a “pass-through entity.” This means income, losses, deductions, etc., resulting from the activities of the company are not taxed at the company level, but are “passed through” to the members of the company. This is also true for partnerships, limited partnerships and so-called “S” corporations. For purposes of this article, I will refer to “pass-through enti¬ties” as partnerships because they are all governed by the tax rules relating to partnerships.

As can be imagined, the opportunity to allocate income, loss and deductions among partners opens up many opportunities for creativity. The example of John and his neighbors is just one of many where taxpayers use a partnership to achieve goals that cannot be achieved by individuals, including transferring chari¬table deductions from partners who cannot use them to partners who can.

To avoid abuse of partnerships, Congress has enacted, and the Treasury Department has promulgated, some of the most complex tax laws and regulations in existence. The essence of these laws and regulations is that partnerships must be created and operated primarily to make a profit, not to generate tax benefits.

The basic tax principle applicable to the syndication of tax deductions is this: Tax deductions (as well as income, losses and other tax benefits, such as tax credits) must be allocated among partners in the same proportion as the partners’ interest in the partnership unless there is “substantial economic effect” for a different allocation. To distill over 12,000 words of regulation: “substantial economic effect” means “business purpose” (i.e., earning money) as opposed to “tax purpose” (i.e., reducing one’s tax liability).

The central legal issue for syndications is not whether a charitable donation has been made, but whether the resulting deduction has been properly allocated.

Partnership agreements (and the operating agreements of other pass-through entities) dictate how partnership income, loss and deductions will be allocated among the partners. In other words, the tax law allows the partners to allocate these items for themselves. However, if the allocation chosen by the partners lacks a “substantial economic effect,” the IRS may disregard the partners’ allocation and reallocate partnership income, loss and deductions based upon the partners’ “interest in the partnership.”

A partner’s interest in the partnership is a subjective concept, but basically considers a partner’s economic, as opposed to tax, interest. For example, the value of cash or property a partner contributed to the partnership, the amount of the partnership’s income and profit to which the partner is entitled and the amount a partner will receive in the event of liquidation of the partnership are all considered in determining a partner’s interest in a partnership.

Consequences for John and His Neighbors

In the case of John’s LLC, the allocation of income and loss to John and the allocation of all tax benefits to the neighbors lack a business purpose and are, instead, designed to help the neighbors avoid taxes. The members’ economic interest in the LLC is clearly at variance with the allocation of tax benefits. In the event of an audit, John’s LLC can expect the IRS to reallocate most of the tax benefits to John in accord with economic interests of the LLC in which John, considering all of the relevant factors, has at least a 94% interest. Each member’s $250,000 tax deduction will be reduced to $15,000, and his or her tax liability will be recalculated. The members will owe the additional tax, plus interest and a substantial penalty.

Disguised Sales

Syndications are sometimes used to attempt to “sell” otherwise unusable charitable deductions. Syndications are also used to attempt to avoid tax on the sale of tax credits generated by conservation easement donations.

Donations made to a partnership by partners are not treated as taxable events. In other words, when John transferred his $3 million farm to John’s LLC, no tax was due on the transfer. By the same token, when assets are distributed by a partnership to its partners, the distribution (so long as it is not partnership income) is not taxable.

Some states, such as Virginia and Colorado, grant tax credits (which are much more beneficial than deductions because they offer a dollar-for-dollar offset of tax liability) to easement donors. These credits may, depending on state law, be sold by the donor to other taxpayers (unlike deductions, which cannot be transferred). The Tax Court has ruled that such sales are taxable.

Easement donors sometimes attempt to use the favorable partnership tax rules described above to sell tax credits without paying tax on the sale. In these schemes, the easement donor “contributes” his tax credits to a partnership or other pass-through entity. Taxpayers who wish to acquire the credits pay cash into the partnership in amounts that represent the purchase price of the credits. Then the partnership allocates the credits to the purchasers and the cash to the donor. The partners argue that the transaction is not taxable. (Once again, this is a dramatic oversimplification.)

However, in several very recent Tax Court decisions these schemes have been recharacterized as “disguised sales” and taxed accordingly. In some schemes I have seen, landowners have sought to use pass-through entities to not only transfer deductions they cannot use to other taxpayers who can, but to sell tax credits without paying tax. The variations are infinite. The facilitators who sometimes create these schemes often claim six-figure fees for doing so.

No taxpayer contemplating involvement in the syndication of a conservation easement tax deduction should do so without the advice of a partnership tax expert and without the benefit of a formal tax opinion letter from that expert.

The Problem of Inflated Appraisals

A significant problem also associated with syndications is that facilitators may seek inflated easement appraisals to further leverage investments. I have recently seen a syndication suggesting that investors may expect deductions based on a value for the land involved that is 800% greater than what the syndication expects to pay for the land.

Appraisals of conservation easements are highly specialized and tax rules establish a number of criteria for the kind of appraisal (a “qualified appraisal”) necessary to substantiate a conservation easement donation deduction. While the appraisal is the donor’s responsibility, the land trust should advise the landowner (preferably in writing) to use an appraiser who meets the definition of “qualified appraiser” provided by the Treasury Regulations. Appraisals by others will not be accepted by the IRS and will lead to disallowance of a donor’s deduction.

The appraiser must strictly comply with all of the Treasury Regulations governing “qualified appraisals.”

Land Trust Standards and Practices asks land trusts to request to see the landowner’s appraisal of a conservation easement. Nowhere is that more important than in cases involving syndications. Appraisals that are substantially divergent from local real estate values bear a much higher burden of proof and are a potential warning sign for landowner and land trust alike.

What Should a Land Trust Do?

What responsibility do land trusts have for easement deduction syndications? As long as a land trust is not promoting a syndication, it has no legal responsibility for the syndication. Although very good conservation might result from syndications, still, land trusts must be concerned about participating in any potentially abusive or possibly fraudulent tax evasion scheme, and the land trust’s donors involved in such syndications may be highly at risk as well.

Should a land trust refuse to sign the appraisal summary required by the Regulations (Form 8283) if it believes the deduc¬tion will be syndicated? While the land trust’s signature on Form 8283 does not represent agreement with the claimed value, the IRS has asked that land trusts use common sense in questioning appraisals that seem inflated and that land trusts help landowners avoid substantially overstating the value of their donations. To avoid feeling the necessity to comment on the specifics of an appraisal, think about the appraisal review as a three-tier system:

• Is the appraisal generally in line with the expected value? If so, Form 8283 may be signed by the land trust without reservation.
• Is the appraisal aggressive in its conclusion of value? In other words, does the informed experience of land values in the land trust’s area suggest that the stated value is at the top of the range or over the top? The land trust might sign Form 8283, but the IRS would expect it to share its concerns regarding the appraisal in writing with the donor. Remember that the IRS may demand to see this writing.
• Is the value conclusion of the appraisal egregiously over the top range in light of the land trust’s knowledge of local land values; or does the land trust believe no gift was made (e.g., the easement was granted to satisfy a governmental regulation); or is the gift described in the appraisal different from the gift received; or does the land trust have some reasonable belief that the appraisal is inflated or even fraudulent? In such cases the land trust should refuse to sign Form 8283. However, it owes some duty to the donor to provide a written explanation for its refusal.

If a land trust plans to review donors’ appraisals and reserves the right, as it should, to refuse to sign Form 8283 in appropriate cases, the land trust should have a written policy governing its review that includes how it will communicate with the prospective donor about its review and responsibilities; what actions it will take when it receives an appraisal about which it has concerns; and what characteristics of an appraisal should cause concern. A land trust should disclose this policy, in writing, to prospective donors early in the donation process. The policy should clearly state that the land trust will not knowingly participate in the fraudulent substantiation of an easement tax deduction or participate in the improper syndication of tax benefits resulting from an easement donation.

The land trust should inform prospective donors in writing of the following: (i) that the land trust may refuse to accept a donation, or to sign a Form 8283, when it believes a donation has not been made, that the appraisal is fraudulent or that the deduction will be improperly syndicated; (ii) the importance of obtaining knowledgeable appraisal and tax advice prior to making a dona¬tion; (iii) the requirements that the donor must satisfy in order to successfully claim a deduction and (iv) the documents the land trust will require for review before signing Form 8283, or providing a written “goods and services” letter to the donor.

Land trusts are strongly advised to obtain the prospective donor’s written acknowledgment of receipt of this policy. Furthermore, land trusts should emphasize that they are not appraisers or in a position to give legal advice, and that their review of the donor’s appraisal cannot be relied upon as validation of the appraisal for tax purposes.

If a title report (which every land trust should obtain in advance of accepting an easement donation) reveals that the landowner is a pass-through entity, the land trust should generally inform (remember, a land trust cannot give legal advice) the representative of the landowner of the potential problems that can result from the allocation of tax benefits among members of the entity. When the land trust has reason to strongly suspect that an improper syndication is planned, it can refuse to accept the proposed donation. However, once a donation has been accepted, if it is a real donation, land trusts should seek the advice of knowledgeable legal counsel before refusing to sign a Form 8283 or refusing to provide the written acknowledgement of the contribution as required by the Regulations, and such refusals should be a last resort.

Conclusion

Although a land trust cannot give legal advice and it is not an appraiser, it does play a key role in public tax policy; policy that allocates millions of dollars of tax benefits to landowners annually and facilitates conservation. Although land trusts have no legal responsibility for appraisals or syndications, they have a public duty to minimize abuses of the tax policies that have so effectively led to the voluntary protection of millions of acres of land in the United States over the past several decades. Land trusts should use common sense and pay attention to the donations they help facilitate, be willing to refuse donations that are shams and tax shelters and question any deal that seems “too good to be true.”

More Information

Land Trust Standards and Practices on Appraisals

Practice 10B. Appraisals. The land trust informs potential land or easement donors (preferably in writing) of the following: IRC appraisal requirements for a qualified appraisal prepared by a qualified appraiser for gifts of property valued at more than $5,000, including information on the timing of the appraisal; that the donor is responsible for any determination of the value of the donation; that the donor should use a qualified appraiser who follows Uniform Standards of Professional Appraisal Practice; that the land trust will request a copy of the completed appraisal; and that the land trust will not knowingly participate in projects where it has significant concerns about the tax deduction.

See the book A Tax Guide to Conservation Easements by Tim Lindstrom.

Also see this webpage with more information.