Conservation Easements

The Internal Revenue Service Large Business and International division (LB&I) has announced the approval of five additional compliance campaigns. LB&I announced on January 31, 2017, the rollout of its first 13 campaigns, followed by 11 campaigns on November 3, 2017, five campaigns on March 13, 2018, six campaigns on May 21, 2018, and five more on July 2, 2018. In addition, LB&I continues to review the tax reform legislation enacted on December 22, 2017, to determine which existing campaigns, if any, could be impacted as a result of a change in the law.

LB&I is moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues that present risk require a response in the form of one or multiple treatment streams to achieve compliance objectives. This approach makes use of IRS knowledge and deploys the right resources to address those issues. The campaigns are the culmination of an extensive effort to redefine large business compliance work and build a supportive infrastructure inside LB&I. Campaign development requires strategic planning and deployment of resources, training and tools, metrics and feedback. LB&I is investing the time and resources necessary to build well-run and well-planned compliance campaigns.

These five additional campaigns were identified through LB&I data analysis and suggestions from IRS employees. LB&I’s goal is to improve return selection, identify issues representing a risk of non-compliance, and make the greatest use of limited resources.

The five campaigns selected for this rollout are:

  • IRC Section 199 – Claims Risk Review

Public Law 115-97 repealed the Domestic Production Activity Deduction (DPAD) for taxable years beginning after December 31, 2017.  This campaign addresses all business entities that may file a claim for additional DPAD under IRC Section 199. The campaign objective is to ensure taxpayer compliance with the requirements of IRC Section 199 through a claim risk review assessment and issue-based examinations of claims with the greatest compliance risk.

  • Syndicated Conservation Easement Transactions

The IRS issued Notice 2017-10, designating specific syndicated conservation easement transactions as listed transactions, requiring disclosure statements by both investors and material advisors. This campaign is intended to encourage taxpayer compliance and ensure consistent treatment of similarly situated taxpayers by ensuring the easement contributions meet the legal requirements for a deduction, and the fair market values are accurate. The initial treatment stream is issue-based examinations. Other treatment streams will be considered as the campaign progresses.

  • Foreign Base Company Sales Income: Manufacturing Branch Rules

In general, foreign base company sales income (FBCSI) does not include income of a controlled foreign corporation (CFC) derived in connection with the sale of personal property manufactured by such corporation. However, if a CFC manufactures property through a branch outside its country of incorporation, the manufacturing branch may be treated as a separate, wholly owned subsidiary of the CFC for purposes of computing the CFC’s FBCSI, which may result in a subpart F inclusion to the U.S. shareholder(s) of the CFC.

The goal of this campaign is to identify and select for examination returns of U.S. shareholders of CFCs that may have underreported subpart F income based on certain interpretations of the manufacturing branch rules. The treatment stream for the campaign will be issue-based examinations.

  • 1120F Interest Expense/Home Office Expense

This campaign addresses compliance on two of the largest deductions claimed on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Treasury Regulation Section 1.882-5 provides a formula to determine the interest expense of a foreign corporation that is allocable to their effectively connected income. The amount of interest expense deductions determined under Treasury Regulation Section 1.882-5 can be substantial. Treasury Regulation Section 1.861-8 governs the amount of Home Office expense deductions allocated to effectively connected income. Home Office Expense allocations have been observed to be material amounts compared to the total deductions taken by a foreign corporation.

The campaign compliance strategy includes the identification of aggressive positions in these areas, such as the use of apportionment factors that may not attribute the proper amount of expenses to the calculation of effectively connected income. The goal of this campaign is to increase taxpayer compliance with the interest expense rules of Treasury Regulation Section 1.882-5 and the Home Office expense allocation rules of Treasury Regulation Section 1.861-8. The treatment stream for this campaign is issue-based examinations.

  • Individuals Employed by Foreign Governments & International Organizations

In some cases, individuals working at foreign embassies, foreign consular offices, and various international organizations may not be reporting compensation or may be reporting it incorrectly. Foreign embassies, foreign consular offices and international organizations operating in the U.S. are not required to withhold federal income and social security taxes from their employees’ compensation nor are they required to file information reports with the Internal Revenue Service.

This lack of withholding and reporting results in unreported income, erroneous deductions and credits, and failure to pay income and Social Security taxes. Because this is a fluid population, there may be a lack of knowledge regarding tax obligations. This campaign will focus on outreach and education by partnering with the Department of State’s Office of Foreign Missions to inform employees of foreign embassies, consular offices and international organizations. The IRS will also address noncompliance in this area by issuing soft letters and conducting examinations.

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In Wendell Falls Development, LLC v. Commissioner, T.C. Memo. 2018-45, the Tax Court denied a charitable contribution deduction for a taxpayer’s contribution of a conservation easement because the taxpayer expected to receive a substantial benefit from the donation.

The taxpayer purchased 27 contiguous parcels of unimproved land, comprising 1,280 acres. The taxpayer planned to subdivide the 1,280 acres into a master-planned community with residential areas, commercial spaces, an elementary school, and a park. The taxpayer would then sell the lots to builders.

The taxpayer identified 125 acres of the 1,280 acres as land upon which a park would be placed. The taxpayer and the County discussed the County acquiring the 125 acres for use as a county park. The taxpayer sought to ensure that the 125 acres would be restricted to park use and proposed placing a conservation easement on the 125 acres. Ultimately, the taxpayer and the County entered into a purchase agreement for the 125 acres, and placing a conservation easement on the land was a precondition to the sale. The taxpayer granted a conservation easement on the 125 acres in favor of a land trust and transferred ownership of the 125 acres to the County. The taxpayer claimed a charitable deduction for its contribution of the conservation easement on its tax return.

The issue here is the “substantial benefits” test. No deduction for a charitable contribution is allowed if the taxpayer expects a substantial benefit from the contribution. The taxpayer owned and intended to sell the 1,280 acres of land adjoining the 125 acres that was designated as park land. The taxpayer’s master-planned community was designed so that all residential areas would have access to the 125-acre park.  According to the Court, the taxpayer expected a substantial benefit from the donation because it sought to ensure that the 125 acres was restricted to park use, and as the prospective seller of the lots the taxpayer “would benefit from the increased value to the lots from the park as an amenity.” Because the taxpayer expected a substantial benefit from the donation, the Court disallowed the charitable deduction. (Note: alternatively, the Court determined that the value of the easement was zero because the park land did not diminish the value of the 125 acres).

August brought three wins for taxpayers who donated conservation easements that were challenged by the IRS.  In all of the cases, terms of the conservation easement deed document carried the day. 

  • In BC Ranch II, L.P. v. Comm’r, No. 16-60068, 2017 BL 282040 (5th Cir. Aug. 11, 2017), the Fifth Circuit overturned a Tax Court decision finding that an easement deed allowing for small boundary adjustments violated the perpetuity requirement of Section 170(h)(2)(C).  The perpetuity requirement provides that, in order to qualify for a charitable contribution deduction for a conservation easement donation, a taxpayer must restrict, in perpetuity, the use which may be made of the real property.  The Fifth Circuit held that the Tax Court’s reliance in Belk  v. Comm’r, 140 T.C 1 (2013), aff’d 774 F.3d 2210 (4th Cir. 2014), to hold that the conservation easement restrictions violated the perpetuity requirement was misplaced because Belk involved a provision where the easement land could be substituted in its entirety for a new parcel of land.  The Fifth Circuit looked at similar cases where small adjustments to the easement were permitted to promote the underlying conservation purpose.  Because that was the case here, the court found that the perpetuity requirement was met.  Addressing the IRS alternative theory that the partners entered into disguised sales for partnership property, the court also determined that the portions of capital contributions made by partners, other than those attributable to the parcels that were distributed to them, were not disguised sales of partnership assets.  
  • Next, in 310 Retail, LLC, v. Comm’r, T.C. Memo 2017-164, and Big River Development, L.P. v. Comm’r, T.C. Memo 2017-166, the Tax Court held that the conservation easement deeds at issue met the contemporary written acknowledgement requirement set forth in Section 170(f)(8)(B).  The contemporary written acknowledgement provision requires that, in order to claim a charitable contribution deduction, the donor is required to obtain from the charity a written statement that describes the donation, states whether the charity provides goods and services in exchange for the donation, and, if goods and services were provided, the fair market value of those goods and service.  This documentation must be obtained before the earlier of the due date of the return or the date the return in filed.  In both cases, the donor did not obtain from the charity separate documentation that is traditionally sent to donees with this specific language.  However, because the conservation easement deeds contained language discussing the consideration given and stating that the deed was the complete agreement of the parties (known as a merger clause), the deed itself acknowledged that the charity did not provide goods and services to the donor and therefore satisfied the contemporaneous written acknowledgement requirements. 
  • In all three cases, while the taxpayers now presumably have established the right to claim the charitable contribution deduction, the next step of determining the value of the conservation easement will be a separate battle.