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Physicians and engineers are in general a lot smarter than accountants. That's why some of them get into tax trouble . Those are the ones who add ruffles and flourishes rather than doing things like everybody else does. They don't realize you best have a tax attorney involved if you are going to be fancy. That is what I see as the lesson in the Tax Court decision in the case of Douglas G. Carroll III. The issue was a conversation easement.
Conservation Easements
If you own property that you sincerely desire to have preserved in its natural state, the donation of a conservation easement is as close to a free lunch as you will get in tax planning. You get a tax deduction for the difference between the highest and best use value of the property (That's the use that yields the most money) and the value of the property as restricted.
There is a lot of abuse in this area. Some of the entities that accept conservation easements are on the flakey side. And in some cases, the highest and best use claimed by the taxpayer in valuing the property as unencumbered is a fantasy.
Not Abusive
The Tax Court did not find anything I would consider abusive in the conservation easement. The donee organizations Maryland Environmental Trust and The Land Preservation Trust Inc seem quite legitimate. MET is a state agency. Maryland's Governor, Speaker of the House and Senate President are ex-officio members of its board.
Doctor Carroll and his wife Deidre Smith appear to very active in conservation circles. There are articles featuring them here and here. There seemed to be no question that the easement they granted on 25 acres of rural land in a historic district serves a valid conservation purpose.
Petitioners have established that the contribution of their conservation easement was accepted by a State government agency after a thorough review process. At trial petitioners offered the testimony of Megan Benjamin, a conservation easement planner with MET. Ms. Benjamin testified that MET does not accept every conservation easement proposed to the agency and adheres to a thorough review policy in determining which easements are suitable for acceptance. .......... Petitioners' conservation easement was subject to this multistep evaluation process before it was accepted by MET.10 Accordingly, we conclude that the thoroughness of MET's easement-review process, combined with the requisite approval from Maryland's highest officials, establishes that petitioners' conservation easement preserves open space (including farmland and forest land) pursuant to a clearly delineated Federal, State, or local governmental conservation policy pursuant to section 170(h)(4)(A)(iii)(II).
So What Went Wrong?
One of the requirements to make a conservation easement deductible is that the conservation purpose be "protected in perpetuity". That is a really long time. And there is recognition that maybe things will change and that in the future people will think that it would be better if we just paved everything. So there is a kind of out. If due to unexpected changes the conservation purpose can no longer be fulfilled then there can be a clause that says that the donee organization gets a cut of the proceeds.
.....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.
So you agree to keep your cow pasture a cow pasture even though you are dead certain that you could get $10 million by converting it to a casino. You keep the cow pasture which is worth $100,000 as such and get a deduction of $9.9 million. Down the road things change, the organization doesn't care so much about it being a cow pasture, the court is OK with that so you sell it for $1 million for house lots. You get $10,000 and the conservation group gets $990,000. If the statute has run on the deduction year you are still way ahead, but that is neither here nor there.
Doctor Carroll refined that a bit.
The granting of this Conservation Easement gives rise to a property right, immediately vested in Grantees, with a fair market value equal to the ratio of the value of this Conservation Easement on the effective date of this grant to the value of the Protected Property without deduction for the value of the Conservation Easement on the effective date of this grant. The value on the effective date of this grant shall be the deduction for federal income tax purposes allowable by reason of this grant, pursuant to Section 170(h) of the Code. The parties shall include the ratio of those values with the Baseline Documentation and shall amend such values, if necessary, to reflect any final determination thereof by the Internal Revenue Service or a court of competent jurisdiction. For purposes of this paragraph, the ratio of the value of the Conservation Easement to the value of the Property unencumbered by the Conservation Easement shall remain constant, and the percentage interests of Grantors and Grantees in the fair market value of the Property thereby determinable shall remain constant.
Seems fair. If the contribution is disallowed in part, the split on a down the road sale gets adjusted.
What's Fair Got To Do With It?
Reilly's First Law of Tax Planning holds "It is what it is. Deal with it." There is a pretty lengthy analysis of why that extra wrinkle kills the easement deduction, but the essence is probably here.
Petitioners appear to argue on brief that the deduction referenced in the conservation easement was simply a method of determining the value of the easement. But there is no evidence of why this provision was in the conservation easement. Deductions for conservation easements can be denied for many reasons unrelated to valuation. At the time the conservation easement was granted, petitioners' deduction faced many hurdles that were unrelated to the value of the easement.13 Indeed, in this case respondent has made many arguments for disallowance that are not based on valuation.
In the event of extinguishment, if the deductions were disallowed, petitioners or their heirs could argue that petitioners never received a tax deduction and, therefore, MET and LPT would not be entitled to extinguishment proceeds.
The Root Of The Problem
Being an accountant, I'm not smart enough to know for sure that little refinement would kill the deduction. I am smart enough to have told Dr. Carroll to involve a tax attorney, but he wasn't my client.
The testimony and other evidence presented at trial demonstrate that Dr. Carroll is a highly educated medical school graduate and had previous experience with conservation easements. Although Dr. Carroll did hire Mr. Haile in 2005 to draft a gift deed for the subject property, Mr. Haile is not a tax attorney and does not answer tax-related questions or give tax advice. Petitioners offered no evidence which would explain why the terms of the conservation easement varied from the requirements of section 1.170A-14(g)(6), Income Tax Regs., nor do they clarify why Dr. Carroll failed to seek competent advice from a tax attorney or other adviser to ensure the conservation easement's compliance with pertinent regulations. In the light of Dr. Carroll's high level of sophistication and experience with conservation easements, we conclude that petitioners have not demonstrated that they acted with reasonable cause and in good faith in not seeking competent tax advice regarding the conservation easement.16 Accordingly, we hold that petitioners are liable for accuracy-related penalties under section 6662(a).
Personally, I think it was a subtle enough error, to forgo any penalty, but I'm not smart enough to be a Tax Court judge either. What is really sad is that Dr. Carroll lost the deduction because he was worried about what his share of an improbable sale would be.
Other Coverage
Lew Taishoff covered the case with a post titled "How Green Was My Valley".
Here’s Doug’s problem. He didn’t use the magic language that the contribution “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’.”
Professor Nancy McLaughlin is traveling, but she let me know that she will be covering the case. Her comment was
Public investment needs to be protected - that's the purpose of division of proceeds reg. and it's not difficult to comply with the reg. I have argued for years that the IRS should issue safe harbor extinguishment and division of proceeds clauses (among others) - that would facilitate compliance and IRS review and minimize this kind of litigation. It also would help ensure the public investment (600 million + annually) is protected.
