United States: Tax-Deductible Conservation Easements: Creation, Analysis, Litigation

By Richard F. Riley*

The Internal Revenue Service ("IRS") and state tax authorities have announced that real estate conservation easements – especially their proper valuation – will be a major focus of tax enforcement activity (audits and litigation). Foley & Lardner LLP has the experience and knowledge to assist with the defense of challenged conservation easements, analyze proposed easements, and structure new easements designed to withstand potential challenge to the greatest extent possible.

The creation and donation of conservation easements on real estate – urban or rural; undeveloped or developed; agricultural, commercial, or residential – can, if properly structured and valued, be a major tax saving opportunity for individual and corporate property owners and a source of substantial donated assets for nonprofit conservation organizations and government conservation agencies. The IRS is likely to audit tax returns claiming deductions for conservation easements, so properly structuring and valuing the conservation easement is critical.

Federal tax law generally does not allow a charitable deduction for a donation of a partial interest in property, such as an easement that regulates or restricts the use of real estate. However, for both individual and corporate taxpayers, an exception allows a deduction for the value of a use restriction on property (an easement) donated to a conservation-oriented tax-exempt organization or government agency that accomplishes one of the following:

• Preservation of land areas for public outdoor recreation or education.

• Protection of natural habitat or ecosystems for fish, wildlife, or plants.

• Preservation of open space for scenic enjoyment or pursuant to a specific federal, state, or local conservation policy.

• Preservation of historically important land or a certified historic structure.

In addition, many states now allow a separate deduction or even a tax credit for state income tax purposes for the donation of some or all of the above types of conservation easements.

The appraiser generally values the conservation for tax deduction or credit purposes using a before-and-after method. That is, the appraiser subtracts the value of the land after the creation and donation of the conservation easement from the value of the land immediately before the easement, and the difference is the amount of the charitable contribution deduction or credit. Note that this essentially requires two appraisals – the value before the easement and the value afterward – and determining the true character of the restrictions created by the easement, in light of restrictions (zoning laws, environmental rules, etc.) that already existed on the property, can be a sophisticated appraisal challenge.

Under both federal and state tax law, there are numerous additional rules governing the types of organizations that may receive and hold the conservation easements, the wording of the restrictions in the easement, and the property eligible for the donation. In addition, federal and state tax rules may differ even with respect to the same easement. A donation of a conservation easement is a very complex transaction, but properly structured, conservation easement donations provide tax benefits for a property owner and promote important conservation interests such as open space preservation, habitat protection, and historic preservation.

Foley & Lardner LLP attorneys are very experienced in all aspects of the creation, donation, and post-donation analysis and defense of conservation easements, including litigation where necessary. Our conservation easement matters include representation of both property owners and developers (donors) and public and private conservation groups (donees) in easements on timberland, undeveloped rural property, environmentally sensitive property, historic structures including both residential and commercial buildings, and many others. We have worked on highly specialized projects including proposals to treat creation of a golf course as an open space easement and providing advice to a state tax agency regarding the reasonableness of the appraisal of a conservation easement and satisfaction of the specific terms of the state tax credit law. We are currently defending taxpayers whose conservation easement deductions are under audit. Foley & Lardner LLP is a national law firm, and our conservation easement projects have arisen throughout the United States.

A critical reason for involving an experienced, widely knowledgeable firm like Foley & Lardner in creating, analyzing and defending conservation easements is that easement tax deductions and credits are publicly announced enforcement priorities of the Internal Revenue Service and state tax agencies. Federal and state officials have testified in Congress and spoken publicly about their concerns that promoters and taxpayers are inappropriately over-inflating valuations of conservation easements. Foley & Lardner LLP can help assure that your conservation easement is properly structured and persuasively appraised to provide all allowable tax benefits while minimizing the risk of successful IRS or State Revenue Department challenge. We also defend challenged deductions and credits structured by others.

Foley & Lardner LLP appreciates the opportunity to discuss the planning, analysis, and defense of conservation easements, under consideration or in place, with property owners, developers, conservation groups, government agencies, appraisers, and others involved in the easement process.

The pending Tax Relief Act of 2005 includes two provisions which will significantly change the taxation of personal use of corporate aircraft. The first provision threatens to increase the amount of income imputed to employees who receive a flight on an employer-provided aircraft. The second provision increases limitations on deducting costs associated with personal use of corporate aircraft.

Legitimate business travel on a corporate aircraft is a deductible company expense. However, Section 274 of the Internal Revenue Code (the "Code") generally prohibits all deductions related to an aircraft when that aircraft is used for personal or entertainment purposes. There is an exception to this rule, which permits employers to deduct these aircraft expenses "to the extent" they report the employee’s personal use of the aircraft as a taxable fringe benefit to the employee. Until October 21, 2004, many companies fully deducted the costs of the personal use of corporate aircraft by employees under Section 274 under the reasoning established in Sutherland Lumber-Southwest, Inc. v. Commissioner 255 F.3d 495 (8th Cir. 2001). In Sutherland Lumber, the court interpreted the phrase "to the extent" to allow employers a full deduction of the costs associated with the personal use of the aircraft as long as long they reported these costs at the Standard Industry Fare Level ("SIFL") Rates as a taxable fringe benefit to the employee.

For corporate aircraft owners, this created a potential tax strategy. A company could allow its officers and directors to use the company plane for personal flights, and while the company could deduct the entire amount of the actual operating costs of such flights, the officers or directors who used the company plane would only be required to include in their personal income the amount of the fringe benefit determined under the Code’s SIFL valuation rates, which generally was an amount much lower than the actual costs of operating the aircraft.

As this tax strategy became more popular, many in the public and in Congress perceived this as a loophole that should be closed. Eventually this culminated in certain legislative changes limiting a company’s ability to deduct expenses for the personal use of business aircraft enacted in the American JOBS Creation Act of 2004, which became effective on October 22, 2004.

To close the perceived loophole, the JOBS Act amended Section 274 to limit the company’s deduction to the amount reported as a taxable fringe benefit by the individual using the aircraft. The limitation only applies to individuals who are "specified individuals," which includes any person who is the direct or indirect owner of more than 10% of any class of equity security of the company, and any officer or director of the company. For individuals who are not considered to be "specified individuals," the exception in Section 274 continued to apply – allowing a full deduction to the company for the amount of the aircraft operating costs attributable to flights for entertainment purposes if the taxable fringe benefit is properly reported.

The Tax Relief Act of 2005 includes two provisions that further limit the ability of a company to deduct expenses for the personal use of a business aircraft. The first provision does away with the friendly SIFL rates, and instead taxes an employee receiving a personal use flight of a corporate aircraft at the higher of fair market value or the full cost (including both fixed and variable costs) of the flight. The second provision applies the deduction limitation created by the JOBS Act to all employees rather than just "specified individuals." These changes will have a dramatic effect on personal use of business aircraft and taxpayers who oppose these changes should make their congressional representatives aware. The National Business Aviation Association has created a easy way to do this electronically on their website at http://web.nbaa.org/public/govt/action/ under the heading "Oppose Harmful Proposals for Business Aircraft Use"). Any concerns your company may have should be voiced soon. The Senate and the House have each passed differing versions of the Tax Relief Act of 2005, and are currently attempting to resolve their legislative differences.

Foley & Lardner LLP can help companies review their current policies regarding personal use of corporate aircraft and answer questions on how these policies will need to be changed if the Tax Relief Act of 2005 is passed. Further, Foley & Lardner LLP can also help with a number of closely related tax issues, including inter-company travel provided to members of consolidated groups, mixed purpose flights (i.e., business and pleasure), tax planning strategies and proper calculation of any disallowance of aircraft operating cost.

*Richard F. Riley is a tax partner in the Washington D.C. office of Foley & Lardner LLP.

*Tymon C. Daniels is a tax associate in the Madison office of Foley & Lardner LLP.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.