IRS conservation easement mistakes reflected in fight against Covid fraud

The IRS's crackdown on syndicated conservation easement fraud was a no-brainer.

Groups of wealthy investors assembled by aggressive tax planners claimed tax deductions for their land donations to charities that were so inflated that they practically led to investigations.

But a series of missteps – including refusing to issue regulations for taxpayers, relying on older, legally challengeable rules and being caught backdating documents in a major case – have hampered the IRS's efforts to end an abusive tax haven that is costing the government billions of dollars.

“Missed opportunities is the right mindset,” David Foster, a partner at Kirkland & Ellis LLP who has represented donors in many syndicated conservation easements, said of the IRS's strategy. “There were a lot of decisions made that were individually defendable, but taken as a whole, they didn't turn out the way anyone – or the government – expected.”

“There was just some kind of fundamental strategic miscalculation in the way easements were enforced.”

Tax lawyers say the agency is now repeating a crucial mistake in what could be its next big fight against allegedly fraudulent claims for billions of dollars in Covid-era employer tax credits.

Despite multiple requests, the IRS did not comment or make an official available for an interview.

Original Sins

The abuse of conservation easements by syndicates can be shocking in some cases and defies common sense. How can a charitable tax deduction of four, five, or even six times the value of a property be legal? How can anyone claim that Arkansas scrubland is worth the same as oceanfront property?

Yet early on, IRS agents were outmatched by experienced attorneys representing easement sponsors and investors, and struggled to handle the growing flood of cases in all areas rather than fighting each claimed deduction individually.

The IRS responded to abusive deductions in 2010 and could have created rules to address them, said Michelle Levin, a Dentons shareholder who represents easement grantors. Instead, the agency resurrected old rules to ban a large number of easements at once, tax lawyers say. That decision would come back to haunt the agency.

“One of the biggest mistakes the IRS made in the easement issue is that they didn't create guidelines,” Levin said. “They had a lot of time to put together regulations, and that would have been a better way to regulate this issue.”

Perhaps the most notable of the old rules the IRS relied on was Treas. Reg. 1.170A-14(g)(6)(ii) – also known as the proceeds clause. It is a rule from the 1980s that required all charitable donations to be made in perpetuity for a taxpayer to claim the deduction.

Critics of the IRS approach say the agency has used the rule to crack down on anything that could be construed as a violation of the rule. “They have no way of distinguishing between good and bad, so they treat them all the same,” Levin said.

For example, suppose “a road runs across the property, but the landowner reserves the right to repair or relocate the road if it becomes damaged. Then they would say, 'Well, that's not a permanent solution,' and the whole thing would be demolished,” says Adam Looney, a professor at the University of Utah and a former U.S. Treasury official.

“So you can imagine that if you're a reputable land trust and you do a good transaction, the risk that your whole transaction could fall apart because of a silly technicality makes it very difficult to execute,” Looney said.

Proceeds clause

Had the agency issued guidance on using the proceeds clause, that approach might have worked, Foster said. But instead it faced procedural challenges that culminated in a U.S. Tax Court ruling in March that invalidated the rule itself because the agency failed to consider all comments under the Administrative Procedure Act.

This forced the agency to litigate in each case on the basis of the values ​​claimed for each easement.

“If the government had legitimate concerns about what the proceeds clause could have looked like or what it should have looked like, they could have easily said, 'If that's what your proceeds clause says, we have no problem with it,'” Foster said. “They chose not to do that. But to be clear, that's because the proceeds clause litigation was never about the proceeds clause, it was about a government strategy to zero out large portions of the claims.”

New rules are a common method for the IRS to strengthen problem areas in the Code, and its rulemaking process in recent years has been marked by legal challenges and strict adherence to APA requirements.

“They've done that in other contexts, like with charitable remainder trusts and charitable lead trusts, right? They issue guidelines and say, 'Here are the terms you need to put in these trusts to make them compliant,' and they should have done that,” said Nancy McLaughlin, a law professor at the University of Utah.

Congress finally intervened in 2022, passing a law that limits the conservation easement deduction to 2.5 times the taxable basis for land owned for less than three years. That year, the IRS began drafting rules limiting the ability of partnerships and pass-through entities to claim conservation easement deductions and finalized those rules in June.

But in the meantime, an ever-growing mountain of cases had piled up before the US tax court. At least 750 such cases are still before the court, wrote Judge Ronald Buch in a recent opinion.

Profits are coming in

Curiously, the recent tax court rulings have given the IRS its first victory in years against conservation requirements, says Russ Shay, an independent consultant and former director of public policy at the Land Trust Alliance, which advocates for land trusts and conservation organizations.

The agency has had a number of successes that practitioners attribute to a new approach that focuses on assessments rather than the specifics of legislation.

“It was actually the tax judges who pushed the IRS to abandon its long-standing aversion to dealing with assessments and to look for shortcuts to exclude cases, which they did not find,” Shay said.

Diana Norris, director of the Alliance's Conservation Defense Network and tax division, said the IRS has also had some success in investigating donors' business activities to uncover potential grounds for disqualification.

“We've seen the IRS focus more on the business models in the abusive transactions rather than winning with hyper-technical arguments about land protection,” she said. “More cases on valuations; more cases on how the partnerships hold these interests and how they are classified; are they investments or inventory?”

However, it is unclear whether the IRS has adjusted its strategic considerations regarding tax avoidance through conservation easements or is merely reacting to decisions of the tax court.

The agency's next big problem – employee retention fraud – dwarfs the problem of conservation easement abuse. The agency reported 1.4 million overdue ERC applications last month and said up to 70 percent of them showed signs of unacceptable levels of risk, though its estimates have been dismissed.

The IRS has attempted to reduce the number of cases it may have to litigate by granting taxpayers partial amnesty who do not want to risk having their claims examined.

Bigger fights

There are certainly big differences between the ERC requirements and the deductions for conservation easements.

Conservation mandates have been around for decades, while Congress passed the ERC program and the IRS rushed to implement it to get money to businesses trying to survive the global Covid-19 pandemic. That left little time to issue regulations, and when the agency realized it was a problem, it felt there was too little time for the legislative process, said Christopher Ferguson, a partner at Kostelanetz LLP.

But as with conservation easements before it, the IRS has relied on sub-legislative guidance with ERCs. It has not yet proposed formal regulations to oversee the area. And following the U.S. Supreme Court decisions in Loper Bright And Corner post, removing previous restrictions on legal challenges to agency regulations, the IRS's sub-statutory guidance on ERCs may be more vulnerable to legal challenges than if it had issued official regulations, Ferguson said.

This approach runs counter to the agency's recent efforts to adopt rules that address other areas of potential abuse, particularly through partnerships.

The IRS issued a proposed rule on basis shifting in June and said it expects the change to generate more than $50 billion over the next decade. Its spring agenda listed three other ongoing rules — including those on undercover sales of partnership interests, transactions involving a partner's interest and the definition of a limited partner's substantial interest.

Dentons' Levin said the agency could set rules for employee retention credits if necessary, potentially saving itself some hassle.

“They have the authority,” she said. “They just haven't learned from their mistakes.”