THE 5TH CIRCUIT PUSHES PBBM DOWN ROSE HILL
The 5th Circuit Court of Appeals has issued a consequential opinion that affects a large number of existing and future conservation easements throughout the U.S.1 The IRS regulations2 require that an easement deed provide for a specific division of proceeds that result from any extinguishment (by judicial proceeding) of all or part of the easement, for example if the property were condemned.3 The 5th Circuit opinion applies this regulation in a way that renders non-deductible any easement that includes a common provision for “proceeds” attributable to improvements built on easement property after the easement donation. The problem created by the 5th Circuit decision cannot be remedied after an easement has been granted.
Conservation easements often allow a landowner to retain a “reserved right” to build, e.g., a house, cabin, barn, or other structure on the property. If the property were later condemned, the proceeds from the condemnation sale would logically include the value of those improvements. It seems equitable that the value attributable to such improvements would be the property of the landowner who paid to build them. Accordingly, improvement clauses typically carve out and reserve the amount of proceeds attributable to the value of such improvements for the land owner, and the remaining proceeds are divided between the land trust and land owner in the proportion described in the regulation.
Our investigation shows that these “improvement” clauses are very common. They appear in many conservation easement forms that land trusts and landowners have adopted. Indeed, in 2008, the IRS issued guidance that approved an improvements clause in a conservation easement deed.4 It saw no problem with the clause then, and until PBBM-Rose Hill, the IRS had not indicated that improvements clauses were an issue. However, adopting the litigation position urged by the IRS in PBBM-Rose Hill, the 5th Circuit held that all proceeds resulting from an extinguishment of a conservation easement must be divided using the proportionate share formula of the regulation, including those attributable to improvements. In essence, the 5th Circuit determined the land trust must be granted an economic interest in, and any “proceeds” attributable to, improvements (e.g., a house, barn, etc.) subsequently built on easement encumbered property.
The 5th Circuit's recent opinion in PBBM-Rose Hill will impact thousands of conservation easement deductions. Three aspects of the 5th Circuit's opinion are significant: (1) the opinion invalidates a common easement deed provision allocating proceeds from judicially extinguished conservation easements; (2) the opinion contradicts existing law governing whether the IRS must comply with the managerial approval of penalties requirement under Code section 6751(b); and (3) the good news for taxpayers is that the 5th Circuit reversed the Tax Court and determined that protection of conservation purpose is based on the language of the easement deed, disregarding the actions of a subsequent owner of the eased property.
This blog addresses the 5th Circuit's decision that extinguishment proceeds divided between the land owner and the land trust must include proceeds attributable to the value of improvements built after the easement donation.Subsequent blogs will address the remaining two issues mentioned above.
The Code clearly requires that a conservation easement must be “perpetual.” Yet the statute is silent as to its application, which has caused the IRS to issue regulations implementing the mandate. One aspect of the perpetuity requirement is addressed in Treasury regulation section 1.170A-14(g)(6) (the “Extinguishment Regulation”). The Extinguishment Regulation provides, in relevant part, that “[i]f a subsequent unexpected change in the conditions surrounding the property … make impossible or impractical the continued use of the property for conservation purposes” the perpetuity requirement can still be satisfied so long as the easement deed provides the land trust with its proportionate share of proceeds from the subsequent extinguishment or condemnation.”5 The Extinguishment Regulation also provides a formula for calculating the land trust's proportionate share of any extinguishment proceeds.6
In PBBM-Rose Hill, the easement deed excluded from such proceeds “an amount attributable to the improvements constructed … pursuant to the Reserved Rights.” This provision had the effect of reserving any proceeds attributable to post-easement improvements for the land owner. The balance of the proceeds were allocated between the land trust and land owner in proportion to their respective interests under the easement deed. The 5th Circuit agreed with the Tax Court that the definition of proceeds in PBBM-Rose Hill's easement deed violated the Extinguishment Regulation and therefore the perpetuity requirement. The 5th Circuit held that the Extinguishment Regulation “does not indicate that any amount, including that attributable to improvements, may be subtracted out” prior to allocating proceeds between the land trust and land owner.7
Prior to the Tax Court's ruling, numerous easement deeds containing “improvements clauses” had passed IRS and court scrutiny in audits and court cases. Indeed, in the one private ruling letter in which the IRS directly addressed and analyzed an improvements clause, the IRS determined that the clause was appropriate. Nonetheless, the 5th Circuit refused to consider the private letter ruling because the 5th Circuit concluded that the “regulation [was] not ambiguous.” 8 The determination leads one to question how the same government agency can construe the same regulatory language two different ways if the regulation was not “ambiguous.”
Reserving proceeds attributable to post-easement improvements on the land owners is necessary, so that landowners can protect the improvements that they construct pursuant to the rights they reserved in an easement deed. Land trusts prefer reserved rights, so that on-site landowners can watch over the land and help steward the conservation values. Indeed, many model conservation easement agreements contain improvements clauses similar to the one the Tax Court and 5th Circuit determined violated the perpetuity requirement. And in PBBM-Rose Hill, NALT filed an Amici Brief that expressed its belief that it had no interest in proceeds attributable to post-easement improvements. NALT, similar to other land trusts, determined it did not have (and did not want) an economic interest in houses, gazebos and barns built by a landowner on easement property.
We are asking the land trust community to provide us with information on how widely used is the practice of reserving for the landowner proceeds from post-easement improvements. For a point of reference, the improvements clause language at issue in PBBM-Rose Hill can be found [here]. We also request that land trusts tell us where they learned about the use of such a clause and to provide us with copies of seminar materials or other resources that they used suggesting that a clause reserving proceeds from post-easement improvements for the landowner is appropriate. We anticipate using this material to support the use of such “proceeds" language in future litigation. Please send any such materials to Jennifer Needham, firstname.lastname@example.org.
2 Treas. Reg. §1.170A-14(g)(6)Treas. Reg. §1.170A-14(g)(6). The regulation requires that the land trust receive a share of proceeds from the property proportionate to the value of the easement at the time of the donation divided by the value of the whole property at that time.
3 A condemnation is a government's use of its power of eminent domain to take land for public purposes, like new or expanded roads or industrial parks, for which it must pay fair compensation.
4 I.R.S. Priv. Ltr. Rul. 2008-36-014 (Sept. 5, 2008).
5 See Treas. Reg. § 1.170A-14(g)(6)(i)
6 See Treas. Reg. § 1.170A-14(g)(6)(ii).
7 PBBM-Rose Hill, LLC, No. 17-60276, at *20.
8 The 5th Circuit found the regulation formula to be unambiguous. However, the court did not address the ambiguity evident from the conflicting interpretations by the IRS in its 2008 private letter ruling and its present litigation position.