The recent case of Harbor Lofts Associates, Crowninshield Corporation, Tax Matters Partner v. Commissioner, 151 T.C. No. 3 (Aug. 27, 2018) teaches yet another lesson on the importance of the perpetuity requirements when claiming a charitable deduction for the donation of a conservation easement. Last October I blogged about another conservation easement case, Palmolive Building Investors v. Commissioner, 149 T.C. No. 18 (Oct. 10, 2017). I did not get into the substance of the law in that blog, but instead focused on the Golsen rule and why the Tax Court needed to put its best analytical foot forward. I referred readers to Peter Reilly’s great blog post on Palmolive for the substance.
I encourage readers who don't know the Golsen rule to review the Golsen post, because Harbor Lofts is a case that the taxpayers may appeal to the First Circuit Court of Appeals. That is important because it’s the First Circuit who disagreed with the Tax Court’s position regarding the subordination requirement at issue in Palmolive. While today’s case involves a different part of the perpetuity requirement (and so there is no First Circuit precedent to bind the Tax Court), the Tax Court is again agreeing with the IRS in reading the perpetuity requirement strictly, this time finding that a long-term lease is not sufficient to meet the perpetuity requirements. If the Tax Court’s opinion is appealed to the First Circuit, the First Circuit may decide to take the same liberal interpretation of the perpetuity requirement as it did in Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), the case that was like Palmolive.
Today’s post will therefore comment on the Tax Court’s approach to interpreting the perpetuity requirements for conservation easements. Long story short, I agree with it. The First Circuit’s liberal approach, while understandable, is wrong. This post will explain why. To do so, I will have to dip into the substantive law with the caveat, as always, that what I say is subject to correction from alert readers who know this area better than I do. In particular, I will doubtless expose my ignorance by asking why the taxpayers did not structure the donation differently. It was likely for a reason that I just cannot see. The fun starts below the fold.
The Law: Getting To Perpetuity
Section 170(a) allows taxpayers a deduction for a “charitable contribution.” Section 170(c) defines that term as “a contribution or gift to or for the use of” a qualified organization and then lists the types of organizations that qualify. Section 170(f)(3)(B) generally disallows a “contribution... of an interest in property which consists of less than the taxpayer’s entire interest in such property....” Section 170(f)(3)(B) then carves out three exceptions to the general rule, the third one of which is for “a qualified conservation contribution.” Section §170(h)(1) says a contribution will be a qualified conservation contribution if it meets three requirements: (A) it is a qualified real property interest; (B) it is to a qualified organization; and (C) it is “exclusively for conservation purposes.” Section 170(h)(2) says a restriction on the use which may be made of real property can be a qualified real property interest for (h)(1)(A) purposes but only if the restriction is granted in perpetuity. Section §170(h)(5) imposes a second, independent, perpetuity requirement for the (h)(1)(C) requirement: it says that a “contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.”
If you don’t know much about conservation easements, you should really visit Professor Nancy McLaughlin’s SSRN page. Professor McLaughlin is also the Reporter for the Uniform Law Commission's Uniform Conservation Easement Act Study Committee, whose report Paul blogged about last week here. On her SSRN page you can download any one of a number of highly informative and well written articles on the subject of conservation easements. I found them enormously helpful in getting up to speed in this area. [Note to civilians: in the legal academy the metrics for “publish” are in flux but one metric that many schools use is the number of downloads a particular professor gets on articles they have posted on sites like SSRN (Social Science Research Network). Downloads there are free. So go give Prof. McLaughlin some downloads. She deserves it.]
In 1979 Harbor Lofts entered into a 61-year lease to use the Daly Drug Building and the Vamp Building in Lynn, Massachusetts (“the Buildings”). The buildings and land were owned by the Economic Development & Industrial Corporation of Lynn (“EDC”). Some of the lease terms gave Harbor Lofts the rights and responsibilities of outright ownership (e.g. a right to a portion of any payments made if the property were taken under eminent domain and the responsibility to insure the building), and some were more traditional lease terms (e.g. a right to renovate that was subject to approval by the EDC). In 2009 the lease term was extended to 2059, making it an 80 year lease. In December 2009, Harbor Lofts and EDC jointly entered into an agreement with the Essex National Heritage Commissioner, Inc. (“Heritage”) to give Heritage a façade easement to preserve the Buildings’ exterior. On its 2009 Form 1065, Harbor Lofts took a sweet $4,457,515 charitable contribution deduction for that donation.
On audit, Harbor Lofts defended its deduction by arguing that its contribution was a “qualified conservation contribution” allowed by §170(f)(3) because it met all the requirements listed in §170(h). The IRS disallowed the deduction chiefly on the grounds that the façade easement failed the perpetuity requirements in §170(h)(2)(C) and (h)(5). There was no question that Heritage was a qualified organization.
In a reviewed opinion, written by Judge Buch and with no reported dissents or concurrences, the Tax Court agreed with the IRS that Harbor Loft was not entitled to the deduction because the donation failed both perpetuity requirements.
Harbor Lofts argued that it’s long-term lease was, functionally, just like a fee ownership and that is what it donated, just like a fee simple interest. Alternatively, Harbor Lofts argued that it was like a co-owner with EDC because without Harbor Loft’s agreement, EDC could not have made a qualified donation. I am assuming the argument is that, but for Harbor Lofts’ agreement, EDC would have had to wait until the lease ran out to give the conservation easement. I could be wrong on that assumption.
The Tax Court rejected both arguments. First, it held that the extended lease term did not convert Harbor Loft’s leasehold interest into a functional ownership interest. It read Massachusetts’s law as saying that a lease is a lease is a lease, and is personalty, not realty. Therefore, Harbor Loft was not a fee owner or co-owner or tenant in common but just a tenant. What it gave could not, under state law, be equated to a fee simple ownership. Since the lease had an end point, it could not satisfy the perpetuity requirement. It did not go on forever, just for another 50 years after the donation.
Harbor Lofts pointed out the many tax cases where courts have treated long-term leases as the economic equivalent of ownership and argued they should be viewed as equitable owners or at least co-owners with EDC. The Tax Court dismissed that argument by noting the equivalency only came up in economic substance and disguised sale doctrines. I teach an example of the latter, a case from back when it was fashionable to try and disguise sales of chattel as long term leases to get rental deductions greater than depreciation. See Starr’s Estate v. Commissioner, 274 F.2d 294 (1959).
The Tax Court also rejected the second argument by noting that even though Harbor Lofts’ donation may have enabled EDC’s donation be a “qualified conservation contribution” that did not make what Harbor Lofts contributed a "qualified conservation contribution" all by itself, because what Harbor Lofts gave would end in 2059, per the lease. Harbor Lofts simply had nothing it could give in perpetuity. I infer the idea here that while Harbor Lofts' participation may have been necessary for EDC to make the donation in 2009, its participation was "just" a timing issue because the lease had a discernable end point. Again, I could be wrong on that and I welcome comments.
If Harbor Lofts appeals to the First Circuit, one issue might be the proper approach to interpreting the term “perpetuity.” We all know that “perpetuity” cannot possibly be taken literally because, as over 22,000 songs remind us, nothing lasts forever. But if the word means less than forever, then the interpretive trick is to figure out how long is long enough to be in “perpetuity.” That depends on whether one approaches §170(h) with an open hand or a tight fist. I think the better approach is the tight one, for three reasons.
First, narrow construction of deduction provisions is the approach most consistent with Supreme Court instructions as to how to approach the Tax Code generally. In many early Supreme Court tax cases you can find language to the effect that “tax laws should be construed in favor of taxpayers.” Probably the most famous is Bowers v. New York & Albany Lighterage Co., 273 U.S. 346, 350 (1927) where you can snip out the quote: “The provision is part of a taxing statute; and such laws are to be interpreted liberally in favor of the taxpayers.”
In those early days there was considerable doubt as to the reach of the income tax statutes. Since 1954, however, the Supreme Court has repeatedly reminded us of the "sweeping scope" of §61’s basic rule: gross income includes all “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1954).
The sweeping scope of §61 has a ripple effect on how the Court approaches the interpretation of statutes authorizing exclusions and deductions. The Court has said that it has “emphasized the corollary to §61(a)'s broad construction, namely the default rule of statutory interpretation that exclusions from income must be narrowly construed." Commissioner v. Schleier, 515 U.S. 323, 328 (1995)(no exclusion for certain lawsuit damages). Similarly, since deductions are a matter of legislative grace and exceptions to the broad scope of §61, they “are strictly construed and allowed only as there is a clear provision therefor.” INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992)(denying deductions for certain business expenses and requiring capitalization instead).
I cannot find any Supreme Court cases since 1954 that follow Bowers and interpret tax statutes liberally in favor of taxpayers. There is only a 2001 concurrence by a nostalgic Justice Thomas that even mentions that canon of construction. United Dominion Industries, Inc. v. U.S. 532 US 822, 839 (2001). But even there, Bowers is the most recent case he (or his clerks) found to support the canon.
The second reason for favoring a narrow construction of the perpetuity requirement focuses on the statutory structure of §170. In contrast to the general §170(a) allowance of deductions, §170(f)(3) completely disallows deductions for donations of partial interests in property. Only then does it permit some exceptions, one of which is the conservation easement. The Tax Court has consistently referred to this statutory structure (complete disallowance followed by limited exceptions in §170(f)(3)(B)) as support for a strict interpretive approach to donations of partial interests in property. For example, in Graev v. Commissioner, 140 T.C. 377 (2013) the taxpayer sought a deduction of a partial interest in property under two of the exceptions in §170(f)(3). On page 392, the court gave this very helpful history of the subsection emphasizing that the qualified conservation easement was a later-added exception to the general disallowance of partial interests in property:
“The disallowance of a deduction for partial interests was added to the Code as section 170(f)(3) by the Tax Reform Act of 1969. In that provision's original form, the only exceptions to disallowance of a deduction for contributions of partial interests were for contributions of “a remainder interest in a personal residence or farm” and “an undivided portion of the taxpayer's entire interest in property” That is, no exception was made for a qualified conservation contribution. However, the Staff of Joint Committee on Taxation opined in its General Explanation of the Tax Reform Act of 1969, at 80 (J. Comm. Print 1970), that “a gift of an open space easement in gross is to be considered a gift of an undivided interest in property where the easement is in perpetuity.”
“Congress made explicit an exception for (i.e., permitted a deduction for) certain easements in the Tax Reform Act of 1976, Pub.L. No. 94–455, sec. 2124(e), 90 Stat. at 1919, which amended section 170(f)(3)(B) to provide in clause (iii) that a donor may claim a deduction for the contribution of an “easement with respect to real property of not less than 30 years' duration granted to * * * [a charitable organization] exclusively for conservation purposes”. The following year Congress revised that exception, eliminating the “30 years' duration” provision and limiting deductibility to an “easement with respect to real property granted in perpetuity.” Tax Reduction and Simplification Act of 1977, Pub.L. No. 95–30, sec. 309(a), 91 Stat. at 154. In the Tax Treatment Extension Act of 1980, Pub.L. No. 96–541, sec. 6(a), 94 Stat. at 3206, Congress amended section 170(f)(3) and added subsection (h), which have remained in effect since then and work in tandem to keep the perpetuity requirement for conservation easement donations."
The third reason for endorsing the Tax Court’s strict interpretation of the perpetuity requirement is that the requirement is best viewed as an anti-abuse rule. As such it should be strictly construed.
Historically, at least up to 1986, courts took a taxpayer-friendly approach to construing the general rule in §170(a), in reliance on an early Supreme Court case, Helvering v. Bliss, 293 U.S. 144 (1934). Notice that the Bliss case is from the era where the Supreme Court's general interpretive approach was the one favorable to taxpayers, before INDOPCO and Schleier. Even as late as 1985 one finds courts still saying that the general rule in §170(a) was to be liberally applied. For example, here is how the District Court for the Eastern District of New York summed up the common understanding in Hartwick College v. U.S., 611 F.2d 400, 405 (1985). Notice the cite to Bliss:
“The public policy behind section 642(c) is to encourage private donations to charities. With the current reductions in federal support to charitable programs, encouraging private support of charitable organizations like plaintiffs is particularly important. Exemptions of income devoted to educational and charitable purposes are not to be narrowly construed. See Helvering v. Bliss, 293 U.S. 144, 151, 55 S.Ct. 17, 20, 79 L.Ed. 246 (1934)." (some internal quotes and citations omitted).
The Supreme Court, however, put the correctness of that general approach to §170(a) in doubt when it decided Hernandez v. Commissioner, 490 U.S. 680 (1989). In Hernandez, the Supreme Court refused to give broad construction to §170(a) when it held that members of the Church of Scientology could not deduct certain payments to their Church. The taxpayers claimed that the deductions had a dual purpose and so should be allowed. The Supreme Court was quite concerned about the fallout from a liberal interpretation of §170(a): “petitioners’ deductibility proposal would expand the charitable contribution deduction far beyond what Congress has provided. Numerous forms of payments to eligible donees plausibly could be categorized as providing a religious benefit or as securing access to a religious services.”
As part of the fallout from Hernandez, the Court vacated another case, Staples v. Commissioner, 821 F.2d 1324 (8th Cir. 1987), where that Circuit had explicitly relied on the Bliss case for a broad construction approach to applying §170. See 109 S.Ct. 3271 for the order vacating the decision. For a good discussion of how Hernandez has played out, see Sklar v. Commissioner, 282 F.3d 610 (9th Cir. 2002)(disallowing deductions and rejecting reading of §170(a) that would allow partial deductions for dual purpose donations).
The effect of Hernandez appears profound. If you go on LEXIS or Westlaw, you will find that before 1989 courts routinely cited the Bliss case for the proposition that tax rules about charitable donations were not to be narrowly construed. But after 1989, one finds only one circuit court case and two district court cases that even cite Bliss. And the Circuit Court case invoking Bliss does so in the breach, not the execution: it reverses the District Court that had actually relied on the Bliss interpretive approach. See Green v. United States, 144 F. Supp. 3rd 1254 (W.D. Okla. 2015) (invoking Bliss for a liberal interpretation of whether the taxpayer can use fair market value or basis to determine the amount of a gift) rev'd by 880 F.3d 519 (10th Cir. 2018) ("we reject the district court’s interpretation of §642(c)(1) and conclude that the amount of the deduction thereunder is limited to the Trust’s adjusted basis in the donated properties."
At the very least one reads in Hernandez a concern that taking a lenient construction of §170(a) would lead to taxpayers abusing the provision. I think that is quite applicable to the perpetuity requirement, which I understand is best viewed as an anti-abuse provision.
Professor McLaughlin gives a very nice explanation of the perpetuity provisions in two articles that are worth your attention. The first one, written in 2010, gives you a broad understanding of how abuses in conservation easement donations led to the perpetuity requirements and how the regulations attempt to address six different ways the perpetuity requirements might be avoided. In particular, she makes the same point that the Tax Court made in Graev: that Congress created the perpetuity requirement to replace the 30 year requirement because the 30 year requirement was not enough to prevent abuse of the conservation easement donation.
The second article, written in 2017, reviews case law developments in four of the most litigated perpetuity issues to point out the never ending cat-and-mouse game: taxpayers seek to game the deduction and the IRS seeks to plug loopholes. The general thrust of Professor McLaughlin’s studies is to show how the perpetuity requirement is an anti-abuse provision.
The issue in Harbor Lofts—whether a long enough lease satisfies the perpetuity requirement—is not one that Professor McLaughlin discusses, at least not in the articles I read. But the Tax Court’s approach in Harbor Lofts in construing the perpetuity requirement is exactly the approach that appears needed to prevent abuse of conservation easement donations. If the taxpayers appeal the case to the First Circuit, I would hope that Circuit would agree with the Tax Court here.
Coda: I wonder why Harbor Lofts did not donate its entire Leasehold to the qualified organization? If it had done that, query whether it could have avoided the perpetuity issue altogether. Go back and look at the §170(f)(3) restrictions. The restrictions are for donations “of an interest in property which consists of less than the taxpayer’s entire interest in such property.” Taken simply as text, that language does not say “less than a fee simple interest.” If one looks at a couple of other areas of tax law one sees cases where leasehold interests are treated as the equivalent of fee ownership for (1) assignment of income cases and (2) capital gain purposes. The classic case in assignment of income cases is Blair v. Commissioner, 300 U.S. 5, (1937)(assignment of income interest in trust property permitted because the income interest was “tree” in taxpayer’s hands). The case I’m thinking of in the capital gains area is Metropolitan Building Co. v. Commissioner, 282 F.2d 592 (9th Cir. 1960)(sale of lessee’s entire leasehold interest to sub-lessee resulted in capital gain because it was sale of what was a “tree” in lessee’s hands). I would welcome any comments on why Harbor Lofts did not do that. I am sure there must have been a good reason.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.