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Fifth Circuit Vacates Tax Court Holding Against Donors of Conservation Easements

(Parker Tax Publishing August 2017)

The Fifth Circuit held that a homesite adjustment provision relating to conservation easements donated by two partnerships to charity did not prevent the grants of the conservation easements from satisfying the perpetuity requirement of Code Sec. 170(h)(2)(C) and thus did not prevent the grantors of these easements from taking charitable deductions. The court also rejected the Tax Court's finding that the entirety of the limited partners' contributions were disguised sales, and remanded the case to correct the amount of any taxable income resulting from the disguised sale. Bosque Canyon Ranch, L.P. v. Comm'r, 2017 PTC 367 (5th Cir. 2017).


Bosque Canyon Ranch, L.P. (BCR I), a partnership, owned a tract of land in Bosque County, Texas, on which it spent $2.2 million on improvements. It then marketed limited partnership interest units in BCR I at $350,000 per unit. Each purchaser of a unit received a distribution of an undeveloped five-acre parcel of property and rights to build a house on the property. The distribution of the property was conditioned on BCR I granting the North American Land Trust (NALT), a Code Sec. 501(c)(3) organization, a conservation easement relating to 1,750 acres of the property. On December 29, 2005, BCR I granted an easement to NALT. Between October and December 2005, BCR I received signed subscription agreements and payments totaling $8.4 million from 24 purchasers of the limited partnership units.

In 2006, another related partnership, BCR II, engaged in transactions similar to those engaged in by BCR I. It received approximately $10 million in payments from the sale of land to 23 purchasers. In 2007, BCR II granted a conservation easement to NALT similar to the one granted by BCR I.

The 2005 and 2007 deeds granting the easements provided that portions of the area subject to the easements included the habitat of an endangered species of bird endemic to Texas. Property subject to the easement could not be used for residential, commercial, institutional, industrial, or agricultural purposes. In addition, the partnerships retained various rights relating to the property, including rights to raise livestock; hunt; fish; trap; cut down trees; and construct buildings and recreational facilities. Ultimately, NALT and the BCR partnerships assembled two binders of "baseline documents" detailing the conservation easements. The easements reserved narrow rights to the grantors that NALT and the BCR Partnerships agreed "could be conducted . . . without having an adverse effect on the protected Conservation Purpose." The easements could be amended only with NALT's consent and then only to modify the boundaries of the homesite parcels (i.e., homesite adjustment provision), but not to increase their areas above five acres. NALT monitors the conservation area and has repeatedly found it to be in good condition and in compliance with the terms of the easements.

On their tax returns for 2005 and 2007, BCR I and BCR II took charitable contribution deductions of $8.4 million and approximately $10 million, respectively, relating to the easement donations. The IRS challenged the deductions and assessed a 40 percent gross valuation misstatement penalty. According to the IRS, no deduction for the easements were allowed because the deeds conveying the easements violated the perpetuity requirement of Code Sec. 170(h)(2)(C). The IRS also found that the sale of the partnerships' interests were really disguised sales of property under Code Sec. 707(a)(2)(B) and Reg. Sec. 1.707-3(b)(1) and (c)(1).

The partnerships argued that the deeds did not violate the perpetuity requirement because any modifications to the boundaries of the land parcels were subject to the reasonable judgment of NALT, the exterior boundaries of the property subject to the easements could not be modified, and the overall amount of property subject to the easements could not be decreased.

Tax Court's Decision

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.

According to the Tax Court, because the homesite parcel boundaries could be changed to include property within the original easement, the easement was not granted in perpetuity. The court cited Belk v. Comm'r, 140 T.C. 1 (2013), aff'd, 2014 PTC 614 (4th Cir. 2014), for the proposition that an easement is not qualified real property if the boundaries of the property subject to the easement may be modified.

The Tax Court also found that the documentation necessary under Reg. Sec. 1.170A-14(g)(5)(i), establishing the condition of the property prior to the donation, did not satisfy the baseline requirements.

The Tax Court also concluded that the property transfers to the limited partners who purchased units in BCR I and BCR II were disguised sales for the following reasons: (1) 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; (2) the limited partners had legally enforceable rights to receive their land parcels and the appurtenant rights; (3) the transactions effectuated exchanges of the benefits and burdens of ownership relating to the land parcels; (4) the distributions to the partners were disproportionately large in relation to the limited partners' interests in partnership profits; and (5) the limited partners received their land parcels in fee simple without an obligation to return them to the partnerships.

Finally, the Tax Court sustained the imposition of the 40 percent penalty on the portion of tax underpayment attributable to the gross valuation misstatements resulting from the charitable deductions taken for the easement contributions.

Fifth Circuit's Decision

The Fifth Circuit rejected the Tax Court's conclusion that the homesite adjustment provision prevented the easements from satisfying the perpetuity requirement. The court said it was satisfied that any potential future tweaking of the boundaries of one or a few homesite locations could not conceivably detract from the conservation purposes for which the easements were granted, especially in light of the requirement for NALT's prior approval of any such change. The court found the Tax Court's reliance on Belk misplaced, noting that the easements at issue differed remarkedly from the easement in Belk. Among other distinctions, the court said, the easements at issue allow only the homesite parcels' boundaries to be changed and then only (1) within the tracts that are subject to the easements, and (2) without increasing the acreage of the homesite parcel in question. They do not allow any change in the exterior boundaries of the easements or in their acreages. Thus, the court observed, neither the exterior boundaries nor the total acreage of the easements at issue will ever change. Only the lot lines of one or more of the five-acre homesite parcels are potentially subject to change, the court noted, and then only (1) within the easements and (2) with NALT's consent.

According to the Fifth Circuit, unlike the easements at issue, the easement in Belk could be moved, lock, stock, and barrel, to a tract or tracts of land entirely different and remote from the property originally covered by that easement. The court in Belk reasoned that, because the donor of the easement could develop the same land that it had promised to protect, simply by lifting the easement and moving it elsewhere, it was not granted in perpetuity. The Belk court also reasoned that such parcel-swapping could undermine the "qualified appraisal of [the] property." The Fifth Circuit noted that these concerns were not present in the instant case and the easements at issue more closely resembled the conservation facade easements in Comm'r v. Simmons, 646 F.3d 6 (D.C. Cir. 2011), and Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012) than the easement in Belk. In those cases, the D.C. Circuit and First Circuit, respectively, ruled that conservation easements were perpetual even though the trusts could consent to the partial lifting of the restrictions to allow repairs and changes to the facades of buildings. Both circuits, the Fifth Circuit noted, held that, "clauses permitting consent and abandonment . . . have no discrete effect upon the perpetuity of easements . . . ." The Fifth Circuit found that, even though those cases addressed the perpetuity requirement in Code Sec. 170(h)(5)(A) rather than the one in Code Sec. 170(h)(2)(C), the common-sense reasoning that they espoused, i.e., that an easement may be modified to promote the underlying conservation interests, applied equally in the instant case.

With respect to the Tax Court's finding that the baseline documentation establishing the condition of the property prior to the donation was insufficient, the Fifth Circuit found that the Tax Court did not consider significant information contained in the record and found that these document were more than sufficient to establish the condition of the property prior to the donation. According to the Fifth Circuit, the Tax Court's disallowance of the contribution deduction based on the inadequacy of the "baseline documentation" was contrary to the purpose of the statute and, if left in place, would discourage and hinder future conservation easements.

The Fifth Circuit thus vacated the Tax Court's holding regarding the perpetuity of the easements and the baseline documentation, and remanded the case to that court to consider the other grounds asserted by the IRS to support the disqualification of the easements as charitable deductions but not addressed by the Tax Court.

The Fifth Circuit then addressed the Tax Court's conclusion that the BCR Partnerships' receipt of the limited partners' entire contributions, ranging from $350,000 to $550,000, were receipts from disguised sales. The court noted that the IRS's expert valued the homesite parcels at $16,500 and the local tax assessor valued them at $28,000. The partnerships contended that, even attributing the "appurtenant rights" to the homesite parcels, the fair market value of the parcels and such rights are nowhere near the entire amount that the limited partners contributed. The IRS countered that the unencumbered area of the ranch and the amount that the limited partners believed would be a pass-through tax deduction for the conservation easement should be included in the amount that was attributable to the disguised sale. The IRS claimed that $100,000 of the amount paid by each limited partner was attributable to the attempt to purchase a tax deduction. Combining these values with the value of the homesite parcels, the IRS concluded that the value of each disguised sale was approximately $336,500 per limited partner.

Noting that the term "appurtenant rights" apparently refers to the limited partners' rights in the common areas of the ranch, the Fifth Circuit said it could not imagine how the fair market value of such rights could equal the entire amount of limited partner contributions. According to the court, there is no ownership interest in the common areas: The limited partners' rights in those areas are only limited rights of use. Further, the court could not comprehend how including $100,000 relating to a tax deduction would be consistent with the Tax Court's determination that partnerships were not entitled to such a deduction. The court thus vacated the decision that the entirety of the limited partners' contributions were disguised sales, and remanded the case to correct the amount of any taxable income that results from the disguised sale.

Finally, as a result of the above holdings, the Fifth Circuit vacated and remanded to the Tax Court for it to determine whether the gross valuation misstatement penalty was applicable and if so, the proper amount of any penalty.

For a discussion of the requirements for taking a charitable deduction for a conservation easement donation, see Parker Tax ¶84,155.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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