Today’s lesson is how to win a valuation dispute with the IRS. I don’t teach much about valuation in my basic tax course. When we work problems involving property, the problems generally tell students to assume a certain fair market value (FMV) for the property. For example, when I teach the deductions allowed by §170 for contributions of property to a charity, what I want students to learn is the reduce-to-basis rule. To work that particular rule, those problems just assert an FMV because I’m trying to get them to focus on what kind of property is being donated and to what kind of charity. See e.g. last week’s lesson “The Reduce-To-Basis Rule For §170 Deductions,” TaxProf Blog (Oct. 17, 2022).
I tell students that in real life, valuation is often open to dispute. That is because facts matter. And facts may often be disputed. Moreover, assumptions matter as well. And assumptions may often be questioned.
This week, we learn a great lesson from the Tax Court on how to win a valuation dispute against the IRS: have a better expert. While that is easy to say, the 43-page opinion in Champions Retreat Golf Founders LLC et al. v. Commissioner, T.C. Memo. 2022-106 (Oct. 17, 2022) (Judge Pugh), teaches how it is not always easy to do. Today’s case involves the valuation of a conservation easement. The taxpayer’s expert was not the best, but the IRS’s expert was worse. So the taxpayer won. The lesson is kind of like the old joke that you don’t have to outrun the bear: a taxpayer’s valuation does not have to be the best possible; it just has to be better than the IRS’ valuation. Details below the fold.
Valuation of Conservation Easements
In my basic tax class we briefly discuss how one determines FMV. We really don’t get much deeper than the classic idea that the best proof of FMV is an arms-length transaction between a willing seller and willing buyer neither under a compulsion to buy or sell. That’s the common law definition, but you can also find it in various regulations, including this estate tax regulation defining a decedent’s estate. See Treas. Reg. 20.2031-1(b).
Valuing conservation easements (or any kind of partial interest) is tricky because they are not themselves bought and sold in arms-length transactions. So the regulations on how to value them focus on something called the “before-and-after-method.” As you might infer, that valuation approach compares the FMV of the property subject to the easement before the easement's grant with its FMV after the grant. The difference is the value of the easement. See Treas. Reg. § 1.170A–14(h)(3)(i)(“The amount of the deduction in the case of a charitable contribution of a perpetual conservation restriction covering a portion of the contiguous property owned by a donor...is the difference between the fair market value of the entire contiguous parcel of property before and after the granting of the restriction.”)
Figuring out the before and after values is notoriously squishy. The before-and-after method can be seen as two steps: (1) a counter-factual determination of how the property could be most profitably used both before the easement and after the easement (the shorthand is “highest and best use”); (2) a comparison of the resulting hypothetical FMV of the property if put to its highest and best use before the easement and the FMV after. The delta is the value of the easement.
While it is theoretically possible to find an arms-length sale of the subject property immediately before and immediately after, taxpayers must generally guesstimate a hypothetical sale and the regulations give a whole host of factors that must be considered in figuring that out. I won’t dive into it here, but three really great resources for those who want more are: (1) a terrific 2016 article by the ever-reliable Professor Nancy A. McLaughlin, Conservation Easements and the Valuation Conundrum, 19 Fla. Tax Rev. 225 (2016); (2) an excellent study by Alan Feld, Jacob Nielsen & Theodore Sims, “Green, or Greed? A Fresh Perspective on the Valuation of Conservation Easements,” 76 Tax L. Rev. ___ (forthcoming 2022); and (3) the horse’s mouth guidance found in the IRS’s Conservation Easement Audit Techniques Guide.
The Role of Expert Witnesses
When a factual area gets squishy, experts can help the Court wade through it. More formally, the role of an expert witness is to help the understand an issue, not to bind the Court to any particular outcome. As Judge Pugh explains: “An expert’s opinion is admissible if it assists us, as the trier of fact, to understand the evidence or to determine a fact in issue.” Op. at 10.
How the Tax Court uses admissible expert witness opinions and reports varies. Most often, the Court grounds its decision on the expert testimony, even as they disclaim the need to be bound by any single expert’s report and emphasize their ability to pick and choose bits and pieces from each one. Here’s one example from Judge Halpern in Perrachio v. Commissioner, T.C. Memo. 2003-280:
"Of course, we are not bound by the opinion of any expert witness, and we may accept or reject expert testimony in the exercise of our sound judgment. Although we may largely accept the opinion of one party's expert over that of the other party's expert, we may be selective in determining what portions of each expert's opinion, if any, to accept. Finally, because valuation necessarily involves an approximation, the figure at which we arrive need not be directly traceable to specific testimony if it is within the range of values that may be properly derived from consideration of all the evidence" (internal citations omitted).
In other words, the Court will generally use of all or part of expert reports and in so doing those reports set the boundaries of the squishy swamp the Court is wading through.
Sometimes, however, the Court may strike out in a different direction, and simply disregard expert opinions the Court finds unreliable. Judge Holmes did that Rajagopalan v. Commissioner, T.C. Memo. 2020-159 (“We don't, however, have to accept an expert opinion, but may instead use our own computation or analysis.”), blogged in Lesson From The Tax Court: The Right Way To Do Conservation Easements, TaxProf Blog (Nov. 30, 2020). And Judge Halpern did that in Trout Ranch, LLC v. Commissioner, T.C. Memo. 2010-283, where he found none of the expert reports convincing: “We shall discuss their assumptions and their arguments, and we shall then construct our own discounted cashflow analyses to calculate the before and after values of the property.”
Judge Pugh takes the usual approach in this case. She explains that she sees her job as deciding which party’s evidence (including expert reports) is “sufficiently more convincing than that of the other party, so that the final result will produce a significant financial defeat for one or the other, rather than a middle-of-the-road compromise, which we suspect each of the parties expects the Court to reach.” Op. at 10. Put another way, while Judge Pugh might (and does here) critically evaluate each expert report, she does so only on the basis of the evidence presented to the Court. She will neither make a party’s argument for them or conduct independent research. Thus, for example, in footnote 1 on Op. p. 2 she notes her awareness that the federal government had filed suit against one of the taxpayer’s experts, but “because neither party brought this to our attention and it is not part of the record before us, we do not consider it in our Opinion.” This is the most classic vision of a judge as a neutral arbiter.
In 2002, the taxpayer Champions Retreat Golf Founders, LLC ("Champions") bought 463 acres of land adjoining the Savannah river. It developed about 366 acres into a private golf club called “Champions Retreat” with these three nine-hole courses on different parts of the property, each one designed by a different famous golfer (Gary Player, Jack Nicklaus, and Arnold Palmer). The course opened for play in 2005. At the same time, Champions developed 95 of the remaining acres into 67 residential lots on the west side of the property. All 67 lots were sold within a few months after construction of the golf course, raising some $13 million. Op. at 2. Finally, Champions built 5 rental “cottages” to generate income from tourists.
In 2010, Champions donated to the North American Land Trust a conservation easement covering about 348 acres of the property (almost all of the golf courses and an adjoining driving range). It did not include the 5 rental cottages. The easement restricted how Champions could use easement area in the future. Most importantly, the easement prohibited development of the easement area into residential lots. Op. at 6.
Champions made the donation to raise badly needed funds to support operations and pay off debt by donating a conservation easement. The idea was that investors would contribute capital for a share of the resulting large charitable deduction.
Given the presence of various wildlife and given the scenic nature of the property, Champions believed it had a good shot at making a qualifying conservation easement. Champions engaged one Claude Clark, III, to perform an appraisal. Mr. Clark believed that the value of the property before the easement was some $10.5 million more than its value after the easement, chiefly because the easement restricted the ability to develop residential lots. Without that restriction, he figured some entrepreneur would be able to buy the property, rip out one of the 9-hole golf courses, and build additional homes there. With the restriction, that could not happen. Relying on Mr. Clark’s work, Champions claimed a charitable deduction of $10.4 million.
In 2014 Champions sold the golf club property for a total of $4.5 million in cash. That sales price did not reflect the value of the property, however, because it included transfer of inventories worth $235k, and because Champion agreed to build a new maintenance facility as part of the sale; that cost Champion $1.6 million.
The IRS audited Champion's 2010 return and disagreed that the easement even qualified as a charitable donation. It disallowed the entire deduction. The Tax Court agreed with the IRS, but was reversed by the 11th Circuit who thought the easement qualified at least as one for “the preservation of open space ... for the scenic enjoyment of the general public" per §170(h)(4)(A)(iii). Even though the golf course was private, and land access was limited, a river ran through it, thus allowing the general (boating) public to enjoy the scenic grandeur of carefully groomed and manicured golfing surfaces as they floated by. See Champions Retreat Golf Founders, LLC v. Commissioner, 959 F.3d 1033 (11th Cir. 2020). Thus, the case was remanded to the Tax Court to determine the value of the easement.
Both parties offered expert witnesses to help the Tax Court find the value. The main dispute was over the counter-factual determination of the highest and best use of the property if no easement had been granted. Everyone agreed that the highest and best use of the property after the easement was as it was being used: a 27-hole private golf club.
In addition to disagreement over the highest and best use, the parties also disagreed on the FMV of the property at that counter-factual highest and best use. Similarly, there was dispute over the FMV, in 2010, of the highest and best use of the property as a 27-hole golf course.
Here’s a summary of each expert. I will follow that with the Lesson.
In the remanded proceeding, the taxpayer put Mr. Clark on the stand as its primary expert witness. There, he testified that the easement was actually worth slightly more than what he had valued it as in 2010, some $10.8 million instead of the $10.4 million claimed on the return.
Mr. Clark opined that the total “before” FMV of the property was $16.8 million. His counter-factual assumption was still that the property could have been redeveloped into a smaller 18-hole golf course with more homes. He estimated the FMV of additional residential lots was $13.3 million, the FMV of a revamped 18-hole golf course was $1.1. million, and the FMV of the rental cottages was $2.4 million.
After the easement, however, most of the property was frozen for use as a 27-hole golf course. There were apparently 17 residential lots along one of the encumbered golf courses that could also be developed without violating the easement. And the 5 rental cottages were not subject to the easement.
Mr. Clark opined that the total "after" FMV was $6 million. To determine the FMV of the property after the easement, as of 2010, Mr. Clark started with the actual sale in 2014 for $4.5 million and adjusted that downwards to reflect both the cost of inventory and new maintenance facility, as well as time value of money, and changes in market conditions. He concluded the total “after” FMV of the golf course alone was $1.5 million and then added back the FMV of the property that was not subject to the easement’s development restriction: the 17 residential lots and the 5 rental cottages.
Hence the $10.8 million valuation for the easement.
The taxpayer also offered a second expert, Mr. Wingard. He agreed with Mr. Clark that the highest and best use of the property before the easement was a cut-down golf course with more homes. The Court’s opinion does not disclose what FMV he assigned to that use. It does note, however, that Mr. Wingard’s analysis varied from Mr. Clark’s in some respects. Judge Pugh thought Mr. Wingard’s analysis somewhat undermined Mr. Clark’s “before” FMV. More on that below.
The IRS’s expert, Mr. Pope, disagreed with Mr. Clark and Mr. Wingard about what constituted the highest and best use of the property before the easement. He thought replacing one of the golf courses with residential lots and re-jiggering the other golf courses into a single 18-hole course would have such practical and legal barriers that no one would do it. Thus his counter-factual conclusion was that the highest and best use of the property remained as a 24-hole golf club. That meant that the easement’s restriction on development had little impact. For various reasons, Mr. Pope thought the “before” FMV was only about $20,000 more than the "after" FMV.
Lesson: Taxpayer Does Not Need The Best Expert, Just A Better Expert
Mr. Clark may not have been the best expert the taxpayer could have produced. He has not yet been able to escape the litigation noted by Judge Pugh in footnote 1. The government still seeks to enjoin him from engaging in conservation easement transactions because of an alleged pattern of knowingly and regularly providing false and inflated appraisals. See United States v. Zak, 426 F.Supp.3d 1365 (N. D. Ga. 2019) (order denying Clark’s motion to dismiss). In addition, he was the subject of this 2019 complaint before the Alabama Real Estate Appraisal Board for making improper conservation easement valuations. In response to that complaint, he signed this Consent Order revoking his Alabama appraiser’s license.
But Mr. Clark did not need to be the best. He just needed to be better than Mr. Pope, the government’s expert. And he was. Judge Pugh repeatedly laments that “The problem that we face in this case is that respondent did not offer a viable alternative to Mr. Clark’s flawed opinion.” Op. at 7 Note 9. In fact, Judge Pugh gives sort of a running commentary in the footnotes on the failures of the government to produce sufficient evidence to discredit Mr. Clark’s analysis.
The basic reason why Mr. Clark turned out to be the better expert was because the taxpayer’s attorney was able to convince Judge Pugh that the highest and best use of the property absent the easement was the redevelopment into additional residential lots with an 18-hole golf course. I won’t go into all the reasons. You can read Judge Pugh’s lucid opinion for that.
Once Judge Pugh accepted Mr. Clark’s highest and best use, Mr. Pope’s expert testimony was limited to fighting Mr. Clark’s valuation approach. The big dog in this fight was deciding what was the 2010 FMV of the counter-factual sales of the counter-factual additional residential lots that would be hypothetically carved out of one of the golf courses.
Here again, Judge Pugh expressed some skepticism about Mr. Clark’s reliability. Here again, however, she explains that she was constrained to accept Mr. Clark’s method unless the IRS came up with an alternative, even though Mr. Clark was not the best expert. She was limited by what the parties presented and would not go outside the evidence presented in the case. Writes Judge Pugh:
"Mr. Clark was not a compelling witness (and indeed we have criticized him in other cases); but we note that respondent did not offer specific criticisms of Mr. Clark’s valuation other than those we address in our analysis, relying instead on general statements. For example, respondent did not challenge the comparables Mr. Clark used or suggest alternatives. Nor is there sufficient evidence in the record for us to second guess Mr. Clark’s valuation except as we set forth below. We are not valuation experts and can only make adjustments to valuations, or fashion our own valuation, to the extent that the record permits. Here, the valuations by both Mr. Clark and Mr. Pope are flawed; but because Mr. Clark’s valuation has more support in the record, we conclude that it was sufficiently more convincing and therefore start with his conclusions and modify them to the extent we can, using our best judgment, given the record before us." Op. at 28, footnote 18 (quotes and cites omitted).
She concludes on this issue: “Thus, constrained by the facts in the record, and with no competing valuation by respondent, we adopt petitioner’s use of the subdivision method as appropriate for the property.” Op. at 29.
Ironically, Judge Pugh uses the taxpayer’s other expert to reduce the “before” FMV from Mr. Clark’s $16.8 million to a lower $14.1 million. That was largely on finding that Mr. Clark was assuming too rapid a pace of counter-factual sales of the counter-factual additional residential lots that would be hypothetically carved out of one of the golf courses.
So the taxpayer (mostly) wins here, not because they had the best expert; it was because they had a better one than the IRS.
Coda: Judge Pugh's opinion is also a great lesson on the various valuation methods available to make the FMV determinations. But rather than cutting and pasting it here, I invite you to bookmark the opinion for later reading.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday to TaxProf Blog (or Tuesday if Monday is a federal holiday) for another difficult-to-value Lesson From The Tax Court.