August 25, 2019

Tenth Circuit: Plain Language of Regulation Requires Mortgage Subordination at Date of Conservation Easement Donation

The Tenth Circuit Court of Appeals issued its opinion in Mitchell v. Commissioner of Internal Revenue on Tuesday, January 6, 2015.

Ms. Mitchell and her late husband purchased property from Mr. Sheek subject an agreement to pay the balance to Mr. Sheek in yearly installments. In 2003, they granted a conservation easement on part of their property to the Montezuma Land Conservancy. At the time of the donation, the Mitchells did not obtain a mortgage subordination agreement from Mr. Sheek, but they did obtain one in 2005. The Mitchells claimed a charitable contribution deduction on their 2003 tax return.

In 2010, the Commissioner of the IRS mailed a notice of deficiency to Ms. Mitchell disallowing the charitable contribution for failure to meet certain Code requirements, specifically for not obtaining a mortgage subordination agreement at the time of the donation. Ms. Mitchell challenged the Commissioner’s determination in Tax Court, but the Tax Court denied the claimed charitable contribution, concluding the Code and its implementing regulations mandated that the mortgage be subordinated on the date of the donation. Ms. Mitchell appealed to the Tenth Circuit.

The Tenth Circuit first analyzed the applicable Code provisions, in particular noting the Code mandates that a contribution shall not be treated as exclusively for contribution purposes unless the contribution is protected in perpetuity. The Commissioner developed the mortgage subordination provision as a means to protect the conservation in perpetuity. The Tenth Circuit accordingly focused its inquiry on whether the regulations can be interpreted to entitle Ms. Mitchell to the deduction despite the undisputed fact that the mortgage was not subordinated on the date of the donation.

The Tenth Circuit first turned to Ms. Mitchell’s claim that, because the regulations are silent on the date of subordination, she is entitled to the deduction because the mortgage was eventually subordinated. The Tenth Circuit disagreed, finding the plain language of the regulation precluded her interpretation, and even if they were to view the regulation as ambiguous, they would defer to the Commissioner’s reasonable interpretation.

Ms. Mitchell next argues that strict compliance with the regulation was unnecessary because the risk of foreclosure was so remote as to be negligible, and because of a Deed provision that allegedly protected the property in perpetuity. The Tenth Circuit found that the plain language of the regulation required it to reject Ms. Mitchell’s arguments.

The Tenth Circuit affirmed the Tax Court’s decision.

Tenth Circuit: ConocoPhillips Entitled to Neither “Basis-Increase” Nor “Going-Forward Deductions

The Tenth Circuit Court of Appeals published its opinion in United States v. ConocoPhillips Company on Wednesday, March 11, 2014.

In the 1970s and 1980s, the Internal Revenue Service was embroiled in a tax dispute with multiple companies (including Phillips Petroleum Company and Arco Transportation Alaska, Inc.) that had jointly developed a pipeline system known as the Trans-Alaska Pipeline System (“TAPS”). The parties agreed to settle the dispute through a Closing Agreement. After entering the agreement, Phillips Petroleum Company (now ConocoPhillips Company) acquired Arco Transportation. In 2000 and 2001, Conoco revisited the tax implications of its acquisition and claimed “going-forward” and “basis-increase” deductions on its amended consolidated tax returns. The IRS refunded Conoco’s 2000 going-forward deductions and did not challenge them here. But the IRS disputed the remaining deductions and the parties brought the dispute to federal district court, where the district court decided the issue on cross-motions for summary judgment. The court rejected Conoco’s position and granted summary judgment to the IRS. Conoco appealed.

Conoco claimed monthly “going-forward” deductions for the additional interests in TAPS that Arco Transportation acquired from 1977 to 2000 and the additional interest that it acquired in 2001. This contention was based on alternative theories that Arco Transportation was an “owner” or “successor in interest” under the Closing Agreement. However, the court held that Arco Transportation was considered an “owner” only with respect to its 21% ownership in TAPS as of July 1, 1977. For the subsequently-acquired interests, Arco Transportation was not considered an “owner.” Because Arco Transportation did not own the additional TAPS interests on July 1, 1977, it was not an “owner” with respect to these interests. Thus, Conoco was not entitled to “going-forward” deductions for these additional interests based on the theory that Arco Transportation was an “owner.”

The court then turned to the question whether Conoco was a “successor in interest.” Under the Closing Agreement, an entity became a “successor in interest” in two ways: (1) by succeeding the owner through statutory succession, or (2) by acquiring a TAPS interest from an affiliated entity when the transferor and transferee filed a consolidated tax return. Arco Transportation did not acquire its later-acquired interests by statutory succession or by transfer from a member of its consolidated group. Thus, Arco Transportation was not a successor in interest for the additional TAPS interests acquired from 1977 to 2001; and the parent company, Conoco, was not entitled to the tax benefit of Arco Transportation’s going-forward deductions on the 2001 consolidated tax return.

Conoco also claimed “basis-increase” deductions. But Conoco’s claim to these deductions was based on a misinterpretation of the scope of the Closing Agreement. Because the Closing Agreement did not fix a restoration cost/liability or exclude it from 26 U.S.C. § 461(h), Conoco was not permitted take the basis-increase deductions before economic performance.

In conclusion, the Tenth Circuit held that Conoco was not entitled to the asserted “going-forward” or “basis-increase” deductions. The court disallowed Conoco’s going-forward deductions because Arco Transportation was not an “owner” or a “successor in interest” with respect to the additional TAPS interests acquired from 1977 to 2001. The court also disallowed the basis-increase deductions because the Closing Agreement’s allowance of a $900 million aggregate deduction did not fix a liability or provide Conoco with a blanket exemption from § 461(h) for that amount.

Accordingly, the district court’s award of summary judgment to the government was AFFIRMED.

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.

Practice Area Preview: Tax Law—Tuesday, Feb. 25

Please consider joining the CBA Tax Law Section and the DBA YLD for Practice Area Preview on Tuesday, Feb. 25 at Rock Bottom Brewery. Everyone is encouraged to attend! The free event includes an informal discussion, complimentary drinks, appetizers and networking. Trevor A. Crow from Dufford & Brown P.C., Tyler C. Murray, President of The Law Offices of Murray & Wright, P.C., Lani A. Payne from KPMG, and Olena Ruth from the Merriam Law Firm will provide insight to attendees on what it is like to work as a young lawyer in the field of tax law. The  networking starts at 5:30 p.m. RSVP online or to lunches@cobar.org or call 303-860-1115, ext. 727.