On May 12, 2020, the Tax Court issued its Memorandum Opinion in Oakbrook Land Holdings, LLC v. Commissioner, T.C. Memo. 2020-54 (Oakbrook I) concurrently with a full Tax Court opinion in Oakbrook Land Holdings v. Commissioner, 154 T.C. No. 10 (Oakbrook II). The issue presented in Oakbrook I was whether Oakbrook’s conservation easement violated the “protected in perpetuity” requirement of IRC § 170(h)(5), as interpreted in Treas. Reg. § 1.170A-14(g)(6), because the donee’s share of the extinguishment proceeds (1) is based on a fixed historical value rather than a proportionate share, and (2) is reduced by the value of any improvements made by the donor. The separate but related issue in Oakbrook II was whether Treas. Reg. § 1.170A-14(g)(6) was a valid regulation under the Administrative Procedure Act (APA), 5 U.S.C. § 553 (2018) and under Chevron U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). You can find a copy of the Oakbrook II summary here.
No One Likes a Bully – Least of All My Judicial Idol, Judge Holmes
An opinion written by Judge Holmes will never be accused of being coy. If Judge Holmes, who would be my top draft pick in a Tax Court fantasy football league, thinks that the petitioner is playing a game of rummy with the Tax Court and is a few cards short of a full deck, the sage jurist will play a sarcastic trump card dripping with keen grandiloquence faster than the unwitting petitioner can say “Uno!” One need not look any further than his brilliant jurisprudential tour-de-force of sarcasm and wit contained in pithy opinion of Hommel v. Commissioner (T.C. Memo. 2020-4). I am not saying I read Judge Holmes opinions for pleasure, only that I get great pleasure when I do read them.
As you know, when a tax court petition is filed, the named defendant is not the IRS, or the boneheaded revenue and/or appeals agent, who so carelessly disregarded a taxpayer’s heartfelt plea for a collection alternative (even though said petitioner refused to submit a Form 433-A), and so when a Tax Court opinion refers to the “Commissioner” instead of the “IRS,” it is in almost all cases a formality, and everyone reading it substitutes the word for IRS (as I do throughout Briefly Taxing) and goes about their business. Not so in Judge Holmes’ opening salvo. When the dear jurist rages against the IRS’s “attacks” against the donation of conservation easements, he’s his waggling finger of disapproval is pointed in the cardinal direction of the figurehead, itself.
The preamble to the Oakbrook I decision describes the IRS’s “attacks” on a “popular form of charitable contribution,” the donation of a conservation easement. The opinion notes that while some strikes are precise, “surgical strikes on what [the IRS] believes are gross exaggerations of value,” the IRS has also launched “sorties…that he hopes will cause more widespread casualties.”
Needless to say, Judge Holmes does not approve of the IRS’s interjection of his own agenda into what would traditionally be the purview of Congress (to legislate) and the Courts (to adjudicate). The IRS, Judge Holmes tells us in no uncertain terms, is not legislator, judge, jury, or executioner – even though he may fancy himself as such. Simply put, Judge Holmes – and the Tax Court by extension – does not like bullies, and that is precisely the portrait of the IRS that the opening paragraphs of the opinion paint of the figurehead.
Judge Holmes picks his words carefully, as evidenced by the paronomasia that weaved its way through the Hommel opinion. Thus, when the opinion uses bellicose words like “attack” and “sortie” and “destroy” and “casualties” to describe the IRS’s (military) campaign against conservation easements and those taxpayers who would dare to use them (whether with good or malintent), it is clear that Judge Holmes wanted them to have the very effect that they do have. Bullies will not be tolerated. It’s a shot across the bow, and one that is echoed in the closing paragraphs of the opinion, too.
At the close of the opinion, the Tax Court strikes down the IRC § 6662 “negligence” or “substantial understatement” penalties. An honest misunderstanding of the law, one that is reasonable and made in good faith, will constitute reasonable cause and vitiate the application of such penalties. When the very agency that claims unreasonableness (the IRS) has upheld substantially similar language in a PLR, for example, a position is reasonable. See Bunney v. Commissioner, 114 T.C. 259, 267, n.10 (2000) (though not precedential, PLRs may be authorities showing reasonableness of return position).
Thus, when reasonable minds can differ as to the meaning of a Treasury Regulation, a position taken is not, ipso facto, unreasonable, simply because it turns out to be the wrong one. Judge Holmes notes that the very regulation in question in Oakbrook I has led to “disagreement among [the Tax Court judges] on whether the contested regulation is valid [and with regard to its meaning], and that might be some indication of the objective reasonableness of Oakbrook’s position.” Stated simply, if the freaking tax court judges cannot agree, how the hell can you penalize a taxpayer from taking an objectively reasonable position?
As always, Judge Holmes, you raise an excellent point. Though the IRS may have won the ultimate battle in Oakbrook I on the letter of the law (the denial of the deduction was sustained), it was a Pyrrhic victory. The IRS lost its penalty argument, and Judge Holmes issued a stern warning to the IRS that even though Oakbrook I “appears to be the first [case] in which the donor fights back” at the IRS’s aggressive tactics, the Tax Court will uphold the letter of the regulation, but this aggression will not stand, man. As the Dude once observed, “This isn’t ‘Nam, [Commissioner]; there are rules.”
White Oak Mountain sits fifteen minutes outside of Chattanooga, Tennessee, and in August 2007, 143 briar-covered acres were purchased by Duane Horton and other investors through an entity they formed called Oakbrook Land Holdings, LLC. Horton learned about conservation easements by happenstance, but intrigued, he met with the Southeast Regional Land Conservancy (SRLC), which held itself out as knowledgeable about conservation easements and willing for its lawyers to draw up the paperwork, should Oakbrook be in the market for an easement. Retaining 37 acres for development, Oakbrook donated the remaining 106 acres to SRLC in December 2008 through a document called “Conservation Easement and Declaration of Restrictions and Covenants” (Deed), which SRLC’s lawyers had drafted.
The Deed contained a provision that provided for the unlikely event that the easement was extinguished by judicial fiat. The “standard” industry language (according to the Tax Court, likely used in thousands of conservation easement deeds) provided in the event of extinguishment, the donee (SRLC) would be entitled to a share of the extinguishment proceeds (1) based on a fixed historical value rather than a proportionate share, and (2) reduced by the value of any improvements made by the donor and legal fees incurred as a result of the condemnation/extinguishment proceeding. Oakbrook secured a qualified appraisal in the amount of $9.55m, which amount it would later claim as a charitable deduction.
Oakbrook hired an accounting firm to prepare its 2008 Form 1065. Although the CPA professed familiarity with conservation easements and their requirements, Horton was skeptical (and under “intense scrutiny” from the investors), and he discussed the return position with the CPAs multiple times – which discussions are in the Tax Court’s record. Each time, the CPAs assured him that the Deed language was appropriate, and the deduction would not be challenged. Unfortunately, the CPA’s “assurance did not extend to the [IRS],” which timely issued a notice of final partnership administrative adjustment (FPAA) to Oakbrook regarding its Form 1065, completely disallowing the deduction and asserting the accuracy-related penalty under IRC § 6662 on the basis of negligence, disregard of regulations, or substantial understatement.
Conservation Easements, Generally
Conservation easements begin and end in one place – perpetuity. The Code requires a conservation easement to be “perpetual.” IRC § 170(h)(2)(C), IRC § 170(h)(5)(A). The issue with this requirement, as Judge Holmes so elegantly notes is that “perpetuity can be a very long time.” A lot can happen between now and forever, and the deed must provide for such contingencies.
With great foresight (sarcasm), regulations were drafted to deal with just such an occurrence. Specifically, Treas. Reg. § 1.170A-14(g)(6)(ii) was intended to regulate the division of compensation for this extinguishment between the donor and donee so that the donee could continue to pursue the easement’s conservation purpose elsewhere and into the future.
Although in 2016, the IRS concluded that conservation easements were potential “tax avoidance transactions” and subsequently listed syndicated (promoted) conservation easements as a “recognized abusive and listed transaction,” the Code permits them pursuant to IRC § 170(h) and its substantial regulations. Of particular importance for Oakbrook I is that the conservation easement must be “exclusively for conservation purposes,” which phrase the Code defines as a contribution for which the conservation purposes are protected in perpetuity. IRC § 170(h)(5)(A).
Luckily, the Treasury Regulations are a bit more precise. Specifically, a conservation purpose is not perpetual if the donee organization that holds the easement is unable to carry on the conservation purpose following judicial extinguishment. Treas. Reg. § 1.170A-14(g)(6)(i). There is, of course, and exception.
If there is an unexpected change, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding, and the easement deed ensures that the charitable donee, following sale of the property, will receive a proportionate share of the proceeds and use those proceeds consistently with the conservation purposes underlying the original gift. Id. The phrase “proportionate sale of proceeds” is later “defined” in Treas. Reg. § 1.170A-14(g)(6)(ii), but the regulation’s clarification has about as much practical effect as physically pointing Stevie Wonder towards the nearest Starbucks. Luckily, Oakbrook I was not the first conservation easement rodeo for the Tax Court.
The grantee’s proportionate share of proceeds upon extinguishment of a conservation easement is a percentage determined by a fraction, the numerator of which is “the fair market value of the conservation easement on the date of the gift,” and the denominator of which is “the fair market value of the property as a whole on the date of the gift.” Coal Property Holdings, LLC v. Commissioner, 153 T.C. 126, 137 (2019); Carroll v. Commissioner, 146 T.C. 196, 216 (2016).
This definition, which the court adopts in Oakbrook I is not uncontroversial, and Judge Holmes spends nine pages of the opinion justifying the Court’s interpretation of the regulation, eschewing the interpretations posited by both Oakbrook and the IRS, though ultimately finding that the IRS’s “interpretation” should prevail, as it is closer to the plain text of the regulation, proving that “close” doesn’t only matter in horseshoes and hand grenades, but sometimes, even, in regulatory interpretation.
Spirit of the Rule Cedes to Letter of the Law
The Tax Court notes that under many (if not most) scenarios of judicial extinguishment, Oakbrook’s interpretation of Treas. Reg. § 1.170A-14(g)(6)(ii) would put more money in the pocket of SRLC. Unfortunately, the Tax Court observes, the job of the court is not to decide whether Oakbrook’s interpretation is more in keeping with the spirit of the regulation, but to determine whether the language of the Deed “squares with the regulation.”
The regulation prohibits any scenario in which Oakbrook gets to recover compensation other than a proportionate share of the proceeds, with the proportion defined by the easement’s FMV over the FMV of the unencumbered and unimproved property. The “fixed value” in the Deed, however, makes it possible (albeit improbable) that this prohibition could be violated. Further, the Tax Court previously held in Kaufman v. Commissioner, 134 T.C. 182, 186 (2010), vacated in part, 687 F.3d 21 (1st Cir. 2012), that a donor must show “strict compliance” with the perpetuity requirement of the regulation and that “substantial compliance” is not enough to carry the day. Accord PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193, 207-08 (5th Cir. 2018).
Bright Line Rule
In order to satisfy the requirements of Treas. Reg. § 1.170A-14(g)(6), the donee must be entitled to any proceeds from extinguishment or condemnation that are at least equal to the total proceeds (unadjusted by the value of any of the donor’s improvements), multiplied by a fraction defined by the ratio of the FMV of the easement to the FMV of the unencumbered property determined as of the date of the grant of the conservation easement.
Original opinion: (T.C. Memo. 2020-54) Oakbrook Land Holdings, LLC v. CommissionerAdd to favorites