A taxpayer’s attempted donation of a conservation easement that qualified for a deduction under IRC §170(h) was found not to meet the requirement that the easement was “protected in perpetuity” in the case of Railroad Holdings, LLC v. Commissioner, TC Memo 2020-22.[1]  The problem arose from a clause that detailed what would happen if the easement were extinguished due to judicial proceedings.

IRC §170(h) provides a charitable contribution deduction for contributions of conservation easements that meet certain requirements.  One of these, found at IRC §170(h)(5)(A), is that the conservation purpose must be protected in perpetuity.

Sometimes circumstances arise when property is subject to a forced judicial sale.  Reg. §1.170A-14(g)(6)(ii) provides that the transfer must be made with the following agreement to deal with such a possible event in the future:

In case of a donation made after February 13, 1986, for a deduction to be allowed under this section, at the time of the gift the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time. See section 1.170A-14(h)(3)(iii) relating to the allocation of basis. For purposes of this paragraph (g)(6)(ii), that proportionate value of the donee’s property rights shall remain constant. Accordingly, when a change in conditions give rise to the extinguishment of a perpetual conservation restriction under paragraph (g)(6)(i) of this section, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction.[2]

Thus, if the easement is found to be equal to 10% of the value of the property at the date of the donation, the charity must receive 10% of the proceeds of any future judicial sale in the future that extinguishes this interest.

In this case, the agreement provided the following to deal with such a forced sale:

(2) This Conservation Easement gives rise to a real property right and interest immediately vested in SERLC. For purposes of this Conservation Easement, the fair market value of SERLC’s right and interest (which value shall remain constant) shall be equal to the difference between (a) the fair market value of the Conservation Area as if not burdened by this Conservation Easement and (b) the fair market value of the Conservation Area burdened by this Conservation Easement, as such values are determined as of the date of this Conservation Easement. If a change in conditions makes impossible or impractical any continued protection of the Conservation Area for conservation purposes, the restrictions contained herein may only be extinguished by judicial proceeding. Upon such proceeding, SERLC, upon a subsequent sale, exchange or involuntary conversion of the Conservation Area, shall be entitled to a portion of the proceeds at least equal to the fair market value of the Conservation Easement as provided above. SERLC shall use its share of the proceeds in a manner consistent with the conservation purposes set forth in the Recitals herein.

(3) Whenever all or part of the Conservation Area is taken in exercise of eminent domain by public, corporate, or other authority so as to abrogate the restrictions imposed by this Conservation Easement, Owner and SERLC shall join in appropriate actions at the time of such taking to recover the full value of the taking and all incidental or direct damages resulting from the taking, which proceeds shall be divided in accordance with the proportionate value of SERLC’s and Owner’s interests as specified above. All expenses, including attorneys’ fees, incurred by Owner and SERLC in such action shall be paid out of the recovered proceeds to the extent not paid by the condemning authority.[3]

The IRS argues that the clause effectively holds the charity’s payment constant, equal to the value on the date of the contribution, rather than giving the charity the percentage of the eventual proceeds.  For example, if the property in total was worth $160 million at the time of the contribution and the easement was worth $16 million (10% of the value), if the property is subject to a forced sale when the property is worth $300 million, the charity would end up only with $16 million under this formula, far less than 10% of the value of the property.

The Tax Court agreed with the IRS that the agreement does not meet the requirements of the regulations, noting:

Though the deed incorporates from the regulation the phrase “proportionate value”, the deed does not create a proportion or fraction that represents the donee’s share of the property right, and hence a corresponding fraction of proceeds to which the donee is perpetually entitled. See PBBM-Rose Hill, Ltd. v. Commissioner, 900 F.3d 193, 205-206 (5th Cir. 2018). Rather, the deed determines instead a “proportionate value * * * at the time of the gift” — meaning a dollar value that “shall remain constant” — and guarantees only that “constant” amount (i.e., that fixed dollar amount) for the donee. The defect can be illustrated as follows:

If the easement contributed by Railroad Holdings’ deed were, at the time of the contribution, worth 10% of the value of a $10 million property, then the “proportionate value” of the easement (as the deed uses that term) would be $1 million, and that dollar value — rather than the fraction of value it did represent — “shall remain constant”. Thus, if a court extinguished the easement many years later after the property had appreciated to $20 million, the donee’s share of extinguishment proceeds would be not 10% of $20 million (i.e., the fractional share represented by $2 million) but rather the “constant” $1 million. The regulation requires that the donee “must be entitled to a portion of the proceeds at least equal to that proportionate value” (in this example, 10% of $20 million, or $2 million), 26 C.F.R. sec. 1.170A-14(g)(6)(ii), but Railroad Holdings’ deed would give the donee only “at least” a constant 10% of the $10 million value “as of the date of” the contribution, or $1 million. (As we explain below in Part IV.A, an entitlement to an amount that is “at least” a fixed value is an entitlement only to no less than that value.)[4]

The taxpayer points to the term “at least” in the provision, arguing that the clause does not limit the charity to receiving only that minimum amount.  But the Tax Court does not find that this saves the deduction, noting:

The totality of the “plain language” and “specific terms” on which this contention rests is the single phrase “at least”, and that phrase will not bear the weight that petitioner’s argument must put on it. Petitioner’s explanation of “split[ting]” “proceeds [that] exceed” the date-of-donation values is an invention with no basis in the text of the deed.

The regulation sets a minimum for the donee’s participation in extinguishment proceeds and then, using the phrase “at least”, makes it explicit that a deed may be more generous to the donee and still comply. But a deed that provides for the donee a share of proceeds that may be less than the minimum cannot comply by adding “at least” to its deficient formula. The donee must obtain through the deed a “property right” that includes a proportionate share of proceeds. If the donee’s only right under the deed is to receive “at least” a deficient share, with a hope that there might be more, then the deed does not comply with the regulation.[5]

The Tax Court also found that a declaration of intent by an officer of the charity that the language reflected the charity’s intent to be in full compliance with all IRC provisions for this donation also is not relevant.  The Court notes the key issue would be the donor’s intent, not that of the charity, and even if it is also the donor’s intent, the deed itself fails to conform to the requirement.  The Court notes that the declaration does not indicate there was an error in drafting.  As well, the taxpayer did not provide evidence that State law would allow the use of other evidence to show the intended meaning, nor that such other evidence existed.[6]

The taxpayer argues finally that the following provision, found in the deed, should serve to correct any ambiguity that might exist based on the “at least” clause:

Any general rule of construction to the contrary notwithstanding, this Conservation Easement shall be liberally construed in favor of the grant to protect the Conservation Values and effect the policies and purposes of SERLC. If any provision of this Conservation Easement is found to be ambiguous, an interpretation consistent with its conservation purposes that would render the provision valid should be favored over any interpretation that would render it invalid.[7]

The Tax Court does not find this argument persuasive either. First, the Court notes that the clause refers only to the portion of the agreement related to the “conservation purpose” and not the “protection in perpetuity” clause.

As well, it would only come into effect to resolve an ambiguity—but the formula for allocating the proceeds is not at all ambiguous in the deed.

Finally, even if we accept that it applied to this issue and there was ambiguity, the Court finds that it would represent an impermissible savings clause.  As the Court notes:

A donor cannot reserve in an easement deed a right that section 170(h) does not permit (such as a right to more than his share of extinguishment proceeds) but then save his charitable contribution by mentioning the rule he has violated and calling for that rule to kick in and save the day if his violation subsequently comes to light.

Part B(2) of article VI of the deed contains an unambiguous expression of the formula to apply to the proceeds of an extinguishment. If the terms of part B(2) had never come to light in a tax proceeding, and if later the easement had ever been judicially extinguished, there is no reason to suppose that a court distributing proceeds would have overruled the express terms of part B(2).[8]

In the end, the Tax Court concluded that as the easement was not protected in perpetuity, the entire $16 million deduction was properly denied by the IRS.

[1] Railroad Holdings, LLC v. Commissioner, TC Memo 2020-22, February 5, 2020, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12168 (retrieved February 8, 2020)

[2] Reg. §1.170A-14(g)(6)(ii)

[3] Railroad Holdings, LLC v. Commissioner, p. 5

[4] Railroad Holdings, LLC v. Commissioner, pp. 11-12

[5] Railroad Holdings, LLC v. Commissioner, pp. 14-15

[6] Railroad Holdings, LLC v. Commissioner, pp. 15-16

[7] Railroad Holdings, LLC v. Commissioner, p. 17

[8] Railroad Holdings, LLC v. Commissioner, pp. 18-19