The Eleventh Circuit Court of Appeals has ruled invalid a portion of regulations adopted in 1986 related to contributions of conservation easements in the case of Hewitt v. Commissioner.[1] The issue involved the Tax Court’s finding, which the appellate panel overruled, that the easement failed to satisfy the “protected-in-perpetuity” requirement found at IRC §170(h)(5), as it violated the judicial extinguishment formula found at Reg. §1.170A-14(g)(6)(ii). The panel found that Treasury had violated the Administrative Procedures Act by failing to address comments provided on this issue as part of issuing the regulations in final form.

The panel begins by noting the Eleventh Circuit had recently found in favor of the IRS on a similar easement in the case of TOT Property Holdings, LLC v. Commissioner, 1 F.4th 1354, 1363 (11th Cir. 2021) but the panel notes that in that case they had not considered the issue of the regulation’s validity as the taxpayers had conceded the matter in that case. But in this case the taxpayers were challenging the regulation’s validity, not just the IRS’s interpretation of that regulation:

…[B]ased on the taxpayers’ concession in TOT, id. at 1362 & n.13, we did not address whether § 1.170A-14(g)(6)(ii) was procedurally valid under the Administrative Procedures Act (“APA”) or substantively valid under the framework in Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). Unlike the taxpayers in TOT, the Hewitts challenge the regulation’s validity on appeal. Specifically, the Hewitts argue that the Commissioner’s interpretation of § 1.170A-14(g)(6)(ii) — prohibiting the subtraction of the value of post-donation improvements to the property on which a conservation easement exists from the proceeds in the event of judicial extinguishment — is arbitrary and capricious for violating the procedural requirements of the APA, see 5 U.S.C. § 706, because the U.S. Treasury Department failed to respond to significant comments as to the improvements issue in promulgating the regulation. The Hewitts further argue that the regulation is substantively invalid under Chevron as an unreasonable interpretation of the statute.[2]

Ultimately the panel chose to issue a decision solely based upon the IRS’s failure to consider comments on the issue, leaving unanswered the question of whether the regulations the IRS arrived at were an unreasonable interpretation of the statute.

The regulation in question reads as follows:

(i) In general. If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee's proceeds (determined under paragraph (g)(6)(ii) of this section) 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.

(ii) Proceeds. . . . [F]or 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. . . . 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.[3]

The panel summarized the provisions of the Administrative Procedures Act that were in question here:

The APA “prescribes a three-step procedure for so-called ‘notice-and-comment rulemaking.’” Perez v. Mortg. Bankers Ass’n, 575 U.S. 92, 96 (2015); accord 5 U.S.C. § 553. First, an agency “must issue a ‘[g]eneral notice of proposed rulemaking,’ ordinarily by publication in the Federal Register.” Perez, 575 U.S. at 96 (alteration in original) (quoting § 553(b)). Second, “if ‘notice [is] required,’ the agency must ‘give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments,’” and the agency “must consider and respond to significant comments received during the period for public comment.” Id. (alteration in original) (quoting § 553(c)). Third, in promulgating the final rule, the agency “must include in the rule’s text ‘a concise general statement of [its] basis and purpose.’” Id. (alteration in original) (quoting § 553(c)). As the Supreme Court has explained, “Rules issued through the notice-and-comment process are often referred to as ‘legislative rules’ because they have the ‘force and effect of law.’” Id. (quoting Chrysler Corp. v. Brown, 441 U.S. 281, 302–03 (1979)).

Thus, “[t]he APA requires the agency to incorporate into a new rule a concise general statement of its basis and purpose.” Lloyd Noland, 762 F.2d at 1566. As we have explained, “statement[s] may vary, but should fully explain the factual and legal basis for the rule.” Id. Indeed, “[b]asis and purpose statements must enable the reviewing court to see the objections and why the agency reacted to them as it did,” id., as “[o]ne of the basic procedural requirements of administrative rulemaking is that an agency must give adequate reasons for its decisions,” Encino Motorcars, LLC v. Navarro, 579 U.S. 211, 221 (2016). And, in the statement, the agency must rebut “vital relevant” or significant comments. See Lloyd Noland, 762 F.2d at 1567; Hussion v. Madigan, 950 F.2d 1546, 1554 (11th Cir. 1992) (“Under the ‘arbitrary and capricious’ standard of review, an agency is . . . required to respond to significant comments that cast doubt on the reasonableness of the rule the agency adopts.” (quoting Balt. Gas & Elec. Co. v. United States, 817 F.2d 108, 116 (D.C. Cir. 1987))). The purpose of notice-and-comment rulemaking is to “give[ ] affected parties fair warning of potential changes in the law and an opportunity to be heard on those changes” while “afford[ing] the agency a chance to avoid errors and make a more informed decision.” Azar v. Allina Health Servs., 139 S. Ct. 1804, 1816 (2019).[4]

After Treasury issued the proposed regulations, the agency received over 700 pages of commentary from 90 organizations and individuals, with 13 addressing the extinguishment proceeds regulation.[5]

The comment the opinion focuses most closely on came from the New York Landmarks Conservancy (NYLC):

Turning to the most detailed comment, the New York Landmarks Conservancy (“NYLC”) urged Treasury to delete the proposed proceeds regulation because it contained pervasive “problems of policy and practical application.” NYLC stated that while Congress enacted the statute “to encourage the protection of [the] . . . environment through the donation of conservation restrictions,” the proposed regulation “would thwart the purpose of the statute by deterring prospective donors,” as those donors would “likely . . . be discouraged from making a donation which may tie themselves or future owners to share proceeds of a sale or exchange with the charitable organization [donee] under circumstances which cannot possibly be foreseen.” NYLC explained that prospective donors frequently were concerned about “perpetuity” issues, which were “mollified upon the donor's recognition that common law permits the extinguishment of restrictions when they no longer serve the original intended purposes.” But NYLC believed “[t]he prospect of extinguishment would no longer mollify these fears if a split of proceeds under unknown circumstances would be required.” As such, and because “the possibility of extinguishment is relatively remote,” NYLC stated it was “unnecessary” for Treasury “to provide for allocation of proceeds after extinguishment.”

NYLC also specifically commented on the issue of whether the value of post-donation improvements to the easement property should be included or excluded from the extinguishment proceeds formula contained in the regulation. NYLC stated that the regulation's structure “contemplates that a ratio of value of the conservation restriction to value of the fee will be fixed at the time of the donation and will remain in effect forever thereafter.” But NYLC asserted that the formula “fail[ed] to take into account that improvements may be made thereafter by the owner which should properly alter the ratio.” In support of its concern, NYLC presented a mathematical example, which was based on a fact pattern in the proposed regulations, see 48 Fed. Reg. at 22,945, to show that requiring the prospective donor to turn over extinguishment proceeds attributable to post-donation improvements to the donee “would obviously be undesirable to the prospective donor and would constitute a windfall to the donee organization.” See Oakbrook, 154 T.C. at 224 (Toro, J., concurring in result). Thus, “in light of the potential inequities,” NYLC recommended “that the proposed proceeds formula be revised to prevent such inequities should the . . . Treasury decide to retain the provision” but “strongly recommend[ed] deletion of the entire extinguishment provision.” (emphasis added).[6]

The opinion goes on to note how Treasury did not deal with this and other related comments when issuing the final regulations:

In the preamble to the final rulemaking, Treasury stated that “[t]hese regulations provide necessary guidance to the public for compliance with the law and affect donors and donees of qualified conservation contributions” and that it had “consider[ed] . . . all comments regarding the proposed amendments.” Id. In the subsequent “Summary of Comments” section, however, Treasury did not discuss or respond to the comments made by NYLC or the other six commenters concerning the extinguishment proceeds regulation. See id. at 1497–98; Oakbrook, 154 T.C. at 188 (“The ‘judicial extinguishment’ provision is not among the amendments specifically addressed in the ‘Summary of Comments.’”). And Treasury stated that “[a]lthough a notice of proposed rulemaking which solicited public comments was issued, the Internal Revenue Service concluded when the notice was issued that the regulations are interpretative and that the notice and public comment procedure requirement of 5 U.S.C. [§] 553 [of the APA] did not apply.” 51 Fed. Reg. at 1498.[7]

The opinion focuses on the following issue to determine if the regulation is to be upheld or thrown out:

…[T]he issue before us is whether Treasury’s failure to respond to NYLC’s and the other commenters’ concerns about the extinguishment proceeds regulation was in violation of the procedural requirements of the APA. Phrased differently, we must determine whether § 1.170A-14(g)(6)(ii), as interpreted by the Commissioner to prohibit the subtraction of any amount of proceeds attributable to post-donation improvements to the easement property in the event of judicial extinguishment, is procedurally valid under the APA where: (1) one commenter — NYLC — made specific comments raising the improvements issue as it relates to extinguishment proceeds and recommended deletion of the provision; (2) six other organizations submitted comments criticizing or urging caution as to the regulation; and (3) Treasury failed to specifically respond to any of those comments, instead simply stating that it had considered “all comments.”[8]

The panel found that Treasury’s failure to respond to these comments doomed the regulation:

As in Lloyd Noland, in promulgating the final extinguishment proceeds regulation, Treasury failed to respond to the relevant and significant comment from NYLC as to the post-donation improvements issue. In the proposed regulations’ preamble, Treasury stated that the “regulations reflect the major policy decisions made by the Congress and expressed in the[ ] committee reports” to the Tax Treatment Extension Act of 1980. 48 Fed. Reg. at 22,940. One of the policy decisions reflected in those “committee reports,” expressly referenced by Treasury, provided that “the preservation of our country’s natural resources and cultural heritage is important,” that “conservation easements now play an important role in preservation efforts,” and that “provisions allowing deductions for conservation easements should be directed at the preservation of unique or otherwise significant land areas or structures.” S. Rep. No. 96-1007, at 9 (1980). NYLC’s comment recognized as much, stating that “[t]he statute was enacted by Congress to encourage the protection of our significant natural and built environment through the donation of conservation restrictions.”

As to the proposed regulation overall, NYLC stated that the proposed regulation “would thwart the purpose of the statute by deterring prospective donors” concerned about tying themselves to share proceeds of a sale with the donee “under circumstances which cannot possibly be foreseen.” Additionally, NYLC specifically commented that the regulation’s proceeds formula: (1) “contemplates that a ratio of value of the conservation restriction to value of the fee will be fixed at the time of the donation and will remain in effect forever thereafter”; and (2) “fail[ed] to take into account that improvements may be made thereafter by the owner which should properly alter the ratio.” And NYLC warned that this outcome “would obviously be undesirable to the prospective donor and would constitute a windfall to the donee organization” and “strongly recommend[ed] deletion of the entire extinguishment provision,” or at least revised “to prevent such inequities.” In other words, NYLC challenged a fundamental premise underlying Treasury’s proposed regulations by “in effect counter[ing] that the proposed rule on future donor improvements was contrary to those policy decisions [mentioned in the proposed regulations], would lead to inequitable results that were inconsistent with the statute, and would deter future contributions.” See Oakbrook, 154 T.C. at 225 (Toro, J., concurring).

Simply put, NYLC’s comment was significant and required a response by Treasury to satisfy the APA’s procedural requirements. And the fact that Treasury stated that it had considered “all comments,” without more discussion, does not change our analysis, as it does not “enable [us] to see [NYLC’s] objections and why [Treasury] reacted to them as it did.” Lloyd Noland, 762 F.2d at 1566.[9]

Thus, the opinion concludes:

Because Treasury, in promulgating the extinguishment proceeds regulation, failed to respond to NYLC’s significant comment concerning the post-donation improvements issue as to proceeds, it violated the APA’s procedural requirements. See Lloyd Noland, 762 F.2d at 1566; see also Oakbrook, 154 T.C. at 225–27 (Toro, J., concurring). We thus conclude that the Commissioner’s interpretation of § 1.170A-14(g)(6)(ii), to disallow the subtraction of the value of post-donation improvements to the easement property in the extinguishment proceeds allocated to the done, is arbitrary and capricious and therefore invalid under the APA’s procedural requirements. Accordingly, we reverse the Tax Court’s order disallowing the Hewitts’ carryover charitable deductions as to the donation of the conservation easement and remand for further proceedings.[10]

Advisers must take care to note that the decision, at least for now, only impacts taxpayers whose appeals would be heard by the Eleventh Circuit Court of Appeals which covers the states of Alabama, Florida and Georgia.[11] Outside of that Circuit, the Tax Court would be expected to continue to follow its own published opinion in Oakbrook Land Holdings, LLC v. Commissioner, 154 T.C. 180 (2020) which upheld the validity of the regulation until and unless the Tax Court decides to abandon reliance on that ruling.

Advisers should watch to see if this same issue is brought before other Circuit Courts of Appeal and how those Circuits rule or, in what is a far less likely development, the IRS decides to appeal this case to the U.S. Supreme Court and that Court decides to hear this matter. Normally the Supreme Court only hears cases like this if there is a clear conflict in the decisions of different Circuit Courts of Appeal on the issue.

[1] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), reversing TC Memo 2020-89, December 29, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/eleventh-circuit-finds-easement-deduction-reg-is-invalid/7cr4t (retrieved December 30, 2021)

[2] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[3] Reg. §1.170A-14(g)(6)

[4] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[5] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[6] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[7] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[8] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[9] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[10] Hewitt v. Commissioner, Case No. 20-13700, (2021 CA11), December 29, 2021

[11] Golsen v. Commissioner, 54 TC 742 (1970)