March 14, 2018

Environmental Law Update

Environmental Law Update provides information on developments in environmental law as they apply to property, trust, and estate matters. The editors of Probate & Property welcome information and suggestions from readers.

Fifth Circuit Vacates Tax Court Ruling on Conservation Easement Deductions

On August 11, 2017, the Court of Appeals for the Fifth Circuit issued its opinion in BC Ranch II, L.P. v. Commissioner, 867 F.3d 547 (5th Cir. 2017). The court vacated and remanded the Tax Court’s ruling that disallowed charitable tax deductions related to two conservation easements created in connection with the residential development of a 3,744-acre tract of land, known as Bosque Canyon Ranch.

The developers donated conservation easements to the North American Land Trust (NALT). NALT determined that the conservation easements would protect the nesting habitat of the gold-cheeked warbler, a listed endangered species, among other conservation values. The conservation easements granted NALT perpetual easements in gross over the conservation areas and prohibited most residential, commercial, industrial, and agricultural uses, reserving “limited” uses to the grantors.

The developers marketed the ranch property for building 47 homes in two phases. The ranch property was divided into five-acre homesites (totaling 235 acres) within two larger conservation tracts preserving the balance of the property for conservation purposes.

The development was effectuated through offering interests in one of two limited partnerships (LPs). Investors in the limited partnerships, after making a capital contribution and executing a subscription agreement, became limited partners in one of the two LPs. If the partnerships elected to grant a conservation easement on the property, they would “at a later date” convey fee simple title to one of the homesites. Limited partners also were promised a membership interest in an association that would own the balance of the conservation property not conveyed as a homesite.

The LPs filed their partnership tax returns showing a charitable deduction of $8.5 million and $7.5 million, respectively, for the value of the conservation easements. These amounts were divided among the limited partners according to their capital contributions. The IRS disallowed the charitable deductions and subjected the LPs to gross valuation misstatement penalties.

The LPs petitioned the Tax Court for readjustment. The Tax Court disallowed the charitable deductions, holding that (1) the conservation easements failed to qualify as deductible charitable contributions because they were not given in perpetuity, (2) the sales of the limited partnership interests were actually disguised sales of partnership property, and (3) the gross valuation misstatement penalty was applicable.

Regarding the issue of whether the conservation easements were granted in perpetuity, the Tax Court relied on Belk v. Commissioner, 140 T.C. 1 (2013), aff’d, 774 F.3d 221 (4th Cir. 2014), in determining that the conservation easements were not qualified for a federal tax deduction because the boundaries of the easement area could be amended. In this case, the boundaries of the homesites could be amended—but not enlarged—by agreement from NALT. The Fifth Circuit disagreed, distinguishing Belk because the homesite parcel boundaries remained within tracts subject to the easements and could not be enlarged. The Fifth Circuit determined that, unlike in Belk, the exterior boundaries of the easement areas and the total acreage of preserved land would never change under the conservation easements with NALT, and then only on agreement by the land trust. Importantly, the court recognized that the easements conferred to the land trust “virtually unrestricted discretion” to withhold consent to changing homesite boundaries. The court also reviewed the conservation easement plan for the ranch, noting that the homesites are tightly clustered in an area adjacent to public roads, in a typical subdivision layout with most lot lines being contiguous to other homesites. On these factors, the court concluded that the homesite adjustment provisions of the conservation easements did not prevent them from satisfying the perpetuity requirement of the Internal Revenue Code.

The court also reviewed the requirement that a conservation donor provide documentation demonstrating the condition of the property at the time of the donation (the so-called “baseline documentation” requirement of the Internal Revenue Code and regulations). Finding that the totality of baseline documentation information developed by the donors was ample to establish the condition of the donated easement properties, the court rejected the Tax Court’s determination that the information was untimely and partially inaccurate. The Fifth Circuit found that the Tax Court ignored several documents included in the record in making this determination and that, taken together, the record demonstrated sufficient “baseline documentation” to meet this requirement.

The IRS had asserted other grounds to disqualify the easements as charitable contributions, but those grounds were not addressed by the Tax Court. In vacating the Tax Court’s conclusions regarding the perpetuity and baseline documentation requirements, the Fifth Circuit remanded the case to the Tax Court to address the other grounds asserted by IRS to disqualify the easements.

Disguised Sales

The Tax Court determined that the property transfers from the LPs to the limited partners were disguised sales subject to taxation. The Tax Court found that the transactions were disguised sales because “the timing and amount of the distributions to the limited partners were determinable with reasonable certainty at the time the partnerships accepted the limited partners’ payments,” the limited partners had legally enforceable rights to receive their homesite parcels, the transactions amounted to an exchange of real property, the distributions were disproportionately large in relation to the interests in the partnership profits, and the limited partners received their homesite parcels in fee simple without an obligation to return them to the partnerships. The Tax Court concluded that the LPs’ receipt of the limited partners’ entire contributions were receipts from disguised sales.

The appellants did not challenge the disguised sales determination of the Tax Court as related to the homesite lots; rather, the appellants argued that the fair market value of the homesites and attendant rights of membership in the association holding the conservation easement tracts are less than the entirety of their contributions. The Fifth Circuit ultimately found a lack of record evidence to establish a specific dollar amount for a disguised sale and remanded the case to the Tax Court to determine the correct amount of taxable income resulting from the disguised sales.

Gross Valuation Misstatement

Because the Fifth Circuit remanded much of the case to the Tax Court and because the Tax Court had not made a finding of the valuation of the easements, the circuit court directed the Tax Court to determine whether the gross valuation misstatement penalty is applicable and the proper amount of any such penalty.

On remand, if the Tax Court determines that partnerships are entitled to at least some charitable deduction, the Tax Court likely will compare valuations prepared by the appellants’ and the IRS’s respective appraisers to determine whether the values of the easements were grossly misstated and subject to penalty.