During the period of this update (Nov. 1, 2021, through Oct. 31, 2022), the IRS issued guidance for taxpayers regarding changes made to Subchapter K over the past few years. Also, the Service issued guidance related to foreign partners. In addition, the courts and the IRS issued various rulings that addressed partnership operations and allocations.

Disallowed deductions

Many disputes arose about deductions, with conservation easements generating a large amount of litigation.

Conservation easements

The IRS has been auditing a number of tax returns for partnerships that took a deduction for a conservation easement through a tax shelter. In many of the cases, the IRS has disallowed the deduction because it believed either the contribution did not meet the “protected in perpetuity” requirement or that the property contributed was overvalued. To deter this type of transaction, Congress as of this writing has included a provision in the proposed Enhancing American Retirement Now (EARN) Act that would limit the deduction if the amount exceeds 2.5% times the sum of each partner’s basis in the partnership.

As described below, numerous recent court cases have dealt with the contribution of conservation easements. In most of the cases, the disputed issue is related to the facts of the case; however, some taxpayers have contested the validity of the law, as in Oakbrook Land Holdings LLC.

As background to the decision, taxpayers are allowed a charitable contribution deduction under Sec. 170(h) if they donate an easement in the land to a conservation organization. However, the easement’s conservation purpose must be guaranteed to extend in perpetuity to qualify. Treasury issued Regs. Sec. 1.170A-14(g)(6) to address the situation in which unforeseen changes to the surrounding land make it “impossible or impractical” for an easement to fulfill its conservation purpose. In this event, the conservation purpose may still be protected in perpetuity “if the restrictions are extinguished by judicial proceeding and all of the donee’s proceeds . . . from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.” Proceeds are calculated by a formula included in Regs. Sec. 1.170A-14(g)(6)(ii). This is called the proceeds regulation.

In Oakbrook Land Holdings, the LLC challenged the validity of the proceeds regulation. The taxpayer contended that, in developing this rule, Treasury violated the notice-and-comment requirements of the Administrative Procedure Act (APA). The taxpayer also argued that Treasury’s interpretation of Sec. 170 was unreasonable and that the proceeds regulation is arbitrary or capricious. The full Tax Court considered these arguments and found in favor of the IRS. In 2022, the taxpayers appealed the case. An appellate court reviewed the case and agreed with the Tax Court, thus affirming the validity of the regulation.

In another case, the taxpayer took a charitable contribution deduction for a conservation easement. The IRS issued the taxpayer an FPAA disallowing this deduction. In this case, the Tax Court examined two issues: (1) whether the easement deed failed to protect the conservation purpose in perpetuity, and (2) whether the taxpayer’s appraisal and documentation failed to meet the substantiation requirements of Sec. 170(h)(4)(B)(iii). The IRS based its argument on an earlier case that found that language in the deed that defined the numerator of the apportionment fraction violated the regulation. However, in this case, the court determined that language in the deed was used differently and that the formula used was consistent with the regulation. The court also found that the question of whether the taxpayer provided appropriate documentation for the appraisal would have to be determined at trial since, even though the taxpayer did not literally comply with the substantiation requirement, there were questions that could not be resolved in a summary judgment.

In a related case, the IRS again disallowed the charitable contribution deduction claimed for a conservation easement. Here, the easement deed did not explicitly address judicial extinguishment; rather, it only expressed the parties’ intent that no change in conditions would at any time or in any event result in the easement’s extinguishment and that if circumstances arose that justified a modification of the restrictions, the parties would agree to an appropriate amendment but that in no event would the amendment violate Sec. 170(h). The court found that the partnership had a reasonable argument that the deed did not violate the regulation or statute, even though it did refer to a possibility of eminent domain. The court determined the language was ambiguous and allowed the deduction.

In another case, a partnership granted a qualified organization a façade easement on a building that was a certified historic structure, for which the partnership took a charitable contribution deduction. The building in question was subject to five deeds of trust securing loans made to the partnership. The terms of the loans made the lenders beneficiaries of the deeds of trust on the building. The deeds of trust required the lenders in some circumstances to allow insurance proceeds arising from damage to the building or the proceeds from its condemnation to be used to repair or restore the building. In other circumstances, the lenders could apply the proceeds to satisfy the indebtedness secured by the deeds of trust. The easement deed provided that, in the event of casualty or condemnation, the partnership, the lenders, and the qualified organization were entitled to share any net proceeds remaining after the satisfaction of prior claims.

The IRS denied the deduction because the easement did not meet the requirements of Sec. 170. The IRS said that the easement failed because the mortgages were not subordinated. In this case, the deeds of trust provided lenders with priority rights to use insurance or condemnation proceeds in specified circumstances to satisfy underlying indebtedness, and the lenders did not subordinate their rights to the qualified organization’s right to enforce in perpetuity the easement’s conservation purposes. Thus, the easement did not qualify as having been made exclusively for conservation purposes and, as a result, was not a qualified conservation contribution under Sec. 170(h). In this situation, the court agreed with the IRS.

In Glade Creek Partners, LLC,the partnership donated a conservation easement for which it took a charitable contribution deduction.When it executed the deed of easement, the LLC included a provision addressing what would happen if it became impossible to use the property for conservation purposes. The deed provided that, in that situation, a court could terminate or extinguish the easement, and the qualified organization that received the easement would be entitled to a portion of the proceeds from any subsequent sale or exchange of the property. The amount the organization received in this case would be calculated using the easement’s FMV at the time of the sale less any increase in value that was attributable to improvements made after the easement was granted. The amount attributed to improvements would go back to the LLC.

The IRS disallowed the charitable contribution deduction because of the way the conservation easement deed handled the possibility of any future extinguishment proceeds. The Tax Court concluded that the LLC had not properly taken the charitable contribution deduction because the easement deed violated Regs. Sec. 1.170A-14(g)(6) and, as such, failed Sec. 170’s in-perpetuity requirement. The LLC appealed the decision to the Eleventh Circuit.

In 2022, the Eleventh Circuit vacated and remanded the case for reconsideration, guided by its own recent decision in Hewitt,where the court had invalidated the regulation in question by determining that the IRS’s interpretation of the regulation was arbitrary and capricious and violated the APA’s procedural requirement. However, taxpayers should be aware that cases brought in other circuits may or may not follow Hewitt.

In another situation, two taxpayers formed a partnership that donated a conservation easement to a qualified organization. The conservation deed, however, retained various rights for the donors. The partnership reported a charitable contribution for the easement, and the taxpayers deducted their share of the charitable contribution on their personal tax returns. The IRS audited the individual tax returns and disallowed the charitable deductions. As part of the investigation, the IRS mailed each partner a letter and the revenue agent’s report proposing penalties under Sec. 6662 related to the underpayment of tax. Ten days after mailing the letter, the auditor sent the case to his immediate supervisor, who approved the penalties in writing. Eventually, the IRS issued the taxpayers statutory notices of deficiency that described the proposed tax changes and penalties resulting from the audit. Each partner timely petitioned the Tax Court for pre-assessment review of his deficiency.

The Tax Court held that the taxpayers’ arguments failed on the merits because their retained rights under the conservation deed rendered the easement in violation of the granted-in-perpetuity requirement under Sec. 170(h)(2)(C). But it also disallowed the IRS’s asserted Sec. 6662 penalties, holding that the letters and examination reports constituted “initial determinations of assessment” under Sec. 6751(b). Because the IRS had mailed the letters without first obtaining supervisory approval of the penalties, the Tax Court held that the government could never assess those penalties. Both the taxpayers and the IRS appealed the decision.

The Eleventh Circuitreversed the Tax Court’s decision that the taxpayers were not entitled to a charitable contribution deduction for a conservation easement donation, because of the appellate court’s 2020 decision in Pine Mountain Preserve, LLLP. However, the case was remanded to the Tax Court for consideration of whether the protected–in–perpetuity requirement under Sec. 170(h)(5)(A) was met, as this issue had not been addressed in Pine Mountain Preserve, LLLP. The appellate court also reversed the Tax Court’s decision that the accuracy-related penalties could not be upheld against the taxpayers because the IRS did not meet the Sec. 6751(b) written supervisory approval requirement. The appellate court followed Kroner, which found that the Tax Court erred in determining in that case that the penalties’ approval was untimely.

Lastly, in another case, the IRS disallowed a charitable contribution deduction claimed for a conservation easement made by an LLCbecause the easement’s conservation purpose was not protected in perpetuity. The IRS argued that the contribution did not meet this requirement because the deed had a “deemed consent” provision that stripped the donee of its perpetual right to prevent uses of property that were not consistent with conservation purposes. The IRS asked the court for summary judgment on this issue but was denied because the argument raised material-fact issues that were not suitable for summary judgment.

Tax shelter promoters and others: The IRS is still conducting audits of taxpayers that took a charitable contribution for a conservation easement, but now the government is also looking at the promoters of the tax shelters. In 2022, the government charged seven individuals with conspiracy to defraud the United States arising out of their promotion of fraudulent tax shelters involving syndicated conservation easements. The indictment charged that the syndicated conservation easement transactions were abusive tax shelters lacking in economic substance or a business purpose.

In another situation, a marketer of a syndicated conservation easement scheme pleaded guilty to filing a false tax return that claimed a fraudulent charitable contribution of a conservation easement. The individual, a CPA, and attorney, admitted that he knew the tax shelter did not entitle him to a tax deduction; however, he claimed the false charitable deduction on his personal tax return for the years in question.

In Equity Investments Associates, LLC, the IRS was auditing an LLC related to a charitable contribution deduction for a conservation easement the IRS deemed to be overvalued.At the same time, there was a criminal investigation of the owners and managers of the LLC related to the tax shelter that provided the deduction. As part of its audit, the IRS issued a summons for information, which the LLC ignored. The LLC sought to quash the summons because the IRS is barred from issuing a summons with respect to any person if a Justice Department criminal referral is in effect. In this case, the LLC argued, the existing criminal referral for its sole agent should be treated as a referral for the LLC as well. The court denied the taxpayer’s request and allowed the IRS to enforce the summons. After the initial court ruling, the LLC’s sole agent was indicted, and the LLC appealed the original ruling. The appeals court upheld the trial court’s decision because it determined that a business entity is a distinct person from its agents. Since the LLC itself did not have a criminal referral in effect, the LLC was required to comply with the IRS summons.

In a related case, a group of appraisers filed a suit against the IRS, seeking to challenge the IRS’s increased scrutiny of syndicated conservation easement transactions as tax schemes. Unfortunately for the appraisers, the court dismissed their case because the summons was not served in a timely manner. It should be interesting to see if other parties attempt to sue the IRS on this matter in the future. It appears that the charitable contribution deduction of conservation easements will be an issue that taxpayers and the IRS will be litigating for the foreseeable future.

However, in late 2022, the Tax Court held that Notice 2017-10, which is the notice that identifies syndicated conservation easement transactions as listed transactions, is invalid because the IRS issued it without following the notice-and-comment procedures required by the Administrative Procedure Act. In response, the IRS issued proposed regulations in December identifying certain syndicated conservation easement transactions as listed transactions.