Tax Court Thoughtfully Reconsiders and Reverses Its Position on Validity of the “Proceeds Regulation”

In a reviewed opinion, Valley Park Ranch,[1] the Tax Court thoughtfully reconsidered its position on the validity of the so-called “proceeds regulation”, Treas. Reg. § 1.170A-14(g)(6)(ii), and found the regulation to be invalid because the IRS finalized it without considering a “relevant and significant” public comment, in violation of the Administrative Procedure Act (APA). The opinion shuts down a technical argument that the IRS has utilized to disallow deductions for conservation easement donations.

Background

In 1980, Congress extended on a permanent basis the charitable contribution deduction for qualified conservation contributions and codified it in section 170(h). Such contributions include the donation of a restriction (granted in perpetuity) on the use which may be made of real property that is exclusively for conservation purposes. A contribution is not treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.

In 1983, the IRS issued proposed regulations relating to section 170(h). Unsurprisingly, the IRS proposed lengthy and complicated rules for the seemingly straightforward perpetuity requirements of the statute. Among the proposed rules was the proceeds regulation, which provided that no deduction would be allowed unless the conservation easement deed contained language vesting the donee organization with a property right that remained constant over time and entitled the donee organization to a proportionate share of the proceeds upon judicial extinguishment of the easement.

The IRS received many comments on the proposed rules, including several directed to the proceeds regulation. Notably, the New York Landmarks Conservancy (NYLC) urged the IRS to delete the proceeds regulation because it would thwart the purpose of the statute by deterring prospective donors. The NYLC observed that the fixed-value formula in the regulation failed to take into account that the owner may make post-donation improvements to the property, in which case the formula would provide a windfall to the donee organization upon extinguishment.

The IRS adopted the regulations in 1986 without the revisions urged by the NYLC. The preamble to the final rulemaking stated that all comments had been considered, but the “Summary of Comments” section did not discuss or respond to the comments by the NYLC and others concerning the proceeds regulation. The donation of conservation easements took off in the subsequent decades, and IRS enforcement eventually followed.

Easements typically eliminate nearly all of the development rights of the burdened land, but the IRS has routinely disallowed the associated deductions on various technical grounds, including that the conservation purpose of the easement was not protected in perpetuity where the extinguishment clause of the easement deed accounted for post-donation improvements. Even though issues of extinguishment have not proven to be a practical concern, the IRS has wielded the proceeds regulation like a machete through a rain forest, eliminating deductions taxpayers claimed for their very real donations.

The IRS’s use of the proceeds regulation met with initial success in Tax Court—after all, the regulation states that it must be satisfied “for a deduction to be allowed under [section 170].” Consequently, taxpayers began to argue that the regulation is invalid because the IRS violated the APA by failing to respond to the public comments on the proceeds regulation. In Oakbrook Land Holdings, LLC v. Comm’r, 154 T.C. 180 (2020), a majority of the Tax Court upheld validity of the proceeds regulation under the APA, and the Court applied that ruling in other cases including Hewitt v. Comm’r, T.C. Memo. 2020-89.

A unanimous panel of the U.S. Court of Appeals for the Eleventh Circuit reversed the Tax Court in Hewitt, 21 F.4th 1336 (11th Cir. 2021), and found the proceeds regulation invalid under the APA. In contrast, a divided panel of the U.S. Court of Appeals for the Sixth Circuit affirmed the Tax Court in Oakbrook Land Holdings, 28 F.4th 700 (6th Cir. 2022). The taxpayers in Oakbrook sought Supreme Court review of the Sixth Circuit’s majority opinion, which the Solicitor General opposed because Oakbrook “would be a poor vehicle in which to address the question because the statue itself compels disallowance of petitioners’ deduction, rendering the validity of the challenged regulation academic.”[1] at 8-9. The Supreme Court denied certiorari.

Valley Park Ranch

In Valley Park Ranch, the Tax Court had an opportunity to reconsider the validity of the proceeds regulation in light of the Hewitt and Oakbrook appeals. Because the petitioner-LLC was organized in Oklahoma, the case is appealable to the Tenth Circuit, and the Tax Court is not bound to follow the appellate decisions in either Hewitt or Oakbrook. Upon thoughtful reconsideration, a majority of the Court reversed course and found the proceeds regulation to be procedurally invalid under the APA.[1].The Court found that the NYLC’s comments on the proceeds regulation challenged a fundamental premise underlying the proposed rule and required a response from the IRS to satisfy the APA’s procedural requirements. Responding to the Eleventh Circuit’s rejection of its rationale in Oakbrook that the “broad statements of purpose contained in the preambles to the final and proposed regulations, coupled with obvious inferences drawn from the regulations themselves, were more than adequate”, the Tax Court was persuaded and agreed that inference and the IRS’s conclusory statements did not suffice to explain its decision.[1] at 22.

Having found the proceeds regulation to be invalid, the Court proceeded to consider whether the easement deed satisfied the statutory requirements that a restriction be granted in perpetuity and that the conservation purpose be protected in perpetuity. The Court interpreted the term “in perpetuity” as it has traditionally been used and understood in common law practice to mean that nothing in the grant envisions a reversion of the easement interest to the landowner, its heirs or assigns. Finding that the easement deed under consideration envisioned no such reversion, the Court found that the contribution satisfied the perpetuity requirements of section 170(h)(2)(C) and (h)(5).[1] at 22-29.

Implications in the Conservation Easement Space

The Valley Park Ranch decision has substantial implications for taxpayers involved in conservation easement disputes with the IRS outside the Sixth Circuit. The Court will no longer consider IRS challenges to the deduction based on the proceeds regulation and instead will evaluate the deed based on the perpetuity requirements in the statute—a test that the vast majority of easement deeds will pass.

The IRS will likely keep coming up with technical arguments and presenting them as threshold issues, while only arguing the core issue of valuation as a last resort. But that approach is obviously straining the Tax Court. In a concurring opinion, Judge Buch recounted the vast amount of summary judgment litigation that has occurred in conservation easement cases, and indicated that such practice has not fulfilled the purpose of summary judgment to expedite litigation.[1] at 31-32. And indeed, in many of the 750 conservation easement cases on the Court’s docket, the assigned judge has had to decide multiple motions for partial summary judgment before conducting a trial on value and other undecided issues.

Perhaps the IRS will follow the Tax Court’s example, listen to the points expressed in Judge Buch’s concurring opinion, and change course. Doing so would significantly lessen the burden on taxpayers and the Court, perhaps allowing a ray of light through from the end of the tunnel.

Broader Implications

The IRS has been repeatedly reminded of its obligation to follow the APA since the Supreme Court clarified that, yes, the APA applies to the IRS just like any other federal agency.[2] In Valley Park Ranch, the Tax Court pointed out that deference is accorded to administrative agency rules if the agency followed the APA. And the Court showed it will carefully evaluate the IRS’s compliance with the APA, including whether the IRS provided a meaningful response to significant public comments.

Going forward, the IRS could use taxpayer comments as the resource that they are and engage in a more collaborative rulemaking process. Or, the IRS could continue to claim that what it’s doing is working—when it is working for neither taxpayers nor the IRS. Unfortunately, the IRS seems unlikely to change course, as demonstrated by its policy that, in administrative appeals, it will not even consider the possibility that it might lose on the grounds that a rule or regulation is invalid under the APA.[3] But, Valley Park Ranch is yet another sign that the IRS has hazards of litigation, like it or not, where compliance with the APA was absent or superficial.

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