Tax statutes and tax regulations mostly use words to talk about numbers. One of the basic lessons I must teach students is how to read numerical formulas that are expressed in words. The importance of that lesson was recently reinforced by Railroad Holdings, LLC, Railroad Land Manager, LLC, Tax Matters Partner v. Commissioner, T.C. Memo. 2020-22 (Feb. 5, 2020) (Judge Gustafson). There, the drafters of a conservation easement deed failed to properly incorporate the regulation’s proportionality requirement, a requirement that expresses a mathematical concept in words. The resulting drafting error was so bad that not even tax litigators could twist the deed’s language to fit the requirement. That cost the taxpayer a $16 million charitable deduction. Details below the fold.
The Law: Of Perpetuity and Proportionality
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.” These, dear readers, are the perpetuity requirements.
Treas. Reg. 1.170A-14(g) interprets the statutory perpetuity requirements. Subsection (g)(6) addresses what happens if some future event extinguishes the conservation easement. Subsection (g)(6)(i) provides that if some future unanticipated sale or exchange of the entire property eliminates the original qualified conservation purpose, the donation can nonetheless meet the perpetuity requirements if “all of the donee's proceeds (determined under paragraph (g)(6)(ii) of this section) from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.”
Subsection (g)(6)(ii) creates a “proportionate value” rule for calculating “all of the donee’s proceeds.” The rule has two parts. First is an up-front requirement that “the donor must 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.” Second, once that “proportionate value” is established, it must remain constant such that “the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction.” (emphasis supplied)
The word “proportionate” is a word that describes a math concept, the concept of “having the same or a constant ratio,” according to Merriam-Webster’s online dictionary (and doubtless many other dictionaries). The regulation says that one first constructs the relevant ratio by putting the initial value of conservation easement in the numerator and the total value of the property in the denominator. That's the proportionate value. The donee organization must then be entitled to receive whatever amount of money results from applying that ratio to what is received from the later sale or exchange of the entire property.
Facts and Lesson
In 2012, the taxpayer here deeded a conservation easement in 452 acres of land to the Southeast Regional Land Conservancy, Inc. (“SERLC”). The taxpayer then took a $16 million charitable donation deduction on its 2012 return. On audit the IRS disallowed the deduction. The taxpayer petitioned Tax Court. The IRS moved for partial summary judgment on the single issue of whether the donation met the perpetuity requirements. Therefore, the Court assumed, for purposes of deciding the motion, that the donation otherwise complied with all the varied requirements for donations of conservation easements.
The IRS’s motion was based on its reading of the taxpayer’s deed. The IRS argued that the deed failed to meet the perpetuity requirement because it failed to properly implement the proportionality requirement. Judge Gustafson agreed. Here’s why.
The taxpayer’s deed attempted to comply with the rules in Treas. Reg. 1.170A-14(g)(6) regarding what would happen if some future event extinguished the conservation easement. It properly provided that in the event of some unforeseen future sale, SERLC would be entitled to a portion of the sale proceeds.
The drafting error was that SERLC would only be entitled to “a portion of the proceeds at least equal to the fair market value of the Conservation Easement as provided above.” But the deed defined “fair market value” as just a number, not a ratio. That is, the deed failed to follow the instructions in Treas.Reg. 1.170A-14(g)(6)(ii) that the “fair market value” must be a proportionate value, a ratio: the value of the easement to the total value of the property. Instead, the deed just provided that the “fair market value” was a number, being the “the difference between (a) the fair market value of the Conservation Area as if not burdened by this Conservation Easement and (b) the fair market value of the Conservation Area burdened by this Conservation Easement, as such values are determined as of the date of this Conservation Easement.”
The drafting error led to this result: while the deed provided that the amount would remain constant, the regulation requires that the deed preserve the ratio to satisfy the statutory perpetuity requirement. That way, if the fair market value of the property increases, so will the amount. Likewise, if the fair market value of the property falls, the amount due SERLC would be less than the initial amount but would still be proportionate to the value of the property.
Here’s the language I think would have worked: “SERLC shall receive from the proceeds of sale an amount no less than the fair market value of the conservation restriction at the time of gift, and at least equal to the proportionate value that, at the time of the gift, the perpetual conservation restriction bore to the value of the property as a whole.” You see, I basically just cut and pasted the regulatory language into the second clause. Just to be safe, I used the first clause to also preserve the numerical value in case the overall fair market value dropped. Query what would happen if the fair market value of the entire property dropped to zero (such as beachfront property that rising sea levels inundated).
The taxpayer’s attorney made three brave arguments to save the deed, but Judge Gustafson disposes of them crisply. None are worth blogging about. In fact, the attorney missed what might have been the taxpayer’s strongest argument: preserving the amount in perpetuity protected against a fall in value more than preserving the ratio. I do not think this is a winning argument, but it at least is more credible that what the attorney offered, especially if the attorney could point to some credible reason to believe that the fair market value of the property would only diminish over time (e.g. the beachfront property).
I cannot imagine how this drafting error occurred. The original governing regulations were put in place in 1986. See 51 Fed. Reg. 1496 (January 14, 1986). I can only speculate that the drafters of this deed simply did not understand that the term “proportionate” means “ratio” and not “number.”
When I was in practice I drafted Wills and Trusts. When you do that kind of work, your mistakes may not come to light for many, many years. I only hope that whoever did the drafting of this taxpayer’s deed in 2012---or whoever may have acquired the practice---has properly liability coverage.
Coda: When I last blogged on conservation easements (Lesson From The Tax Court: The Perpetual Debate Over Conservation Easements Continues) I noted that the term “perpetuity” cannot possibly be taken literally. 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.” I stand by the three reasons I gave in that post on why the term should be strictly interpreted to prevent abuses.
Bryan Camp is still the George H. Mahon Professor of Law at Texas Tech University. But it won’t last forever.