Treasury Department Conservation Easement Regulation Invalidated

In an important development in the ongoing litigation over taxation of conservation easements, Hewitt v. Commissioner, 2021 U.S. App. LEXIS 38555 (11th Cir. Dec. 29, 2021), invalidated a U.S. Treasury Department regulation issued in 1986 for failure to comply with the Administrative Procedure Act.  The panel reversed a United States Tax Court’s decision, and remanded the case for further proceedings in accordance with that ruling. 

The facts of the case center on a 2012 conservation easement donation made by the Hewitts.  This conservation easement was created over property owned by their family, some of which had been held for more than 60 years.  Based on the value of that easement, the Hewitts claimed tax deductions over the course of several years, totaling approximately $2.8 million.  In 2017, the IRS disallowed the deductions. 

The statute, 26 U.S.C. § 170, gives taxpayers a deduction for charitable contributions made during the course of a tax year.  The contributions can be made with any number of types of property, including easements placed upon real property.  Some of the more common easements are façade easements (protecting the appearance of historic buildings) and conservation easements (protecting the natural state of land and preventing development).  Because these property rights aren’t often bought or sold on the open market, Congress and the U.S. Treasury created a set of rules for establishing the donated value.  See § 170; Treas. Reg. § 1.170A-1 through -18.  As the value of the donated property increases, so does the complexity of the rules and requirements for the tax deductions.  This complexity inevitably leads to controversy and litigation.

One of the most important requirements imposed by section 170 is that the property donated be done so in perpetuity.  § 170(h)(5).  Congress was silent on many nuanced details of how this requirement works in practice, including what happens to an easement donation if the easement were extinguished.  So Treasury set out to answer some of those unanswered practical questions.  In 1986, after a notice-and-comment period, Treasury regulation 1.170A-14(g)(6) was finalized.  This regulation filled in several blanks left by Congress, providing a means by which the statutory perpetuity requirement could be deemed satisfied in the event an easement is extinguished. 

Before deciding the Hewitts’ case, the Tax Court issued a divided, precedential opinion in a case called Oakbrook Land Holdings, LLC v. Commissioner, 154 T.C. 180 (2020), appeal argued, No. 20-02117 (6th Cir. Oct. 27, 2021).  There, the Tax Court ruled in favor of the IRS, upholding the validity of Treasury regulation 1.170A-14(g)(6) and finding that the IRS did not violate the Administrative Procedure Act (APA) in its promulgation.  (The APA governs the process by which federal agencies develop and issue regulations.  It includes, among other things, requirements for publishing notices, allowing time for stakeholder comments, addressing substantive comments received, and interpreting other agency guidance.) 

In the Hewitts’ case, the IRS contended that Treasury regulation § 1.170A-14(g)(6) was not satisfied because the easement documents did not address correctly what would happen in the event the easement were extinguished.  The Hewitts disagreed, arguing, among other things, that the regulation was invalid.  In view of its previous upholding of the regulation, the Tax Court issued a decision in favor of the IRS.  See Hewitt v. Commissioner, T.C. Memo. 2020-89 at *15 n.6.  An appeal to the Eleventh Circuit followed.

In an opinion written by Judge Barbara Lagoa, the Eleventh Circuit addressed the Hewitts’ APA argument head-on.  The panel’s analysis looked back to the 1983 origin of Treasury regulation § 1.170A-14(g)(6) when the notice of proposed rulemaking was first issued.  This notice “proposed regulations relating to contributions of partial interests in property for conservation purposes” and proposed to clarify “the statutory rules in effect under [the Tax Treatment Extension Act of 1980].”  48 Fed. Reg. 22,940.  One of the subparagraphs in the proposed regulations ultimately became § 1.170A-14(g)(6).  Id. at 22,946-47.  More than 700 pages of comments were received by Treasury from 90 organizations and individuals, seven of which “expressed concern that allocation of post-extinguishment proceeds under the proposed Proceeds Regulation was unworkable, did not reflect the reality of the donee’s interest, or could result in an unfair loss to the property owner and a corresponding windfall for the donee.”

The Eleventh Circuit focused on one comment in particular from the New York Landmarks Conservancy (NYLC) and noted that there were several others that expressed similar concern.  The NYLC comment was the “most detailed” on the issue.  Not only did its comment call for the proposed proceeds regulation to be deleted, but it also explained its position, providing specific examples of the regulation’s shortcomings and inequities.  Following a public hearing, Treasury revised and adopted final regulations.  The preamble noted that it had “consider[ed] . . . all comments regarding the proposed amendments” to the original proposed regulatory language.  51 Fed. Reg. 1496.  There was no discussion or response to the comments made by the NYLC. 

The Eleventh Circuit proceeded to highlight concerns with the regulation’s validity expressed by two Tax Court judges in side opinions—Judge Toro in a concurring opinion, and Judge Holmes in a dissenting opinion—issued alongside the Tax Court’s decision in Oakbrook.  Judge Toro’s concurrence highlighted the specificity and significance of the NYLC comment and the absence of Treasury’s response.  He also noted that at that time, it was common practice for Treasury to presume that it was exempt from the APA’s requirements.  Judge Holmes’s dissent came to a similar conclusion on that point.  He explained that Treasury’s boilerplate statement that it had considered “all comments” was wholly inadequate. 

The Eleventh Circuit agreed with Judges Toro and Holmes:  “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.’”  Hewitt, 2021 U.S. App. LEXIS 38555, at *36-37 (quoting Lloyd Noland Hosp. & Clinic v. Heckler, 762 F.2d 1561, 1566 (11th Cir. 1985)).  Accordingly, the panel found that Treasury regulation] “§ 1.170A-14(g)(6)(ii)—as read by the Commissioner to prohibit subtracting the value of post-donation improvements to the easement property from the proceeds allocated to the donor and donee in the event of judicial extinguishment—is arbitrary and capricious under the APA for failing to comply with the APA’s procedural requirements and is thus invalid.”  Hewitt, 2021 U.S. App. LEXIS 38555, at *32. 

The case will next be remanded to the Tax Court for reconsideration and will be closely watched for its impact both within and without the Eleventh Circuit.

Posted by Daniel Strickland.

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