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Appellate Court Invalidates Conservation Easement Regulation As Procedurally Defective

On December 29, the Eleventh Circuit in Hewitt v. Commissioner gave taxpayers a nice victory to ring in the New Year.  There, the Court struck down a 1980’s era conservation easement regulation and reminded Treasury and the IRS that the notice-and-comment cornerstone of the Administrative Procedures Act (APA) requires that agencies genuinely consider and address legitimate public comments received on proposed regulations.

In 1995, the Supreme Court in Perez v. Mortg. Bankers Ass'n, had described an essentially four-step procedure for notice-and-comment rulemaking: (1) an agency must formally notify the public of the proposed regulation; (2) the agency must “give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments;” (3) the agency “must consider and respond to significant comments received during the period for public comment;” and (4) the agency “must include in the rule's text “a concise general statement of [its] basis and purpose.”  These requirements generally apply to Treasury regulations, and if such regulations do not satisfy the requirements they are procedurally defective and invalid.

Courts are empowered to review Treasury regulations for such procedure defects, i.e., whether regulations meet the notice-and-comment requirements set forth in the APA and described in Perez v. Mortg. Bankers Ass'n.  See also Lowy, Legal Authorities in U.S. Federal Tax Matters – Research & Interpretation, 3rd Ed., TAX MANAGEMENT PORTFOLIO SERIES (2016), for a discussion of procedural and substantive defects that may invalidate regulations.  Importantly, the courts have clarified that the aforementioned notice-and-comment procedural requirements mandate that the agency include adequate explanations for reviewing courts to see the objections raised in relevant and significant comments to the agency and the choices the agency made in response to the comments.  This record of the regulatory action is necessary for the reviewing court to exercise its oversight under Section 706(2)(A) of the APA to “hold unlawful and set aside agency action, findings, and conclusions found to be ... arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”   

The Eleventh Circuit in Hewitt emphasized, as other courts have, that their review under the APA is not a “rubber stamp.”  The Court also emphasized that it reviews the adequacy of Treasury’s response to comments based on the regulatory record established during the notice-and-comment process.  Post-hac rationalizations cannot save an otherwise procedurally defective reg.  Quoting Supreme Court jurisprudence, the Eleventh Circuit stated: “[w]e may not supply a reasoned basis for the agency's action that the agency itself has not given,” and further explained that courts will not accept rationalizations from the government’s litigation counsel, but instead will rely on reasons articulated by the agency itself at the time it promulgated the regulation.

In Hewitt, the taxpayers sought a carryover charitable contribution deductions in the order of $2.7 million for donating an easement that traversed their family farm.  They donated the easement to the Atlantic Coast Conservancy.  Charitable deductions are generally allowable under Section 170(a), however a generally applicable caveat is that the donation must involve “the taxpayer's entire interest” in the donated property.  Section 170(f)(3)(A), however, provides an exception for “qualified conservation contributions.”  Among the definitional requirements in the statute to achieve qualified conservation contribution status is that the contribution be exclusively for conservation purposes, which requires that the conservation purpose of the easement be “protected in perpetuity.”  The statute, however, does not define the “protected in perpetuity” requirement. 

In 1983, Treasury noticed proposed rules “relating to contributions of partial interests in property for conservation purposes.”  In 1986, Treasury finalized the regulations which included Treas. Reg. § 1.170A-14(g)(6), governing the allocation of proceeds between the donor and donee in the event of judicial extinguishment of a donated conservation easement.  The Court summarized: “the regulations require that the donee of an easement be granted a vested right to the value of judicial sale proceeds (e.g. in condemnation) multiplied by a fraction equal to the value of the conservation easement at the time of the gift, divided by the value of the property as a whole at that time.”  In prior litigation, the Eleventh Circuit had accepted the IRS’ interpretation that Treas. Reg. § 1.170A-14(g)(6)(ii)'s proceeds formula “does not allow for any increase in value after the date of the grant attributable to improvements’ to be subtracted from the extinguishment . . . proceeds before the fraction is applied to the proceeds.”  The deed in Hewitt would have subtracted the value of post-easement improvements made by the Hewitts when determining the Atlantic Coast Conservancy’s share of the proceeds if the easement was judicially extinguished and the property sold.  Consequently, if the regulation as interpreted by the IRS governed the case, the Hewitts would lose.

The Hewitts challenged Treas. Reg. § 1.170A-14(g)(6)(ii)’s proceeds formula on procedural grounds, first in the Tax Court, where they lost in a divided opinion, and then on appeal to the Eleventh Circuit.  This was the first procedural challenge to the proceeds formula in a federal appellate court.  Considering Treas. Reg. § 1.170A-14(g)(6)(ii)'s proceeds formula, as interpreted by the IRS, the Eleventh Circuit reviewed the regulatory record.  During the notice-and-comment process, Treasury had received extensive comments on formula contained in the proposed regulation.  Focusing on the comments received by the New York Landmarks Conservancy, which the Court found to be “the most detailed” of such comments, the Court recapitulated the pervasive problems of policy and practical application raised in the comments. 

After a public hearing, Treasury adopted the proposed regulations with revisions, and stated in the regulation’s preamble that it had “consider[ed] . . . all comments regarding the proposed amendments.”  Contrary to this stock statement, however, the Court found that Treasury had not actually considered – or at least had not made a record of any such consideration – of the significant comments concerning the proceeds formula.  The Eleventh Circuit summed up: “Simply put, [the New York Landmarks Conservancy’s] comment was significant and required a response by Treasury to satisfy the APA’s procedural requirements.”  The Eleventh Circuit therefore concluded that Treas. Reg § 1.170A-14(g)(6)(ii), as construed by the IRS to prohibit subtracting the value of post-donation improvements to the easement property from the proceeds allocated to the donor and donee in the event of judicial extinguishment, was arbitrary and capricious under the APA for failing to comply with the APA's procedural requirements and is thus invalid.

While the decision remains subject to motions for rehearing and a cert petition, it adds to the growing chorus of courts that refuse to rubber stamp Treasury’s rule-making process and pay lip service to the APA’s requirement that agencies genuinely consider – and document their response – to all significant comments received during the notice-and-comment process.  Indeed, in the past decade, procedural challenges have become as important as substantive challenges in keeping Treasury regulations in check and consistent with the intent of the statutes under which they are promulgated.  This also highlights the importance of submitting comments to Treasury on proposed regulations, and offers some assurance that Treasury will be held accountable if they blow off well-thought out comments.  For many taxpayers, the Hewitt Court’s rebuke was a welcome way to close-out 2021.

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  • Peter A. Lowy

    Peter A. Lowy, a shareholder in Chamberlain Hrdlicka’s Houston office, is best known for his tax controversy work and deep experience in the energy sector. He also advises corporations and other taxpayers in a broad spectrum of ...