First Circuit Rejects IRS Regulations Interpretation With Caveat to Taxpayers About Penalties (7/20/12)

In Kaufman v. Shulman, ___ F.3d ___, 2012 U.S. App. LEXIS 14858 (1st Cir. 2012), here, the First Circuit reversed the Tax Court's acceptance of the IRS regulations' interpretation of the requirements for claiming a charitable contribution for a facade easement.  The substantive issue was whether the statute's requirement that the easement be granted "in perpetuity" (§ 170(h)(2)(C)) was not met if there was a remote chance that the charity could abandon the easement.  The substantive issue is more nuanced than that, but is not critical for a discussion of the procedure issues.  I focus here on the two procedure issues I think important in the case:  First, the Court rejected the IRS's interpretation of its regulations.  This is a Chevron issue in the case (Chevron is not mentioned but the Mayo interpretation of Chevron is, Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 711-13 (2012)).  Second, the Court had cautionary warnings for taxpayers claiming aggressive valuations fore easements.

Regarding the IRS's proferred interpretation of the regulations, the Court noted the absurdity of the position which, if traced to the logical extreme, would defeat almost all charitable contributions of easements that Congress clearly intended to allow.  The Court then noted:

We normally defer to an agency's reasonable reading of its own regulations, e.g., United States v. Cleveland Indians Baseball Co., 532 U.S. 200, 220 (2001), but cannot find reasonable an impromptu reading that is not compelled and would defeat the purpose of the statute, as we think is the case here. Cf. Grunbeck v. Dime Sav. Bank of N.Y., FSB, 74 F.3d 331, 336 (1st Cir. 1996).

In rejecting the interpretation, the First Circuit aligned itself with the D.C. Circuit in Commissioner v. Simmons, 646 F.3d 6, 10 (D.C. Cir. 2011).  The Court then reasoned:

The IRS insists that paragraph (g)(1) is a "reasonable interpretation" of the perpetuity language of 26 U.S.C. § 170(h)(5),  and is therefore entitled to deference. See Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 711-13 (2012). Yet the question here is not whether paragraph (g)(1) is reasonable, but whether the IRS's interpretation of that regulation is reasonable. The language of paragraph (g)(1) nowhere suggests the stringent outcome that the IRS seeks to ascribe to it and the consequences of the reading would be to deprive the donee organization of flexibility to deal with remote contingencies. 

In addition, the concern posited by the IRS is within its power to control: the IRS's own regulations require that tax-exempt organizations such as the Trust be operated "exclusively" for charitable purposes, 26 C.F.R. § 1.501(c)(3)-1, a requirement that the IRS can enforce against the Trust. See, e.g., Alexander v. "Americans United" Inc., 416 U.S. 752 (1974); Music Square Church v. United States, 218 F.3d 1367 (Fed. Cir. 2000). We agree with Simmons that such deductions "cannot be disallowed based upon the remote possibility [that the donee organization] will abandon the easements." 646 F.3d at 10.

For the discussion of the Court's deference to interpretations of regulations' interpretations, see the 2012 texts at pp. 51-52 (nonfootnoted) and 75-76 (footnoted).  I will add this case to a footnote so that it is available in a later version.

In a similar vein, the Court rejected the IRS's attempt to deny the deduction because of minor technical footfaults in the recordkeeping and reporting requirements.

Finally, in remanding the case to the Tax Court to decide the valuation issue, the Court had these warnings for taxpayers.  The Court noted that, if indeed there were a substantial overvaluation as the IRS claimed, the taxpayers could be subject to the substantial valuation misstatement penalty in § 6662 (the applicable subsections are § 6662(a), (b)(3) and (e)) and might not be protected by the reasonable cause exception in § 6664(c)(3)(B).  In this regard, the Court noted that the easement substantially paralleled the existing historic district requirements and thus, granting the easement, may not have decreased the value of the property in the amount claimed.

The Court then concluded:

The Kaufmans themselves were surprised at the size of the valuation, albeit out of concern that it implied--as it must if the Kaufmans were conveying anything of value--a substantial reduction in the resale value of their home. In an effort to reassure them, a Trust representative told the Kaufmans that experience showed that such easements did not reduce resale value, and this could easily be the IRS's opening argument in a valuation trial. The Trust representative explained in pertinent part that 

[i]n areas that are regulated by local historic preservation ordinances and bodies such as Boston historic neighborhoods (including yours) . . . , properties with an easement are not at a market value disadvantage when compared to the other properties in the same neighborhood. n8 

   n8 The Kaufmans have objected to the admission of this e-mail into evidence on grounds of hearsay, relevance, and noncompliance with the expert witness requirements of Rule 143(g) of the Tax Court Rules of Practice and Procedure. While the Trust representative's testimony may not be admissible for the purpose of proving the value of the easement (or lack thereof), it may well be relevant to the question of whether the Kaufmans acted in "good faith," and at trial the Tax Court admitted the e-mail into evidence for that purpose. 

As indicated by the large cash contributions required of donors, the Trust had a substantial economic incentive for itself in facilitating such conservation easements; and to this end and because of the 10 percent target for donations, it also had a stake in assuring a high valuation. Similarly, the appraiser, who admitted receiving fees for a succession of such appraisals for Trust easements, assuredly had an interest in remaining on the list of those recommended by the Trust to potential donors.

The burden in the Tax Court initially rests on the taxpayer to justify his or her deduction. See Tax Ct. R. Prac. & P. 142(a)(1); see also INDOPCO, Inc. v. Comm'r, 503 U.S. 79, 84 (1992). The burdens and presumptions relating to penalties are more complicated, compare, e.g., 26 U.S.C. § 7491(c), with Higbee v. Comm'r, 116 T.C. 438, 446-47 (2001), and there is no reason to pursue the subject of the Kaufmans' fault before determining first whether their deduction was legitimate. Judging from the amici, the present appeals have the hallmarks of a test case to settle larger issues between the industry and the IRS; and on remand the Kaufmans and the IRS could well work out a settlement without a trial. 

Doubtless it is the desire to avoid such trials, as well as the difficulty of detecting and investigating suspicious cases one by one, that explains the IRS's aggressive legal positions in this case. And, despite our rejection of those particular positions, we do not question the IRS's concern, transcending this case, that individuals and organizations have been abusing the conservation statute "to improperly shield income or assets from taxation." IRS News Release IR-2005-19 (Feb. 28, 2005), see also IRS News Release IR-2006-25 (Feb. 7, 2006) (repeating language from 2005 news release). 

However, to reject overly aggressive IRS interpretations of existing regulations is hardly to disarm the IRS. Without stifling Congress' aim to encourage legitimate easements, one can imagine IRS regulations that require appraisers to be functionally independent of donee organizations, curtail dubious deductions in historic districts where local regulations already protect against alterations, and require more specific market-sale based information to support any deduction. Forward looking regulations also serve to give fair warning to taxpayers. 

If taxpayers still do not get the message, the penalties regime is formidable, see, e.g., 26 U.S.C. § 6662(h)(1) (40 percent penalty for gross valuation misstatements); and, for willful abusers, there are criminal penalties, e.g., 26 U.S.C. § 7201 (prison term up to five years). The Justice Department has already secured a permanent injunction against the Trust to prohibit some of the practices alluded to in this case. nn9 The IRS is properly zealous to protect the revenues and over the long run it has the tools to do so.

   n9 See Stipulated Order of Permanent Injunction, United States v. McClain, No. 11-1087 (D.D.C. July 15, 2011), which inter alia prevents the Trust from claiming that the IRS has recognized a "safe harbor" for easement valuations in the 10-15 percent range and from "[p]articipating in the appraisal process for a conservation easement in any regard, including but not limited to recommending . . . any appraiser . . . or list of appraisers" beyond furnishing a list of all appraisers who have been certified to appraise conservation easements by a professional organization.

JAT Notes:
   1.   The Court adverts to amici's brief in suggesting that this is a test case.  Not only does amici suggest that, but I think, the presence of absolutely top tier appellate counsel for the taxpayers suggest that more than the mere dollars in the case may be the real issue.
   2.  It is interesting that the court suggests on regulations proposal that could likely pass Chevron muster in requiring the appraisers to be independent.  This echoes a parallel issue in the context of abusive tax shelters where the experts -- from lawyers to accountants to financial wizards lending some supported expertise as key components of the plan, particularly the penalty insurance -- are not really independent of the promoters.