In Case You Missed It: Hewitt v. Commissioner Has Broken New Ground in Disputes Over Conservation Easements
Big news came out of the Eleventh Circuit Court of Appeals at the end of 2021 involving a closely watched conservation easement case. In Hewitt v. Commissioner,1 the Eleventh Circuit Court of Appeals overturned the Tax Court and held that a provision in the conservation easement regulations, promulgated in the 1980s, is procedurally flawed under the Administrative Procedure Act (APA). This case should be of interest to those following the developing body of cases involving the application of the APA’s rules to U.S. Department of the Treasury (Treasury) and Internal Revenue Service (IRS) determinations. On a more granular level, the holding of this case has important implications for the dozens (if not hundreds) of taxpayers that have had conservation easement deductions challenged based on these regulations.
The Treasury regulations at issue in Hewitt are the "proceeds regulations" (codified at Treas. Reg. § 1.170A-14(g)(6)(ii)), which provide guidance on how to allocate condemnation sale proceeds between the donor and the donee in the rare event of an extinguishment of a conservation easement. These regulations are intended to ensure that a donation complies with the "protected-in-perpetuity" requirement under IRC section 170(h)(5). The proceeds regulations require a proportional allocation of proceeds between the donor and the donee according to a specific formula. The donee must receive a share of the sale proceeds 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."2 Taxpayers can deviate from that formula only where "state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction."3
Under the easement at issue in Hewitt, in the unlikely event that the easement was extinguished, the share of the sales proceeds payable to the donee would generally be determined under the regulations' prescribed proportionate value formula. But the easement also provided that the donee's share would be reduced by any appreciation attributable to post-donation improvements to the property. Based on this "improvements provision," the IRS denied the taxpayers' entire charitable contribution deduction, arguing that the easement improperly reduced the donee's share of extinguishment proceeds in violation of the proceeds regulations. In the Tax Court, the taxpayers argued that the IRS misinterpreted the proceeds regulations and that, in any event, the proceeds regulations were procedurally and substantively invalid. The Tax Court rejected both of those arguments and sustained the IRS’s determination.
On appeal, the Eleventh Circuit Court of Appeals held that Treasury failed to follow the APA's procedural rules when promulgating the proceeds regulations by neglecting to respond to a significant comment regarding the treatment of post-donation improvements. Therefore, the court held that “the Commissioner's interpretation” of the regulations to disallow the subtraction of improvements "was arbitrary and capricious and therefore invalid under the APA's procedural requirements," and reversed the Tax Court and ruled in favor of the taxpayers.
For other taxpayers in the Eleventh Circuit that have only the improvements provision issue and no other identified problems with their easement deeds, this case should be considered a big win and should result in the allowance of the claimed conservation easement deductions (subject, of course, to any valuation-based challenges). But for other taxpayers, the scope of this decision is arguably less clear. We have already seen that taxpayers and the government are taking different positions on the holding. In Oakbrook Land Holdings, LLC v. Commissioner,4 another conservation easement case on appeal from the Tax Court, for example, the parties filed comments with the Sixth Circuit Court of Appeals following the decision in Hewitt, taking opposing views on whether the decision invalidated the regulations in their entirety. As reflected in those comments, the court's holding — that the IRS's "interpretation of Treas. Reg. § 1.170A-14(g)(6)(ii) . . . is arbitrary and capricious and violates the APA's procedural requirements" — may be interpretated in one of two ways. On the one hand, Hewitt could be read broadly as invalidating the entirety of Treas. Reg. § 1.170A-14(g)(6)(ii). If this interpretation holds, as we believe it should, taxpayers should be able to defend against IRS attacks based on the proceeds regulations, including attacks regarding the proportionate value formula, by arguing that the regulations are invalid. On the other hand, we expect that the IRS will take the position, as the Department of Justice has in the Oakbrook case, that the decision should be interpreted narrowly to invalidate the regulations only as applied to improvements provisions like the one at issue in Hewitt.
We may get more clarity on the scope of Hewitt when the Sixth Circuit Court of Appeals issues its decision in Oakbrook.5 The decision is expected imminently (oral argument was held a few weeks prior to the Hewitt argument). The Oakbrook facts overlap significantly with those in Hewitt – it has both the improvement provision issue and a similar APA challenge to the regulations. In addition, the Oakbrook easement has a second problem under the proceeds regulations, because it provides that the donee is entitled to a fixed value determined at the time of the donation, rather than a proportionate value determined at the time of the sale. Thus, it is possible that the Sixth Circuit Court of Appeals could sidestep the issues in Hewitt involving the validity of the regulations entirely, by deciding that the proportionate value problem violates the statute (rather than the regulations). Alternatively, the court could review the validity of the proceeds regulations as applied to the proportionate value issue, without addressing the improvement provision. Finally, and most interestingly, it is possible that the Oakbrook court will address the very same issues that were addressed in Hewitt and may either agree with Hewitt or set up a split in the Circuits regarding the APA challenge to the regulations.
Taking a step back from its implications on conservation easement cases, Hewitt represents one of the few successful challenges to a Treasury regulation on procedural grounds.6 Treasury and the IRS were long considered immune from the APA's requirements, but the trend has shifted in recent years.7 We expect that this trend could continue, and we may continue to see more challenges to Treasury and IRS agency determinations in appropriate cases.
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1 Hewitt v. Comm'r of IRS, No. 20-13700, 2021 U.S. App. LEXIS 38555 (11th Cir. Dec. 29, 2021).
2 Treas. Reg. § 1.170A-14(g)(6)(ii).
4 Oakbrook Land Holdings, LLC v. Comm’r, No. 20-02141 (6th Cir. filed Nov. 23, 2020).
6 See, e.g., Dominion Res., Inc. v. United States, 681 F.3d 1313 (Fed. Cir. 2012) (holding that Treasury failed to provide a reasoned explanation when it promulgated the regulation at issue and, therefore, it was unlawful under the APA); Altera Corp. v. Comm'r, 145 T.C. 91 (2015) (holding in a unanimous decision that Treasury failed to respond to significant comments when promulgating the regulation at issue), rev'd, 926 F.3d 1061 (2019); Chamber of Com. of U.S.A. v. IRS, No. 1:16-cv-944-LY, 2017 BL 358853 (W.D. Tex. Sept. 29, 2017) (holding that Treasury violated the APA by issuing legislative regulations without adhering to notice and comment procedures).
7 See e.g., Mann Constr. Inc. v. United States, No. 201500 (6th Cir. filed May 14, 2021); Liberty Glob., Inc. v. United States, No. 1:20-cv-03501 (D. Colo. filed Nov. 27, 2020); FedEx Corp. v. United States, No. 2:20-cv-02794 (W.D. Tenn. filed Nov. 2, 2020); CIC Servs., LLC v. IRS, No. 3:17-cv-00110 (E.D. Tenn. filed Mar. 27, 2017); 3M Co. v. Comm'r, No. 5816-13 (US Tax Ct. filed Mar. 11, 2013).
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