The United States Tax Court recently ruled against the Internal Revenue Service (IRS), representing a partial procedural victory for syndicated conservation easements, although the Court did not rule on the underlying merits of the taxpayer’s charitable deduction claims.
The background on syndicated conservation easements
The IRS has been fighting a long running battle against syndicated conservation easements. In late December of 2016, the IRS issued Notice 2017-10, identifying certain syndicated conservation easement transactions beginning January 1, 2010, as “listed transactions” for purposes of Treasury Regulation § 1.6011-4(b)(2).
Notice 2017-10 requires these transactions to be disclosed to the IRS on Form 8886 if, among other things, the amount of the charitable contribution is more than 2.5 times the amount invested in the syndicated easement. This reporting requirement and its accompanying penalties were the subject of this Tax Court ruling.
Taxpayers pursue conservation easements for several reasons. Primarily, conservation easements provide a way for taxpayers to protect and preserve their property while also providing a tax deduction. Some taxpayers use conservation easements as a sophisticated tool in estate planning to prevent burdensome estate taxes. In any event, conservation easements can be a win-win opportunity benefiting both the taxpayer and the environment.
Alternatively, while the IRS acknowledges the stated goals of conservation easements, the IRS views certain conservation easement transactions as abusive. According to the IRS, taxpayers, often encouraged by promoters and armed with questionable appraisals, take inappropriately large deductions for easements.
Further, according to the IRS, in some cases taxpayers claim deductions when they are not entitled to any deduction at all. Also, taxpayers have sometimes used or developed these properties in a manner inconsistent with section 501(c)(3). In other cases, the recipient charity has allowed property owners to modify the easement or develop the land in a manner inconsistent with the easement's restrictions.
What the Tax Court ruling means
This procedural victory does not mean the Tax Court ruled that all conservation easement transactions have merit. Instead, it means only that certain IRS penalties for disclosure were invalidated.
The Court made its ruling on the following specific facts. Prior to 2016, Green Valley Investors, LLC, Tick Creek, LLC, and Big Hill LLC each granted a conservation easement to Triangle Land Conservation (TLC). These LLCs filed their respective 2014 and 2015 Form 1065 Partnership tax returns claiming a charitable contribution for the conservation easement.
Soon after 2016, the IRS audited each of the LLCs Form 1065 Partnership returns and in 2019 the IRS issued a Final Partnership Administrate Adjustment (FPAA), disallowing claimed deductions for noncash charitable contributions. The IRS argued the LLCs did not meet all the requirements for claiming a charitable deduction, including failing to establish the values of the property interest contributed. The IRS also asserted a gross valuation misstatement penalty under section 6662(h), a substantial valuation misstatement penalty under section 6662(e), a negligence penalty under sections 6662(b)(1) and (c), and a substantial understatement penalty under sections 6662(b)(2) and (d). Importantly, the IRS also asserted the additional reportable transaction penalty under section 6662A because the LLCs failed to file Form 8886 disclosing the transaction.
The LLCs petitioned the Tax Court, seeking relief and challenging the IRS’s FPAA determination, asserting that 1) the IRS sought to improperly impose such penalties retroactively and, 2) the IRS failed to comply with the notice-and-comment rulemaking procedures of the Administrative Procedure Act (APA) when issuing Notice 2017-10.
The IRS argued that Notice 2017-10 was properly issued without notice-and-comment rulemaking and requested partial summary judgment, claiming Congress exempted the IRS from following the APA's normal procedures when it enacted section 6707A (relating to reportable transactions).
Ultimately, the Court ruled in favor of petitioners, holding 1) Notice 2017-10 was improperly issued by the IRS without notice and comment as required under the APA, and 2) Notice 2017-10 will be set aside by the Court, and Petitioner’s Cross-Motions for Summary Judgment will be granted in part by prohibiting the imposition of I.R.C. § 6662A penalties.
What happens next for conservation easements
As it stands, these LLCs have not prevailed on the merits, because the Tax Court’s decision only addresses the issue of the IRS not following APA requirements and only for the reportable transaction disclosure penalty.
The IRS can still assert all the other related penalties. Also, the IRS is likely to appeal, and will likely rerelease Notice 2017-10 under the notice and comment procedures.
This ruling may not even provide another similarly situated taxpayer support to withhold disclosures on their own returns. In fact, reasonable advisers may still conclude disclosure is the better answer to protect against penalties. Every potential investor or easement donor should seek independent analysis before engaging in a conservation easement transaction.
IRS Response to Ruling
On December 6, 2022, the Department of the Treasury, IRS issued proposed Regulation 106134-22, which seeks to turn the Notice 2017-10 disclosure requirements into a regulation. This is the IRS’s response to the Court’s ruling which has the potential to take the sting out of any benefit from the Court ruling on an ongoing basis.
It also requires all those participating in the same defined conservation easements in previous years to provide disclosures within 90 days of when the Regulation becomes final. The preambles to the ruling signal the IRS’s intent to dispute the ruling and the potential outcomes in complete disagreement with the ruling. Of course, this allows the notice and comment period through February 6, 2023, that the Court indicate was unjustifiably absent and seemingly corrects any potential adjustment.
Additionally, Senators Grassley and Wyden indicated they will seek a statutory response to the perceived abuses of syndicated Conservation Easements by proposing legislation (which they have proposed in other forms before). This proposed legislation would ride in the Improving Access to Retirement Act and would limit the amount of charitable deduction for an investment partner to 2.5 times what they originally invested. This essentially mirrors the disclosure threshold in Notice 2017-10 and would severely limit syndicated easements as they are currently constituted. Notably it carries significant bipartisan support but has not passed in previous iterations.
What does this court ruling mean for you?
Our team of tax advisors can help you understand how this, and other tax court rulings, will affect your tax planning efforts.