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Many people are baffled about the status of conservation easement donations, which is logical given … [+]
Many people are baffled about the status of conservation easement donations, which is logical given all that has happened recently. Among other things, courts ruled that the IRS violated the law when calling certain things as “listed transactions,” the IRS tried to salvage the situation by issuing Proposed Regulations, and Congress drastically changed the rules by adding a new provision. Concepts overlapped, terminology morphed, and confusion resulted. This article aims to supply some clarity.
Invalidation of Notice 2017-10
The IRS announced in Notice 2017-10 that syndicated conservation easement transactions (“SCETs”) would be considered “listed transactions.” Several things occur when a transaction acquires this label. For instance, participants and material advisors must file disclosure statements with the IRS, assessment periods might be extended, and additional sanctions can apply. The IRS further declared in Notice 2017-10 that it intended to challenge SCETs on grounds that they constituted “tax-avoidance transactions” involving serious overvaluations. The IRS made good on its threat, implementing a multi-year compliance campaign that led to hundreds of cases backlogged in Tax Court. The IRS prevailed in several early cases on technical issues; that is, those related to supposed flaws with easement-related documentation, not valuation.
Not everything went the IRS’s way, though. For example, in Green Valley Investors, LLC v. Commissioner, the Tax Court ruled that the IRS failed to comply with the Administrative Procedures Act when it issued Notice 2017-10. It neglected to first issue a draft version, allow public input, and clearly explain its basis and purpose, as required. The Tax Court clarified that its decision went well beyond just the partnership in that particular case. It stated that it “intends to apply this decision setting aside Notice 2017-10 to the benefit of all similarly situated taxpayers who come before us.”
Proposed Regulations Affecting Disclosure Obligations
The IRS was not going to take that Tax Court defeat lying down. It quickly issued Proposed Regulations in late 2022 in an attempt to legally characterize SCETs as listed transactions. The Proposed Regulations feature a lot of the same information contained in Notice 2017-10 from years earlier, but it had a few new aspects, too.
First, the Proposed Regulations explicitly say that certain fee simple donations of real property (instead of donations of conservation easements on real property) are “substantially similar” to SCETs and subject to the same disclosure rules. The earlier Notice 2017-10 broadly stated that it covered SCETs and “substantially similar transactions,” but it did not specifically indicate that fee simple donations fell into the latter category.
Second, the Proposed Regulations introduce a clear threshold. They provide that if the promotional materials for a particular transaction indicate that the partners will be allocated a charitable tax deduction that is at least 2.5 times the size of their capital contribution to the partnership, the transaction generally will be an SCET (“2.5 Times Reporting Rule”).
Anticipating some “funny math” by taxpayers, the Proposed Regulations offer additional guidance about calculations when it comes to the 2.5 Times Reporting Rule. They state that when promotional materials suggest a possible range of tax deductions, the highest figure governs. Similarly, in situations where promotional materials contain multiple, inconsistent numbers, the IRS looks to the larger.
In instances where taxpayers claim that promotional materials are missing, lost, deleted, or never existed, the donation occurred within three years of when partners made their capital contributions, and partners claim a sufficiently large tax deduction, the Proposed Regulation creates a presumption that the partnership violated the 2.5 Times Reporting Rule.
Perhaps most interestingly, the Proposed Regulations introduce an abuse-avoidance concept (“Anti-Stuffing Rule”). It works like this. For purposes of determining whether the 2.5 Times Reporting Rule is triggered, a partner’s capital contribution is limited to the amount attributable to the portion of real property on which a conservation easement is donated. Put differently, if part of a partner’s investment in a partnership is directed to something other than the real property later conserved (e.g., other property that gets developed, cash, securities, etc.), then that part is not taken into account. The Anti-Stuffing Rule can be somewhat confusing, so the Proposed Regulations offer an example, which has been simplified here. A partnership owned both real property worth $500,000 and securities worth $500,000. Individual A is just one of four partners, each of whom made a capital contribution of $250,000. The promotional materials indicated that the partnership planned to allocate a charitable tax deduction of $500,000 to each of the four partners; that would be twice the amount invested. The partnership donated a conservation easement and claimed a $2 million tax deduction, after which it allocated $500,000 to each partner, including Individual A. Applying the Anti-Stuffing Rule, the amount of the capital contribution by Individual A that went toward the relevant real property was $125,000; that is, 50 percent of his total contribution of $250,000. The promotional materials indicated that Individual A would receive a tax deduction of $500,000. Because Individual A’s expected return (of $500,000) was four times the size of his capital contribution related to the property (of $125,000), the transaction surpasses the 2.5 Times Reporting Rule and becomes an SCET under the Proposed Regulations.
Third, the Proposed Regulations expand the notion of “promotional materials,” which is a big deal considering that the 2.5 Times Reporting Rule is based on what the promotional materials promise in the way of partner returns. They indicate that “promotional materials” broadly cover (i) tax analyses, tax opinions, and other written items “that are material to an understanding of the purported tax treatment or tax structure of the transaction that have been shown or provided to any person who acquired or may acquire an interest in the transaction, or to their representatives, tax advisors, or agents,” and (ii) any other written or oral communication provided to potential investors, such as marketing materials, appraisals (preliminary, draft or final), websites, deeds, private placement memoranda, operating agreements, subscription agreements, and statements about the anticipated value of the conservation easement or charitable deduction.
Fourth, the Proposed Regulations change course when it comes to treatment of organizations to which conservation easements are donated, such as land trusts. The Proposed Regulations start by confirming the IRS’s existing position, which is that promoters, appraisers, return preparers, and others who make “tax statements” regarding an SCET are considered “materials advisors.” This means, among other things, that they must file disclosure statements describing their roles, safeguard certain records, and comply with IRS requests for such records. Notice 2017-10 previously indicated that the IRS would not treat qualified organizations, like land trusts, as material advisors. The Proposed Regulations do an about-face, eliminating the exclusion.
New Law Affecting Tax Obligations
Just three weeks after the IRS issued the Proposed Regulations, Congress enacted a new easement-related law. Specifically, it introduced Section 170(h)(7), which generally states that a partnership will not be entitled to any tax deduction if the amount of the conservation easement donation exceeds 2.5 times the total basis of the partners in the partnership (“2.5 Times Disallowance Rule”). To clarify, the new law does not limit deductions; rather, it fully disallows them, resulting in $0, if they surpass the threshold.
If complete disallowance were not bad enough by itself, Congress also inserted a new penalty. The IRS may now impose a “gross valuation misstatement penalty” equal to 40 percent of the tax underpayment when a tax deduction is rejected pursuant to the 2.5 Times Disallowance Rule. Moreover, the law expressly states that taxpayers cannot raise a “reasonable cause” defense to the penalty, including reasonable reliance on qualified professionals.
Congress created three exceptions to the general 2.5 Times Disallowance Rule described above. First, historic preservation easements are not covered, as long as taxpayers satisfy special reporting duties. Second, the 2.5 Times Disallowance Rule is inapplicable where all, or substantially all, the interests in the relevant partnership are held, either directly or indirectly, by “an individual and members of the family of such individual.” Third, the 2.5 Times Disallowance Rule does not affect any donation that satisfies a complex three-year holding period.
Two additional issues, not specifically addressed by Congress, deserve comment. The 2.5 Times Disallowance Rule only applies to donations by “pass-through entities,” normally partnerships. It makes no mention of donations by individual taxpayers. Moreover, the 2.5 Times Disallowance Rule affects “qualified conservation contributions,” such as conservation easements. It does not indicate that other charitable actions, such as fee simple donations, face the same restrictions.
The 2.5 Times Disallowance Rule applies to donations made on December 29, 2022, or later. In other words, the new reality in the easement world generally starts in 2023.
Public Input
The IRS invited public comments to the Proposed Regulations, as it must. Many indulged the IRS, including organizers of SCETs, conservation alliances, attorneys, appraisal groups, land trust coalitions, individual land trusts, and taxpayer advocacy organizations. Did they all agree on what the IRS should do? No. There were differences of opinion, of course, but the suggestions can be organized into three main groups. First, commentators largely criticized the IRS for past enforcement gone awry and urged future actions focused on the bigger picture of land conservation. Second, others recommended that the IRS scrap things and start over because Congress passed new Section 170(h)(7) after the IRS issued the Proposed Regulations, the former renders parts of the latter invalid, and the two sources are inconsistent in several critical ways. Third, assuming the IRS refuses to start all over, the last group supplied a very, very long list of suggestions. The IRS has yet to react.
Certainty and Uncertainty
Desire by many taxpayers to protect the environment while simultaneously accessing a congressional tax incentive is fairly constant. Many other things are unpredictable, though. Will the IRS drastically change the Proposed Regulations before issuing them in final form? When will the IRS guidance take effect? How will the IRS and the courts interpret the new law, especially the three exceptions to the 2.5 Times Disallowance Rule, in the meantime? Taxpayers, practitioners, land trusts, and many others eagerly await answers to these open questions and more.
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