Offering prospective investors charitable deduction
of at least 2 and one-half times their investment
Notice 2017-10

The IRS has issued IRS Notice 2017-10, indicating that they have identified a new listed transaction, known as a syndicated conservation easement transaction.  These are ones that are promoted as providing investors with the opportunity to obtain charitable contribution deductions in amounts that significantly exceed the amount invested.

Of course, under IRC Section 170(f)(3)(B)(iii), a deduction is allowed for a deduction of a qualified conservation contribution.  This is one that is a contribution of a “qualified real property interest” (QRPI) to a qualified organization exclusively for conservation purposes. See IRC Section 170(h)(1) thorugh (5); see also Regs. Section 1.170A-14.  Under IRC 170(h)(2)(C), QRPIs include a restriction, granted in perpetuity, on the use that may be made of real property.  For purposes of this notice, the IRS is treating the QRPI as referring to a conservation easement only.

Promoters of these syndicated conservation easement transactions go to prospective investors in a partnership or other pass-through entity the possibility of a charitable contribution deduction for donations of a conservation easement, and by this, they identify the pass-through entity that owns real property, or they form one.  Additional tiers of pass-through entities may be formed and become part of the structure.

The promotional materials then suggest that prospective investors may be entitled to a share of a charitable contribution deduction that equals or exceeds an amount that is 2 and one-half times the amount of the investor’s investment.  The promoters obtain an appraisal that purports to be a “qualified appraisal” under IRC 170(f)(11)(E)(i) but, in fact, it greatly inflates the value of the conservation easement based on unreasonable conclusions about the development potential of the real property.  After the investor invests in the pass-through entity, the pass-through entity turns around and “donates” the conservation easement encumbering the property to a tax-exempt entity.  Investors holding their interest in the pass-through entity for less than 1 year rely on the pass-through entity’s holding period in the underlying real property to treat the donated conservation easement as LTCG property under IRC 170(e)(1).

The promoter receives a fee or other consideration with respect to his or her or its promotion and this may be in the form of an interest in the pass-through entity.

The IRS focus of the attack will be on the overvaluation of the conservation easement.  The IRS announces that they may also challenge the purported tax benefits from the transaction, using the partnership anti-abuse rule, econonmic substance or other such rules or doctrines.

The promotional materials may be oral or written.

Donees are not treated as a party to the transaction or as a participant under 1.6011-4.  Participants generally include investors, the pass-through entity and any tier) and any other person whose tax return reflects tax consequences of this transaction.

The IRS is focused on transactions entered into on or after January 1, 2010 that are the same as, or substantially similar to, this transaction.  Persons entering into this transaction on or after January 1, 2010 must disclose these for each year they participated in the transactions provided the period of limitations for assessment has not ended as of December 23, 2016.  Material advisors, including appraisers, who make a “tax statement” on or after January 1, 2010 with respect to transactions entered into on or after January 1, 2010, have disclosure and list maintenance obligations under IRC Sections 6111 and 6112.    May 1, 2017 is a deadline for those otherwise obligated to file a disclosure statement.

In Green Valley Investors, LLC v. Commissioner, 159 T.C. No. 5 (November 9, 2022), the United States Tax Court held that IRS Notice 2017-10, 2017-4 I.R.B. 544 was a “legislative rule” because by its issuance, Notice 2017-10 created new substantive reporting obligations for taxpayers and material advisors, the violation of which prompts exposure to financial penalties and sanctions.  As such, imposition of Section 6662A penalties may be prohibited, given that Notice 2017-10 was issued without notice and comment as required under the APA and nothing under 26 U.S.C. Section 6011 nor 26 USCS Section 6707A sets forth language that would lead the court to conclude that the IRS is exempt from the baseline procedures for rulemaking under the APA.

In the Green Valley Investors case, the IRS argued before the United States Tax Court that Congress authorized the IRS to identify “listed transactions” without notice and comment rulemaking, based on the text of Section 6707A, Regulation 1.6011-4, and other provisions of the American Jobs Creation Act of 2004 (AJCA).  Section 6662A was enacted as part of the AJCA, effective for tax years after October 22, 2004.  After enactment of the AJCA, temporary regulations were issued, defining “listed transactions” to include those types of transactions which the IRS has determined to be tax avoidance transactions and identified by notice, regulation or other form of published guidance.  After publishing this temporary regulation, the IRS requested comments.  Additional notice and request for comments was then published in Notices 2005-11 and 2005-12, which alerted taxpayers to amendments and invited comments from the public regarding rules and standards relating to Sections 6707A, 6662A, 6662, and 6664, as amended.  2022 U.S. Tax Ct. LEXIS 643, at *6-7.  Final regulations were then published, with the IRS again requesting comments as to Regulations Section 1.6011-4, and the term “listed transaction” continuing to be defined as a transaction that is the same or substantially similar to one of the types of transactions that the IRS has determined to be tax avoidance transactions and identified by notice, regulation, or other forms of published guidance.  Regs. Section 1.6011-4(b)(2).  Id.

Notice 2017-10 was issued AFTER the taxpayer LLCs sought to benefit from the identified conservation easement transactions.  The returns that were filed were partnership tax returns (Form 1065 (2014), timely filed in 2015, claiming a deduction for a charitable easement contribution deduction, as made to Triangle Land Conservancy on December 31, 2014.  It was not until December 23, 2016 when the IRS issued Notice 2017-10, identifying ALL syndicated conservation easement transactions beginning January 1, 2010, including all substantially similar transactions, as “listed transactions” for purposes of the reporting obligations and Regulations 1.6011-4(b)(2).  These LLC taxpayers were issued notices of final partnership administrative adjustment (FPAA) on June 24, 2019, declaring that the IRS was seeking to disallow the claimed deductions for these noncash charitable contributions, on the basis that these LLCs did not establish that they met all of the criteria for deduction under IRC Section 170 and they failed to establish that the values of the property interests contributed exceeded -0-.  In addition, the FPAA asserted that the taxpayers should be penalized, using the gross valuation misstatement penalty (Section 6662(h)), a substantial valuation misstatement penalty (Section 6662(e)), a negligence penalty (Section 6662(b)(1) and (c)) and a substantial understatement penalty under Section 6662(b)(2) and (d).  Later, in pleadings, the IRS sought to impose the reportable transaction penalty under Section 6662A.  On September 20, 2019, the LLC taxpayers petitioned the Tax Court, challenging the FPAA determinations.  Id., at *3-5.

The taxpayers did not dispute that the transactions they had pursued were the same or substantially similar to the certain syndicated conservation easement transactions described in Notice 2017-10.

The taxpayers argued that Regulation 1.6011-4 requires the IRS to identify a transaction as being reportable, prospectively.  However, as the IRS noted, Regulation 1.6011-4(e)(2) sets forth that the taxpayer has a duty to disclose a previous transaction within 90 calendar days from the date in which the prior transaction becomes a listed transaction or transaction of interest, so long as the period of limitations for assessment remains open.  And, as the Tax Court notes, they have upheld “retroactive” assessments of penalties, even in cases when the taxpayers become subject to penalties after they had entered into transactions or after their tax returns had been filed, citing to Soni v. Commissioner, T.C. Memo 2013-30, at 8-9, Kenna Trading, LLC v. Commissioner, 143 T.C. 322, 371-72 (2014), Patin v. Commissioner, 88 T.C. 1086, 1127 n. 34 (1987), Skeen v. Commissioner, 864 F.2d 93 (9th Cir. 1989), Hatheway v. Commissioner, 856 F. 2d 186 (4th Cir. 1988), McGehee Family Clinic, P.A. v. Commissioner, T. C. Memo 2010-202.  Id. at 7-8.  When the taxpayers responded by asserting that the United States Supreme Court had struck down the retroactive application of a newly promulgated regulation by the DHHS in Bowen v. Georgetown University Hospital, 488 U.S. 204, 208 (1988), the Tax Court declined to decide whether Section 6662A penalties can be applied retroactively, on the basis of these cases.

Instead, the Tax Court reviewed the Notice and Comment requirements under the APA.  A 3-step procedure for notice and comment rulemaking mandates that agencies like the IRS are required to issue a general notice of proposed rulemaking, allow interested persons an opportunity to participate, and include in the final rule a concise general statement of its basis and purpose.  Perez v. Mortg. Bankers Ass’n, 575 U.S. 92, 96 (2015)(quoting 5 USC Section 553(c)).

That being said, the Tax Court notes that not all “rules” must be subjected to the notice and comment process.  For example, such process does not apply to interpretive rules, general statements of policy, or rules of agency organization, procedure, or practice.  And the APA recognizes that Congress may modify these requirements.

The Tax Court also notes that according the U.S. Supreme Court in CIC Servs, LLC v. IRS, 141 S. Ct 1582 (2021), material advisors have a right to challenge any IRS notice as potentially violating the APA.  And, in CIC Services, the Federal Court there had indicated that the taxpayer was likely to prevail on its challenge of Notice 2016-66, specifically because of the IRS’s failure to first comply with APA’s notice and comment requirements.

The IRS argued then that these concerns are unfounded because Notice 2017-10 was an interpretative rule, not a legislative rule (but even if legislative, Congress authorized issuance by procedure, overruling application of the notice and comment requirements under the APA).  2022 U.S. Tax Ct. LEXIS 643, at *10.

The Tax Court held that the act of identifying a transaction as a listed transaction is, by its very nature, the creation of a substantive (i.e., legislative) rule and not merely one of interpretation.  Thus, a legislative rule.  By its issuance, Notice 2017-10 creates new substantive reporting obligations (IRS Form 8886 and IRS Form 8918, and maintain lists) for taxpayers and material advisors, the violation of which prompts exposure to financial penalties and sanctions–or as the Tax Court puts it, “the prototype of a legislative rule.”  Id at *20-21.

The Tax Court then rejects the IRS argument that Congress intended on exempting the IRS from having to comply with notice and comment rulemaking under the APA, when it enacted Section 6707A.  (APA does allow an agency to depart from normal notice and comment procedures for good cause, but the IRS elected NOT to invoke the good cause exception when issuing Notice 2017-10).  Despite efforts by the IRS to look to congressional oversight hearings, written statements by chairs of committees, and testimony, to then claim that these amount to expressions of Congressional intent sufficient to override the requirements of the APA, the Tax Court remained “unconvinced” that Congress expressly authorized the IRS to identify syndicated conservation easement transactions as a listed transaction without complying with APA’s notice and comment procedures.  Thus, the Tax Court ruled that summary adjudication in favor of the taxpayers was appropriate as to prevent imposition of the Section 6662A penalties, since Notice 2017-10 was issued without notice and comment as required by the APA.

In a concurring opinion, Judge Pugh points out that the IRS could have chosen to invoke the good cause exception, as it did when issuing regulations targeting another listed transaction, the so-called Son-of-Boss transactions (Notice 2000-44).  Judge Gale dissents, focusing on how Congress, in enacting Section 6707A, expressly referenced the regulations under Section 6011, and in doing so, intended to except identification of listed transactions from the notice and comment requirements of the APA.  Judge Nega also dissents, concerned that the majority’s holding is “worryingly close to a standard requiring magical passwords in order to effectuate an exemption from” the APA, and that cross-referencing to the regulations under Section 6011 constituted strong textual evidence of Congress’ intent to replace the ritual application of the APA in this area.