Can Taxpayers Clobbered by IRS Challenges to Their Federal Income Tax Deductions for Conservation Easement Grants Recoup their Loss?

taxpayers recoup loss

Section 170(h) of the Internal Revenue Code of 1986, as amended (the “Code”), sets forth rules allowing income tax deductions to taxpayers who grant conservation easements on real estate in perpetuity to qualifying non-profit organizations, generally within exacting requirements.  But the beneficent congressional intentions behind their enactment of Section 170(h) had the unintended consequence of some independent real estate developers and many promoters of syndicated conservation easement deduction investment vehicles “juicing-up” the deduction or chipping away at the “in perpetuity” rules in good faith or by disingenuous means.  See, for example, Lumpkin HC, LLC, Hurricane Creek Partners, LLC, Tax Matters Partner v. Commissioner, TC Memo. 2020-95 (June 23, 2020).

To the author’s knowledge, during 2010, the IRS began to pull many tax returns for examination that had reported seemingly outsized Section 170(h) deductions.  Over the ensuing years, the IRS discovered a lot of returns with outsized Section 170(h) deductions, examined each, but on a coordinated basis from selected Revenue Agent offices across the country, and in due course issued Notices of Deficiency or Final Notices of Partnership Adjustment.  A frequently encountered basis for these final IRS actions is that the granted conservation easements under examination were not compliant with one or more the requirements of Section 170(h) or the Treasury Regulations thereunder and/or the conservation easement grant under review was valued at too high a value for tax deduction purposes.

Beginning in 2011 the U. S. Tax Court has decided approximately 80 cases.  The IRS is mostly winning mainly for reasons that defy appeal to the U.S. Circuit Courts, practically speaking, although a few lost Tax Court cases have been appealed, such as Pine Mountain Reserve, LLLP et al. v. Commissioner, ___ F3d ____ (October 22, 2020). There the LLLP established on appeal that its retaining some limited development areas within the bounds of the otherwise conserved larger wooded area did not run afoul of the “in perpetuity” requirement.  But, the IRS has won so many cases in Tax Court and so many are awaiting decisions, that on June 25, 2020 (IR-2020-130), IRS Commissioner Chuck Rettig announced a settlement program for taxpayers who had invested in syndicated conservation easement deduction investment vehicles, typically limited partnerships, and whose cases are docketed in Tax Court at this time at some stage of the court proceedings.

The terms of the IRS settlement offer have been recently spelled out in IRS Office of Chief Counsel Notice CC-2021-001 (October 1, 2020).  The settlement terms are complex owing to the many variations on the theme of syndicated conservation easement deduction limited partnerships and the fact that the Internal Revenue Code sets forth multitudinous cash penalties of varying degrees. Bottom line settlement terms include investor agreement to disallowance of all conservation easement related tax deductions and tax losses, but an investor is allowed to reduce his or her gross income for an adjustment year by the investor’s actual investment in the limited partnership during that year.  Generally, this is favorable. The terms further include payment of tax penalties, but at percentages of taxes underpaid lower than the corresponding statutory penalty percentages.  The terms expressly do not include reduced statutory interest rates on additional taxes due and reduced penalty amounts.  An important consideration in at least some situations is that the IRS is willing to settle with a renegade faction of investors who have lost faith (or worse) in the Tax Matters Partner in charge of the case.  Finally, in addition, the notice indicates the IRS is willing to extend the same settlement terms to cases not docketed in court, but which instead are on appeal from IRS Examinations’ determinations to the IRS National Office of Appeals.

As with all of the many promoted or syndicated tax reduction opportunities over the last approximately 50 years, there are (1) those taxpayers who credibly trusted their tax advisors’ advice before putting money into transactions generating Section 170(h) conservation easement deductions, (2) those taxpayers who may or may not have been skeptical, but in either case put money into transactions on the basis of seemingly solid tax opinion letters procured by promoters from law or accounting firms, and (3) those taxpayers who knew or had reason to know that the deductions had to be too rich, but took a chance that the IRS would not timely examine their tax returns or the investment vehicle’s tax return. None of this matters as far as the IRS settlement program.

As concerns those persons falling into the first and second groups, and  believe they were misled, it may be comforting to know that, in general, New Jersey has a six-year statute of limitations for most legal and accounting malpractice claims, as compared to other states such as New York (generally two years) and Pennsylvania (generally four years).  Further, ordinarily, New Jersey residents, as well as non-New Jersey residents who consulted with or relied upon a tax opinion from a law or accounting firm maintaining a New Jersey office, are eligible to file suit in New Jersey Superior Court against their tax advisors or the tax opinion promulgators.  As should not be too difficult to imagine, each situation is going to be different.  For example, there is a need to carefully assess the extent to which an aggrieved taxpayer was a genuinely credulous person or reasonably relied on tax advice or a tax opinion letter.   In addition, like many state courts, the New Jersey courts ordinarily require plaintiffs to take non-fruitless steps in order to mitigate their losses and lawsuit damages. The Notice CC-2021-001 procedures and settlement structure, if available (since for decided cases they are not) and opted for, will reduce losses and damages many investors would otherwise bear assuming the Tax Court is likely to decide against them.  Hence for many situations future malpractice court cases are likely to identify the notice as a non-fruitless mitigation route.  On the other hand, a given investor might have invested in a conservation easement deduction transaction as to which the bona fides of the tax structure is more apparent than would justify simply opting for the IRS settlement terms.

We are familiar with both the benefits of a Section 170(h) deduction and its exacting requirements, including allowed valuation criteria and the particulars of the tax return disclosure requirements.  We are also familiar with such issues as when the statute of limitations against malpractice claims begins to run and the circumstances wherein a person, such an investor’s estate, has standing to bring suit in the New Jersey courts. We have the expertise to judge the relative merits of an investment vehicle’s tax structure.  We have experience in representing taxpayers in settlement negotiations with the IRS such as would be the circumstances of a renegade faction of investors who have lost faith in the Tax Matters Partner.  Loss of faith may occur for example if the IRS asserts the civil tax fraud penalty against a limited partnership the further consequence of which looks likely to be each partner is going to have to pay a penalty equaling 75% of his or her underpaid taxes.  Consequently, if you are reading this article and have personal knowledge of situations involving taxpayers in decided cases, docketed cases, cases before IRS Appeals, or who are just now having their or the investment vehicle’s tax returns examined, we recommend that you contact our attorneys Robert S. Schwartz or Michael J. Faul, Jr., at your earliest convenience at 908-647-1022.   Focusing on a malpractice lawsuit might or might not be the best option.

This writing is not and should not be interpreted as the rendering of legal advice or performance of legal services to any person by Herold Law, P.A.  In accordance with professional ethical rules, Herold Law, P.A., renders legal advice and performs legal services only in the context of an attorney-client relationship entered into before rendering advice or performing services.