April 22, 2019

Tenth Circuit: Tax Court Did Not Err in Concluding Highest and Best Use for Property Was Agriculture Before Conservation Easement Was Granted

The Tenth Circuit Court of Appeals published its opinion in Esgar Corporation v. Commissioner of Internal Revenue on Friday, March 7, 2014.

On December 17, 2004, the Taxpayers (Esgar Corporation, George and Georgetta Tempel, and Delmar and Patricia Holmes) each donated a conservation easement over their respective property to the Greenlands Reserve. The donations granted a perpetual easement over the properties, giving Greenlands the right to preserve the natural condition of the land and protect its biological, ecological, and environmental characteristics.

The Taxpayers claimed charitable deductions on their 2004, 2005, and 2006 tax returns for “qualified conservation contributions” under I.R.C. §170(f)(3)(B)(iii). The Taxpayers engaged William Milenski to appraise their contributions. Mr. Milenski concluded that, had the conservation easements not been granted, the properties would have realized their greatest potential as a gravel mining operation. Based on the value of that relinquished use, Mr. Milenski valued each of the Taxpayers’ conservation easements. Also as a result of their donations, the Taxpayers received transferable tax credits from the State of Colorado. Within two weeks of receiving the credits, the Taxpayers sold portions of their credits to third parties.

After an audit of the Taxpayers’ 2004, 2005, and 2006 returns, the Commissioner determined that the Taxpayers’ conservation easements were in fact valueless and that the sales proceeds from their state tax credits should be reported as ordinary income. The Commissioner issued notices of deficiency for the 2004, 2005, and 2006 tax years.

A trial was held where the only issue was the highest and best use of  property before the easement. The Commissioner argued it was agriculture and the Taxpayers argued it was gravel mining. The Tax Court sided with the Commissioner and this appeal followed.

The Taxpayers first argued that the Tax Court erred by placing on them the burden of proving the before value of their properties. Generally, deductions are a matter of legislative grace, and a taxpayer bears the burden of proving entitlement to any claimed deduction. However, Section 7491(a) of the I.R.C. shifts the burden of proof to the Commissioner on any factual issue that the taxpayer supports with credible evidence. The Taxpayers argued that they introduced credible evidence that gravel mining was their properties’ highest and best use, thus shifting the burden to the Commissioner. However, the Tenth Circuit held that Section 7491 does not require burden shift when, as here, both parties produced evidence and the evidence weighed in the Commissioner’s favor.

The Taxpayers also argued that the Tax Court erred by drawing an adverse factual inference against them. The Tax Court stated: “Neither [the Taxpayers] nor their experts provided us with an estimate of remaining aggregate. [The Taxpayers] own the land on which the Midwestern Farms Pit is situated and chose not to provide information on the amount of aggregate remaining. Their failure to introduce evidence “which if true, would be favorable to . . . [them], gives rise to the presumption that if produced it would be unfavorable.”

The Taxpayers argued that it was impermissible to use this “missing evidence” inference against them, given that the burden of proof rested with the Commissioner. The Tenth Circuit disagreed. It is the function of the Tax Court to draw appropriate inferences, and choose between conflicting inferences in finding the facts of a case.

Next, the Taxpayers argued that the Tax Court applied erroneous legal standards to value their conservation easements. They made two arguments: (1) that the Tax Court erred by adopting the properties’ current use as its highest and best use rather than taking a “development-based approach,” and (2) that the Tax Court erred by citing eminent domain principles in reaching its valuation determination.

Valuation does not depend on whether the owner actually has put the property to its highest and best use. Rather, courts must focus on the highest and most profitable use for which the property is adaptable and needed or likely to be needed in the reasonably near future. After taking into account the properties’ current use and the fact that the likelihood of development was remote, the Tax Court certainly could find that the properties’ current use, agriculture, was its highest and best use. The Tax Court applied the correct highest and best use standard, looking for the use that was most reasonably probable in the reasonably near future, and it did not clearly err by concluding that use was agriculture.

The Taxpayers argued that eminent domain principles—standards used to value property to determine just compensation—were inapplicable when valuing conservation easements. Just compensation valuation requires an identical finding, i.e., the “highest and most profitable use” for which the property was suited before the taking. The objective assessment that the Treasury Regulations require do not materially differ from those used to determine the highest and best use of property for just compensation valuation.

Finally, the Taxpayers argued that their state tax credits, which they held for about two weeks, were long-term capital assets. However, the Tenth Circuit held that the Tax Court correctly concluded that the Taxpayers had no property rights in a conservation easement contribution State tax credit until the donation was complete and the credits were granted. The credits never were, nor did they become, part of the Taxpayers’ real property rights. Instead, the Taxpayers’ holding period in their credits began at the time the credits were granted and ended when petitioners sold them. Since petitioners sold their State tax credits in the same month in which they received them, the capital gains from the sale of the credits were short term.

AFFIRMED.

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