by Beckett Cantley and Geoffrey Dietrich
This article is intended to provide a basic set of frequently asked questions on captive insurance companies. The questions are in no way meant to be exhaustive on the subject, but rather solely cover certain basic uniform questions potential captive insurance company owners need to ask before forming one. Please note that the authors only advise captive owners and advisors on specific issues of captive insurance law and do not form or operate captive insurance companies.
What is an IRC § 831(b) Captive Insurance Company?
An Internal Revenue Code (“IRC”) § 831(b) small captive insurance company (“CIC”) is, in essence, a corporation formed to offer insurance to a parent corporation or other affiliated entities. The CIC may offer administrative and tax benefits over self-insurance and commercially available insurance. The questions addressed below briefly discuss the history, the structural details, and the potential benefits.
How Did Captive Insurance Start?
Captives emerged as a planning tool in the 1950’s. Fred Reiss created American Risk Management in 1958 to assist U.S. corporations in establishing their own insurance companies as an alternative to conventional risk management. Due to the peculiarities of state insurance laws at the time, most CICs were formed outside the U.S., often in “debtor havens” where the companies experienced few, if any, local tax consequences. After the U.S. passed tax legislation temporarily eliminating many benefits of CIC insurance arrangements for U.S. companies, Reiss formed International Risk Management in Bermuda. This move precipitated the dominance of offshore domiciles in the CIC market for the remainder of the twentieth century.
Historically, CICs were most often utilized by large U.S. corporations. One common motivation was, and continues to be, a company’s inability to purchase commercial insurance at acceptable premium and coverage levels. The taxpayers in Consumers Oil and Weber had operations in areas prone to flooding and neither taxpayer was able to obtain commercial insurance coverage due to the elevated risk. Similarly, the taxpayers in Gulf Oil and Ocean Drilling operated in high-risk industries and were only able to obtain commercial insurance at prohibitively high prices. The companies formed CICs to provide the coverage they could not otherwise obtain under acceptable terms.
Another common theme is a company’s desire for more administrative control over the insurance policy. Beech Aircraft was unable to obtain commercial insurance that would allow the company to control its legal defense in the event of a claim.  The company had been sued under a previous policy, and the jury returned a sizeable verdict against the company, the majority of which was designated as punitive damages. After an investigation, the company was convinced that the verdict was a result of a failure by the insurer’s legal team to adequately prepare and try the case. The company had monitored the activity of the insurer’s attorneys during the course of the trial, and even unsuccessfully filed a motion to have those attorneys removed. To afford itself more control over the administrative terms of the policy, the company formed a wholly owned subsidiary CIC.
Throughout the 1970’s and 1980’s, judicial and executive interpretation identified circumstances under which a CIC insurance arrangement would be respected in the U.S. In general, courts ruled captive structures were valid insurance companies when they either insured a sufficiently large number of the parent company insureds or obtained at least 30% non-parent risk. Increased certainty through pro-taxpayer decisions led to increased utilization of CICs as a risk management strategy by major U.S. corporations. States began passing legislation enabling formation of CICs, and more growth to the domestic sector resulted. A concomitant increase in courtroom activity led to a rise in certainty as judges circumscribed the permissibility of CICs. A critical mass accumulated in the 1990’s, and the CIC industry “exploded” as smaller and even privately-held businesses began to view CICs as an attractive alternative to more common risk management strategies. Today, a majority of states have passed CIC-enabling legislation.
What Can a Captive Do?
Generally speaking, a CIC may offer coverage of virtually any type to the operating business, and the terms of the policy are remarkably flexible. By far the most common arrangement is for the parent company to maintain existing coverage through commercially available policies while having the captive fill policy gaps and provide coverage for stochastic (low frequency, higher payout) risks. Also, Congress has provided a tax incentive for the formation of IRC § 831(b) small CICs. In effect, the tax code helps offset the costs of establishing and operating a regulated, small insurance company.
What are the Benefits of a Captive?
A CIC may afford its owners numerous benefits. A CIC can provide niche coverage for unique or specific risks that would not be otherwise transferrable, or not transferrable at an acceptable cost, in the commercial insurance market. This is especially advantageous to an entity with an above average risk profile that seeks to reduce its exposure in a cost-effective manner. Thus, so long as the policies are commercially reasonable, a CIC owner can “create whatever type of coverage for the operating business [he] can dream up.” In his authoritative book on the subject, Jay Adkisson lists dozens of policy types ranging from the relatively mundane, e.g, errors and omissions, and malpractice, to the somewhat esoteric, e.g., confiscation and expropriation, and weather risks. Moreover, as highlighted by the Beech Aircraft case, the policy terms may be tailored to meet the individual needs of the insured, again, subject to commercial reasonableness.
Also, a CIC may be used as a means of cost stabilization for an insured who has grown weary of premium increases in a hardening commercial insurance market. These increases may be based on market forces or underwriting software rather than the claims experience of the insured entity. For a company with a better than average loss experience, a CIC can save premium dollars that would otherwise be used to subsidize the loss experience of other market members.
Next, a CIC can reduce or eliminate brokerage commissions and marketing and administrative expenses, which are typically wrapped into commercial insurance premiums. Thus, a CIC arrangement allows a business to potentially lower its overhead while leaving more premium dollars in reserve for claims payment and surplus investment. If the CIC “wins its gamble” with the insured, it can generate profit for the parent corporation that would otherwise accrue to the third-1.party commercial insurer. As surplus funds accumulate, the funds can be invested. Moreover, a parent corporation may generally exercise some control over the investment decisions of the CIC.
In addition to these benefits, Congress has provided a tax incentive for CIC formation under IRC § 831(b). In effect, § 831(b) helps offset the costs of establishing and operating a regulated, small insurance company. A valid IRC § 831(b) CIC may allow a parent corporation to manage risk exposure without incurring the income tax problems associated with self-insurance. Whereas contributions to a reserve account for self-insurance are generally not tax deductible, premiums paid to a CIC by its insured entity may be deductible, similar to the deductibility of premiums paid for commercial insurance. IRC § 162(a) provides that “there shall be allowed deductions on necessary and ordinary business expenses incurred in carrying on a business.” Treasury Regulations § 1.162-1(a) states that business expenses include insurance premiums paid on policies covering fire, storm, theft, accident, or similar losses in the course of business. Thus, provided that the CIC is considered an “insurance company,” issuing “insurance” through arrangements that are considered “insurance contracts,” as discussed above, the parent corporation should be able to deduct premium payments to the CIC.
Furthermore, a CIC may earn premiums, within limits, without incurring federal income tax. IRC § 831(a) provides that tax shall be imposed under IRC § 11 on the taxable income of any insurance company other than life insurance companies. However, IRC § 831(b) provides that a non-life property and casualty insurance company, which receives annual premiums not to exceed $2.3 million, can elect to receive these premiums tax-free. Thus, the CIC would incur no tax on underwriting income earned on premiums paid, so long as the aggregate premiums total less than $2.3 million annually.
Notably, the CIC is still taxed on income earned through investment activity. Assuming that the CIC is profitable in its underwriting and investment operations, profits will be distributed to the CIC shareholders in the form of dividends. Alternatively, a CIC shareholder could realize profits through the sale of his shares in the CIC. In either the case of a qualified dividend or sale of stock, the income would be taxed at the long-term capital gains rate, under current law, rather than at the rate applicable to ordinary income.
How is a Captive Owned?
Typically, a CIC is either owned directly by its parent corporation or by the shareholders of the parent corporation. The organizational structure of a CIC closely resembles that of a mutual insurance company, albeit for a more limited number of participants. “CIC” refers to a brother-sister arrangement in the discussion below unless otherwise noted. Without belaboring the details of the day-to-day operation of an insurance company, this discussion seeks to give a brief overview of selected topics. The CIC and its insured should independently operate in an arms-length relationship to the greatest extent possible. Thus, while the CIC should be tightly woven into the parent company’s overall business plan to maximize efficiency, the CIC should maintain its own business goals and plan for success.
Who Manages a Captive?
The ongoing management of the CIC is critical in ensuring the success of the enterprise. The CIC should recruit appropriately credentialed professionals to fulfill management, underwriting, accounting and audit duties. The insurance manager fills the fundamental role of determining which risks to underwrite and drafting the policies that insure the chosen risks. The insurance manager must seek actuarial assistance in evaluating risks and determining premium and reserve levels. Also, it is ultimately the insurance manager’s responsibility to ensure that the CIC complies with its license terms, regulatory requirements, deadlines, and the like.
Are Captives Audited?
Most jurisdictions require annual audits of insurance companies by an accounting firm approved by the Insurance Commissioner. Choosing a firm that is experienced in CIC insurance may help the CIC avoid the myriad pitfalls that await CICs in the IRC.
The CIC should undergo periodic reevaluation to maximize efficiency. Such reevaluation may allow a CIC to underwrite more risk given its capital structure, and the goals of management. Moreover, risks currently underwritten by the CIC may have become more inexpensive to insure in the commercial market, again, subject to management goals. Typically, a CIC must provide notice to the Insurance Commissioner of its jurisdiction when there will be significant changes to its operations or ownership structure.
How are Captive Insurance Companies Formed?
Aside from what structure the CIC will take, many factors must be considered before undertaking the formation of a CIC. First, an experienced attorney or consultant should be engaged to perform a feasibility study. This will provide the prospective owner with an independent, clinical opinion as to whether a CIC is an appropriate vehicle to achieve the desired benefits, given the owner’s business and overall financial plan. This step should also begin to educate the proposed owner of the regulatory and compliance requirements associated with operating an insurance company according to the statutory regime of the licensing jurisdiction.
Also, a detailed actuarial study should be prepared, and, in fact, generally must be submitted with the insurance license application. The actuarial study should determine the amounts and types of coverage that will be underwritten. The study should also include information as to how the premium amounts will be determined and the capitalization requirements associated with the new CIC. There should be no communication between the potential insured, the party supervising the study, and the actuary that attempts to manipulate the numbers to arrive at tax-friendly numbers. Once the feasibility and actuarial studies are completed, the insurance license application can be submitted in the jurisdiction of choice.
Where are Captive Insurance Companies Formed?
A CIC can be formed and licensed pursuant to the laws of a U.S. state, or those of a foreign country. The company will be “domiciled” in the jurisdiction where it was formed. Many factors impact the decision as to whether to form the CIC domestically or offshore and the choice between domiciles in either arena. Those factors include, but are not limited to: (1) the CIC’s exposure to the U.S. tax system; (2) the capitalization burden required at formation; (3) the flexibility the CIC is allowed in investing its resources; and, (4) the asset protection afforded the U.S. shareholders of the CIC.
The tax and compliance burdens imposed by U.S. law on a CIC and its U.S. shareholders may be a consideration in deciding whether to form a CIC domestically or offshore. Notably, an organization in an offshore jurisdiction will not preclude the IRS from assessing and collecting U.S. income tax. Therefore, the decision as to whether to form a CIC in a domestic or offshore jurisdiction should be made based on the local reporting requirements and taxation to which a CIC would be subject, accepting as fact that the IRS is quite capable of visiting federal income taxation on an offshore CIC.
Both domestic and offshore CICs are subject to U.S. income taxation. A foreign CIC may elect to be taxed as a domestic entity under IRC § 953(d). A company making such an election directly subjects all income earned globally to U.S. federal income tax, rather than indirectly through its U.S. shareholders under IRC subchapter F. The benefits to a U.S.-owned offshore CIC making an IRC § 953(d) election include exemption from the federal excise tax (“FET”), simplified compliance and administration and, at least theoretically, communication to the IRS that the CIC need not be subjected to heightened scrutiny by virtue of its offshore domicile. An IRC § 953(d) election is irrevocable absent IRS consent.
A CIC that chooses not to make an IRC § 953(d) election could find itself categorized as a controlled foreign corporation (“CFC”) if more than 25% of its shares are held by U.S. owners. A CFC classification would render the CIC income currently taxable its U.S. shareholders. Under these circumstances, the U.S. shareholders of the CIC would be required to currently include all CIC profits not directly allocable to insurance contracts issued on risks outside the U.S. in the CIC owner’s taxable income, irrespective of the timing of the distributions.
What are the Disadvantages of Forming a Captive Insurance Company Offshore?
The disadvantages of forming a CIC under the laws of a foreign country potentially include subjecting the policy premiums to the FET and increasing the compliance burden of the CIC by exposing the company to a greater risk of an intrusive audit. Policy premiums paid to an offshore CIC by a U.S. insured may be subject to the FET if the IRS views the arrangement as an “importation” of a foreign service. Foreign services imported to the U.S. are subject to the FET. Specifically, property/casualty premiums paid to an offshore CIC by a U.S. insured are subject to a FET of 4% for original insurance and 1% for reinsurance. Because the offshore CIC provides insurance, actuarial, and management services to its U.S. shareholders, the IRS may view the arrangement as an “importation” of foreign services, thus exposing its U.S. shareholders to the increased U.S. tax burden of the FET. While some domestic jurisdictions charge premium taxes, shareholders of a domestic CIC can generally avoid the additional tax liability in the form of premium taxes by simply choosing to organize the CIC in a state that does not require premium taxes.
An otherwise compliant CIC should have nothing to fear from the mere fact that it is domiciled offshore. However, that offshore domicile alone may be enough to subject the company to an “ever-changing and perilous compliance burden” and a risk that the company will be swept up in the increasing number of IRS audits of offshore entities. Around 2005, the Senate Permanent Subcommittee on Investigations (“PSI”), under the leadership of Senator Carl Levin, began to view U.S. taxpayers’ offshore holdings with increasing suspicion. This sentiment grew out of the government’s reduced ability to monitor its citizens’ offshore holdings. When PSI investigations began to uncover empirical evidence supporting this suspicion, Congress, the Department of Justice, and the IRS became engendered with a belief that U.S. holdings in offshore arrangements were potentially abusive and evasive. Congress has enacted and continues to propose, numerous legislative schemes to assist the IRS in enforcing U.S. tax laws offshore. Without addressing the details of the various enacted or proposed legislation, it is sufficient to say that organizing a CIC offshore to reduce one’s exposure to U.S. tax laws is by no means a foolproof strategy.
How are Captives Capitalized?
The capitalization burden, or the sum of money required under local law to be contributed to a reserve account upon formation, will likely affect whether one decides to organize a CIC domestically or offshore, and the choice of domicile within these categories. Domestic jurisdictions have historically required between $300,000 and $300 million capitalization to form a CIC, depending on such factors as the type of CIC, the proposed coverage offered by the CIC, and the relationship between the CIC and the insured. Laypeople, and indeed some tax and insurance professionals, have long espoused the relaxed offshore regulatory environment as a benefit of organizing a CIC offshore. This perception arises in part from the lower minimum capital contributions typically required in offshore jurisdictions and the less restrictive rules and regulations many offshore jurisdictions impose on insurance and financial institutions. For example, offshore regulators generally rely on independent CPA verifications, whereas domestic regulators typically require examinations by state regulatory bodies and state-approved audit firms.
While the local regulatory environment is important in choosing a jurisdiction in which to found a CIC, a planner must not overlook the requirements superimposed on all insurance companies by the IRS The IRS must consider the CIC an insurance company for premiums to be deductible under IRC § 162, and for a CIC to receive the tax benefits of IRC § 831(b), and the policies issued must reflect an insurance arrangement. To consider a policy an insurance arrangement, the IRS must find that the risk of economic loss was shifted from the parent-insured to the CIC, i.e. “risk shifting”. Without adequate capitalization, the CIC may have insufficient reserves to cover its insureds’ current and anticipated claims. Because an insured would bear the entire risk of loss if his insurer failed to satisfy the insured’s claim, adequate capitalization factors heavily in determining whether risk has shifted between an insured and a CIC. Therefore, any CIC seeking to participate in the benefits bestowed upon insurance companies by the IRC may be subject to substantially higher capitalization requirements than those imposed by the offshore jurisdiction.
Notably, some U.S. states have made their minimum capitalization requirements more palatable in recent years. For example, Delaware reduced its requirement to $250,000 combined capitalization among separate CIC entities formed and administered as part of the same series. Under such an arrangement, a group of individual CIC entities may share the same capitalization. Thus, provided that all other CIC law is strictly observed, the individual entities can maintain the reserves necessary for proper risk-shifting while keeping their individual capitalization requirements reasonably low. Such domestic options at least warrant a second look from a prospective owner seeking to minimize his initial capital contribution without inviting IRS scrutiny.
What Investments Can a Captive Insurance Company Make?
One consideration in choosing whether to organize a CIC domestically or offshore is the investment flexibility a jurisdiction affords a CIC with respect to its surplus. Surplus is the income that a CIC retains in excess of the funds needed to satisfy its current claims. Some foreign jurisdictions permit a CIC to invest its surplus in any investment vehicle, provided the investment does not impair the capital base or run afoul of the foundational requirements of the insurance arrangement, including making investments so unreasonably illiquid as to potentially prevent the payment of its actuarially anticipated claims. Because the primary responsibility of an insurance company is to pay claims as they arise, a CIC that fails to abide by its solvency requirements would not be considered a valid insurance company for any purpose. As such, while a foreign jurisdiction may permit a CIC greater investment flexibility, the CIC is still subject to the IRC requirements applicable to all insurance arrangements. A CIC not primarily engaged in the business of underwriting insurance or reinsurance activities would not be considered an insurance company. Thus, CIC compliance with the regulations of the foreign jurisdiction is significant in assessing whether a CIC is primarily engaged in the business of insurance, but the controlling factor in analyzing whether a CIC qualifies as an insurance company is the nature of the business transacted in the taxable year.
IRS pronouncements warn that certain arrangements where an insurance company’s insurance business is outweighed by its investment activities may not withstand this analysis. While some of this guidance appears in the context of life insurance, which a CIC may not insure, the issues raised with respect to life insurance companies should apply with equal force to companies that insure risks other than life. IRS Notice 2003-34 warned taxpayers that investing in certain U.S. shareholder-owned offshore purported life insurance companies to defer recognition of ordinary income, or to re-characterize ordinary income as capital gains, may present a compliance risk. The IRS recognized that arrangements of this type are used to invest in hedge funds or those investments in which hedge funds ordinarily invest, typically resulting in a relatively small proportion of genuine insurance activities in comparison to the offshore entity’s investment activities.
These arrangements result in the offshore entity earning investment income substantially in excess of the entity’s ordinary insurance business needs. Shareholders often eschew any current distribution, claiming that since the appreciation arises from the conduct of insurance business rather than passive investment income, the appreciation constitutes capital gain instead of ordinary income. The IRS recognized that operating an insurance company will almost certainly involve investment activity. However, genuine insurance companies use the returns from their investments to satisfy claims, underwrite more business, and fund distributions to the company’s shareholders. A foreign jurisdiction’s certification of an entity as an insurance company under the jurisdiction’s local rules does not necessarily equate to IRS recognition of the entity as an insurance company, especially where the entity is not primarily occupied in the issuance or reinsurance of insurance or annuities. For federal income tax purposes, an entity is only considered an insurance company when it primarily employs its capital in the pursuit of income from underwriting additional insurance risks. In making this determination, the IRS will analyze an entity’s aggregate operations and sources of income.
The IRS may determine that an offshore CIC is not an insurance company for federal income tax purposes if the CIC is predominantly used as a conduit for hedge fund investment. Under such circumstances, the IRS could impose current taxation on those U.S. persons earning passive income through the offshore entity under the Passive Foreign Investment Company (“PFIC”) rules. Under IRC § 1279(a), a foreign corporation is a PFIC if (1) 75% or more of the entity’s gross income is passive income, or, (2) at least 50% of the entity’s assets produce, or are held for the production of, passive income. Corporations engaged primarily in the active conduct of insurance business are outside the purview of the PFIC rules, as they are subject to federal income taxation under the IRC subchapter L U.S. life insurance company rules. IRS Notice 2003-34 stated that the IRS will challenge the validity of these types of investment schemes, through the application of the PFIC rules, on a finding that a foreign corporation is not an insurance company for federal tax purposes. Thus, the latitude a foreign jurisdiction gives a CIC with respect to investing its surplus may be significantly circumscribed, at least to the extent that the entity’s investment activities may not exceed its insurance activities, lest the CIC find itself challenged as a PFIC.
Does a Captive Insurance Company Provide Asset Protection?
Adding a layer of asset protection may enter into the calculus when deciding whether to organize a CIC domestically or offshore. Various offshore jurisdictions claim that their regulators hold information about CIC assets in strict confidence, allowing a CIC to be organized and operated in secrecy. Many people also believe that disclosure of the identity of the parent entity to the IRS can be avoided through a valid IRC § 953(d) election, on the rationale that the CIC itself is the U.S. taxpayer and owner of all CIC assets. Avoiding disclosure to both foreign and domestic authorities may seem a beneficial attribute of offshore CIC organizations. Such secrecy may render a creditor unable to follow the money, leaving him less enthusiastic about the prospect of costly, protracted litigation, given the uncertainty as to whether the debtor is “judgment proof.”
Moreover, an IRC § 953(d) election could force a creditor to file suit against the CIC in the courts of the offshore domicile, effectively allowing the CIC to choose both the venue and the controlling law. Such a result is possible because a valid IRC § 953(d) election applies only to the IRC, and not to any other titles of the U.S. Code, including the Federal Rules of Civil Procedure. Thus, a creditor would be unable to argue that the CIC was domiciled in the U.S. and would have to prove that the U.S. court had personal jurisdiction over the CIC. A U.S. court could only exercise personal jurisdiction over the corporation on a showing that the corporation had the requisite minimum contacts with the jurisdiction or had purposefully availed itself of the U.S. court’s jurisdiction. An offshore CIC that collects substantial premiums from a U.S. insured in exchange for insurance may indeed have sufficient contacts to fall within the U.S. court’s jurisdiction. However, assuming a U.S. court could not exercise personal jurisdiction over a foreign CIC, creditors would effectively be forced to bring suit against the CIC in the foreign domicile’s courts, under the foreign domicile’s laws. Creditors may be unwilling to undertake such a daunting task, particularly where the offshore domicile has strict asset protection and account secrecy laws. Furthermore, even if U.S. courts are able to exercise personal jurisdiction over the CIC, and a creditor secures a judgment against the corporation, the foreign jurisdiction may be unwilling to enforce the U.S. judgment. Such a blow could be fatal to a creditor in the case of a debtor who has few assets outside the offshore jurisdiction.
If a creditor secures a judgment against a U.S. citizen, a U.S. court may very well declare a transfer offshore illegal or invalid at its source. The Court may be hesitant to relinquish jurisdiction over a transfer it perceives as a fraudulent attempt to evade the transferor’s creditors, especially if the creditor successfully maneuvers the transferor into a bankruptcy action. U.S. bankruptcy courts have broad powers to invalidate transfers that hinder or delay satisfaction of a creditor’s claim, and often use these powers to frustrate offshore asset protection arrangements. A hypothetical debtor could transfer significant assets offshore and outside the debtor’s control and beneficial enjoyment in the form of premium payment to a foreign CIC in an effort to become insolvent. Once found insolvent, creditors could position the debtor into bankruptcy, and the bankruptcy trustee would take control of the debtor’s estate. The trustee may be able to force a waiver of the attorney-client privilege, and obtain any information provided to the debtor by an asset protection attorney. This would likely allow the bankruptcy trustee to uncover documents and information revealing the location of the debtor’s offshore assets. In the case of a CIC, this information would likely include the non-public records of where the CIC assets are located. Once the bankruptcy trustee uncovered this information, it would be an easy task to unwind an asset protection arrangement designed to render the debtor insolvent. Then, the bankruptcy trustee could reclaim the assets, or repatriate premiums paid to the CIC or assets purchased with those premiums to satisfy creditor claims.
U.S. courts have declared that it is against public policy to enforce the laws of a foreign jurisdiction where those laws violate established principles of U.S. law. Foreign jurisdictions that are known for asset protection often intentionally draft legislation to circumvent the laws of other jurisdictions, including the U.S. As such, a U.S. judge may be loath to apply a foreign law that is unlikely to withstand an attack on public policy grounds. Thus, if a U.S. court finds that foreign laws are being used in contravention of public policy, the Court may unwind an offshore CIC.
A creditor may successfully void a transfer of funds from a U.S. party to an offshore CIC if the creditor can convince the Court that the transfer was made for improper asset protection purposes. Thus, a court may rule that capitalization or premium payments made to an offshore CIC by a U.S. shareholder or insured are void ab initio, especially if the debtor is before the U.S. bankruptcy court, as discussed above. Moreover, if the IRS and DOJ suspect that a CIC was formed for asset protection, they may question whether the CIC is being primarily operated as an insurance company, irrespective of creditor claims.
How Do Captive Insurance Companies Operate?
A CIC is, first and foremost, an insurance company, and must be operated in a manner consistent with being predominantly in the business of insurance. To avail itself of the favorable tax treatment the IRC bestows upon insurance companies, a CIC must, of course, meet the definition of “insurance company.” Failure to meet this requirement could result in the exposure of all of the entity’s income to C corporation double taxation. Treasury Regulations § 1.801-3(a) provide that an insurance company is one whose primary and predominant business activity is the issuance of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. Under IRC § 816(a), an “insurance company” is any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by an insurance company.
Captives must also comply with the “Harper Test,” so named because it is based on three factors outlined in the Harper case.
The three factors are:
(1) Whether the arrangement involves the existence of an “insurance risk”;
(2) whether there was both risk-shifting and risk distribution; and
(3) whether the arrangement was for “insurance” in its commonly accepted sense.
“Insurance risk” requires the insurance company to specifically define the risk, which is contained in the policy. In addition, the insured must be able to demonstrate a premium was paid and the insurance company issued an insurance policy. Risk shifting and distribution are covered below.
Insurance in its commonly accepted sense requires the transaction to comply with generally accepted industry practice.
The Harper court found adequate capital and arms-length premiums determinative, as was the existence of regulatory authority (here, the Hong Kong government). Other IRS documents have discussed the need for the captive to comply with the state law definition of an insurance company and the existence of standard insurance company documentation.
If a CIC charges commercially unreasonable premiums and/or otherwise engages in non-arms-length transactions, the IRS may not respect the CIC as a legitimate insurance company. While arms-length dealing and separate management fees alone are not sufficient to prove that an entity is an insurance company, such conduct telegraphs the existence of a bona fide “insurance company.” As discussed above, any CIC hopeful of recognition as an “insurance company” must otherwise operate as an “insurance company,” employ professionals with the appropriate credential to fill critical roles within the company and comport with local licensing and capitalization requirements.
Also, an “insurance company” must provide “insurance” through “insurance contracts.” Unfortunately, the IRC provides little guidance in defining these terms. In general, an agreement must transfer the risk of economic loss, contemplate the occurrence of a stated contingency, and comprise something more than a mere business or investment risk to receive insurance treatment for federal income tax purposes. Insurance Services Offices often provide policies for captives. A CIC must show that it has adequately shifted the risk of economic loss from the insured to the insurer (“risk shifting”), and that the insurer has adequately spread that risk among various insurance companies or other unrelated entities such that no single entity bears the entire risk of economic loss (“risk distribution”). A CIC may accomplish this goal using IRS safe harbors or otherwise.
What is Risk Shifting?
In Helvering v. LeGierse, the United States Supreme Court (“Supreme Court”) analyzed the risk-shifting issue. In LeGierse, an elderly, uninsurable taxpayer purchased a life insurance policy and a life-only annuity contract one month before her death. By purchasing the annuity contract from the same insurer, without which the insurer refused to issue the life insurance policy, the taxpayer neutralized the insurer’s risk with respect to the life insurance policy. The taxpayer purchased the life insurance policy primarily to take advantage of favorable estate tax treatment available, and the arrangement had a little net effect on her economic position. The Court held that because the life insurance policy and the annuity contract offset one another, there was no risk shifting from insured-to-insurer.
Risk shifting is only present when a party facing the risk of economic loss transfers some or all of the financial consequences of that potential loss to an insurer. Risk shifting generally requires an enforceable written insurance contract, with premiums negotiated and actually paid at arms-length, and the insurance company to be a discrete entity capable of satisfying its obligations and properly formed under the laws of the applicable jurisdiction. The thrust of the risk-shifting analysis is whether the premium-paying party has truly transferred the economic impact of the potential loss to the insurer.
The Humana court held that an arrangement solely between a parent company and a subsidiary CIC could not be considered insurance for federal income tax purposes because it failed to shift risk from the insured to the insurer. Humana paid premiums on its own behalf to a wholly-owned CIC in exchange for coverage. The Court noted that the similarities between such an arrangement and a reserve account for self-insurance, contributions to which are not tax-deductible, were impossible to ignore. The underlying rationale for the Court’s decision was that Humana did not truly transfer any risk of loss to the CIC, since any loss incurred by the CIC would ultimately be absorbed by Humana as the sole owner of the CIC. Nonetheless, the Humana court held that an arrangement between a subsidiary CIC and several dozen other subsidiaries of the parent entity did satisfy the risk-shifting element. The Court reasoned that a loss incurred by the CIC would not directly transfer to the sibling subsidiaries in the same way a loss would transfer between a wholly-owned subsidiary CIC and its parent.
Notably, the Court stated that the doctrine of substance over form, discussed in greater detail in another of our FAQ articles, could be invoked to challenge the existence of separate and distinct entities, which are required to show the existence of risk shifting. However, the Court went on to state that the doctrine would only be applicable where no valid business purpose exists for the transactions or where a clear Congressional intent to curtail such transactions can be shown. The Humana court concluded that Congress had not yet manifested any intent to disregard the separate corporate entity in the context of CICs and respected the separate identities of the entities.
With proper planning and execution, a CIC should have no trouble showing a valid business purpose for maintaining separate corporate entities. Thus, a substance over form argument employed to challenge the existence of risk shifting should be ineffective unless the transaction is found to lack economic substance aside from mere tax benefits (discussed further, below).
Since Humana, the IRS has provided broad “safe harbor” rulings. In the main “safe harbor” provision, found in Revenue Ruling 2002-90, the IRS explained that an arrangement of at least twelve subsidiaries paying premiums to an affiliated CIC constitutes effective risk-shifting where each subsidiary has no more than 15% and no less than 5% of the total risk insured and none of the claimed twelve subsidiaries are disregarded entities.
Since the promulgation of the “safe harbor” provisions, the IRS appears eager to challenge a CIC on the grounds of risk-shifting in only the most egregious and abusive of circumstances. This underscores the importance of adhering to the general guidelines discussed above. Risk shifting may be questioned where guarantees exist to neutralize a CIC risk of loss and where contracts are not entered into at arms-length. Other factors the IRS may consider in a risk-shifting challenge include: whether the insured parties face a genuine hazard of economic loss in an amount which justifies premium payments made at commercially reasonable rates; whether the validity of insurance claims was investigated and established before the claims were paid; and, whether the CIC business operations and assets are maintained separately from the business operations and assets of the parent entity.
What is Risk Distribution?
Risk distribution is also required for an arrangement to be considered insurance. Risk distribution involves the pooling of insurance premiums from separate insured entities so that an individual insured is not paying for a significant portion of its own risk. Rather, the risks, and claims, of an individual insured would be subsidized in large part by the premiums paid by other insured entities in the pool. The law of large numbers dictates that the likelihood of a single claim exceeding premium payments for a given period of time decreases as the length of time and number of insureds in a given pool increase.
A risk distribution analysis is broader in focus than that of a risk-shifting analysis. The risk distribution analysis looks to whether an insurer has distributed the risk of an individual insured over a larger group of entities, rather than strictly between the insurer and the single insured. Unfortunately, authority adequately discussing what constitutes risk distribution where risk shifting is found to exist is scarce. However, the Humana court found that an arrangement where a CIC insured multiple sibling subsidiaries from an affiliated group constitutes valid risk distribution since the premiums paid by each insured could offset the CIC losses as a whole. While decisions have never established the minimum quantity of unrelated business sufficient to constitute risk distribution, courts have ruled that 30% is sufficient and 2% is not.
The IRS has issued several Private Letter Rulings that outline two different risk distribution models. In the first, the insured pays a premium to an insurance company, which then cedes risk back to the insured’s captive. For example, the insured pays a premium of $100,000 to an insurer, which then cedes a percentage of the risk (anywhere between $30,000 and $90,000) back to the captive. Here, the risk distribution occurs within the financial accounts of the insurance company, as the insured's premium is combined with those from other, unique insureds.
In the second, the insured pays the full premium to his captive, which then cedes at least 50% of its risk to a pool where other, unique insureds do the same. Then, after an insured’s pool contribution is mixed with other, unique insureds, the pool cedes most of the original contribution back to the insured.
For example, an insured pays $100,000 to his captive, which then cedes at last $50,000 of its premiums to a pool, which in turn returns a majority of the original funds to the captive.
In summary, to be treated as an insurance company for federal income tax purposes, a Captive Insurance Company must show that its insureds have adequately shifted their risk of loss to the CIC and that the CIC has adequately distributed that risk over various diverse entities. A CIC maintaining its own arms-length operational identity and conducting its business in a manner consistent with standard insurance industry norms will also support such treatment. If a CIC can meet these requirements, many advantages may be available to the CIC and its owner.
-  Beckett G. Cantley, Esq. (University of California, Berkley, B.A. 1989; Southwestern University School of Law, J.D. cum laude 1995; and University of Florida, College of Law, LL.M. in Taxation, 1997) teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C.
The author may be reached for comment at firstname.lastname@example.org.
-  Geoffrey C. Dietrich, Esq. (United States Military Academy at West Point, B.S. 2000; Brigham Young University Law School, J.D. 2008) is a shareholder in Cantley Dietrich, P.C.
-  Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012).
-  Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
-  Jay D. Adkisson, Adkisson’s Captive Insurance Companies: An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. xiii.
-  Id.
-  Id.
-  Id. at xiv.
Beckett Cantley, F. Hale Stewart, Current Tax Issues with Captive Insurance Companies, Bus. L. Today, February 2014, 1.
-  F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
-  Consumers Oil Corporation of Trenton v. United States, 166 F. Supp. 796, 797-798 (N.J. 1960).
-  United States v. Weber Paper Co., 320 F.2d 199, 201 (8th Cir. 1963).
-  Stewart, supra at 6.
-  Gulf Oil Corp. v. C.I.R., 914 F.2d 396 (3d Cir. 1990).
-  Ocean Drilling and Exploration Co. v. United States, 988 F.2d 1135 (Fed. Cir. 1993).
-  F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 5-6.
-  Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
-  Beech Aircraft Corp. v. United States, Civil No. 82-1369, 1984 WL 988, *1 (D. Kan. 1984).
-  Id.
-  Id. at *3.
-  Id.
-  Id. at *4.
-  Id.
-  Humana, Harper, Amerco
-  Id.
-  Id.
-  Id.
-  Id. Id.
-  Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 56.
 Donald S. Malecki, CGL Commercial General Liability, © 2005 The National Underwriter Company, (For example, the commercial general liability policy usually excludes coverage for product recall and damage to “your product.” A captive could write a “difference in conditions” or DIC policy to specifically fill all gaps in the third party policy.)
-  Like commercially available insurance, captives have menu of standard coverages such as administrative actions, legal liability, product liability, product recall, pollution liability, etc…
- Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006), 56.
-  Id. at 56-68.
-  Jay D. Adkisson, Adkisson’s Captive Insurance Companies An Introduction to Captives, Closely-Held Insurance Companies, and Risk Retention Groups, iUniverse, Inc., (2006) p. 2.
-  Id. at 54-55.
-  F. Hale Stewart, U.S. Captive Insurance Law, iUniverse, Inc. (2010) p. 31.
-  Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 227.
-  Id. at 269.
-  See IRC § 953(d).
-  Beckett Cantley, Steering into the Storm: Amplification of Captive Insurance Company Compliance Issues in the Offshore Crackdown, Hous. Bus. & Tax L. J. 224 (2012), 269.
-  Id.
-  Id.
-  Id. at 268.
-  Id.
-  Id.
-  See IRC § 4371.
-  Id. at 269-70.
-  Id. at 251-52.
-  Id. at 242.
-  Id. at 272.
-  Treas. Reg. § 1.801-3(a).
-  IRC§§ 1291-98.
-  Beckett Cantley, The Forgotten Taxation Landmine: Application of the Accumulated Earnings Tax to I.R.C. § 831(b) Captive Insurance Companies, 11 Rich. J. Global L. & Bus. 159, 160 (2012), 163.
-  Harper Group and Subsidiaries v. C.I.R., 96 T.C. 45, 58 (T.C. 1991)
-  by F. Hale Stewart and Beckett Cantley, Captive Guidance After The ‘Dirty Dozen’ Listing, Tax Notes, June 8, 2015, p. 1191
-  IRC § 816(a).
-  Helvering v. LeGierse, 312 U.S. 531, 542 (1941); Rev. Rul. 89-96, 1989-2 C.B. 114 (1989).
-  See http://www.verisk.com/iso.html
-  Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering, 312 U.S. at 539).\
-  Helvering v. LeGeirse, 312 U.S. 531, 539 (1941).
-  Bobbe Hirsh & Alan S. Lederman, The Service Clarifies the Facts and Circumstances Approach to Captive Insurance Companies, 100 J. Tax’n 168, 169 (Mar. 2004).
-  Clougherty Packing Co. v. C.I.R., 84 T.C. 948, 959, aff’d, 811 F. 2d 1297, 1300 (9th Cir. 1987).
-  Humana, Inc. v. C.I.R, 881 F. 2d 247, 251 (6th Cir. 1995) (citing Helvering v. LeGierse, 312 U.S. at 539).
-  See Kidde Indus., Inc. v. United States, 40 Fed. Cl. 42, 53 (Fed. Cl. 1997) dismissed, 194 F.3d 1330 (Fed. Cir. 1999).
-  Humana, Inc. v. C.I.R, 881 F. 2d 247 (6th Cir. 1995).
What is a Syndicated Conservation Easement?
Authored by Beckett G. Cantley and Geoffrey C. Dietrich
A "syndicated" conservation easement is a transaction whereby the promoter organizes a group of investors together in an entity, uses the investors' cash contributions to the entity to purchase land, and places a conservation easement on the land restricting the private use of it. When you place a valid conservation easement on a parcel of land, you are reducing the value of the property by making a charitable donation of the perpetual use of the land to a charitable land trust. The IRS is challenging many syndicated conservation easements because, among other things, they take the position that the value of the conservation easement is being overstated when taking the charitable deductions generally allowed under Section § 170 of the Internal Revenue Code. The purpose of the deduction is to encourage the preservation of land. The amount of the deduction is generally equal to the difference between the value of the land at its "highest and best use" and the value of the land after the conservation easement is executed.
On June 25, 2020, the IRS announced a settlement initiative (“SI”) to certain taxpayers with pending docketed cases involving syndicated conservation easement (“SCE”) transactions. The SI is the current culmination of a long series of attacks by the IRS against SCE transactions. The IRS has recently found success in the Tax Court against syndicated conservation easements, but the agency’s overall legal position may be overstated. It is possible that the recent SI is merely an attempt to capitalize on leverage while the IRS has it. Regardless, the current state of the law surrounding SCEs is murky at best. Whether a taxpayer is contemplating the settlement offer, is currently involved in an unaudited SCE transaction, or is considering involvement in an SCE transaction in the future, the road ahead is foggy and potentially treacherous.
This article attempts to shed light on the obstacles that face syndicated conservation easement (SCE) transactions, including:
(1) an overview of syndicated conservation easement transactions and the main attacks against them;
(2) analysis of the IRS’ main attacks and the relevant issues that arise;
(3) illustrations of the relevant pro-taxpayer and anti-taxpayer cases on each issue;
(4) subsequent considerations that taxpayers need to take into account and the future outlook of syndicated conservation easement; and
(5) a summary of syndicated conservation easement key findings.
What is a Conservation Easement?
Under Section § 170 of the Internal Revenue Code, taxpayers are allowed to take a deduction for donating a conservation easement on their land. The purpose of the deduction is to encourage the preservation of land. The amount of the deduction is generally equal to the difference between the value of the land at its “highest and best use” and the value of the land after the conservation easement is executed. To take advantage of this deduction, many taxpayers have created transactions that are now referred to as syndicated conservation easement transactions. Typically in these cases, investors form and contribute funds to a partnership. The partnership then buys another partnership containing a tract of land that has been held by it for more than one year. The partnership obtains an appraisal of the land’s “highest and best use” which is considerably higher than the amount the land-owning partnership paid for the land. Then the partnership donates a conservation easement over the land to a local conservancy. Finally, the partners take large deductions (usually far more than their initial investment in the partnership) based on the new valuation of the land for their charitable contribution under Section 170.
The IRS is challenging many syndicated conservation easements as abusive tax shelters. The Internal Revenue Service (“IRS”) became suspicious of conservation easements in 2016, when it first designated syndicated conservation easement (“SCEs”) transactions as “listed transactions.” In 2019, the IRS announced a “significant increase in enforcement actions” related to SCE transactions as SCEs made the IRS’ “Dirty Dozen” list of tax scams. This increase in enforcement actions has primarily resulted in IRS victories in the Tax Court. Thus, the IRS recently announced a Settlement Initiative (“SI”) to leverage its favorable outcomes against the taxpayers. Some critics are skeptical of the SI, claiming the IRS only wins SCE cases on technical grounds and the IRS does not hold as strong of a position as it claims on the true issues surrounding conservation easements. Accordingly, many suggest that few taxpayers will take part in the SI.
In the Tax Court, the IRS is fighting the entire deduction, which many argue cuts against congressional intent. In the cases where the taxpayers prevail, the IRS is typically still able to reduce the value of the easement. There is virtually no case where the taxpayers get to keep the entire deduction. Despite their recent success in the Tax Court, the IRS is far from an outright victory in the war on conservation easements. The determinative issues in these cases are temporary roadblocks for SCE transactions. Eventually, taxpayers will figure out how to structure their SCE transactions to avoid the pitfalls of recent cases. For example, the IRS recently convinced the Tax Court that certain taxpayers’ easement deeds violate the perpetuity requirement of conservation easements because the extinguishment clause of the deed provides the one with a fixed value instead of a “proportionate value” upon extinguishment. Going forward, those drafting SCE deeds will make sure that the extinguishment clause complies with this requirement. Additionally, many conservation easements struck down in the Tax Court found much more favorable outcomes upon appeal. In fact, the most influential recent case is likely to be appealed in the 6th Circuit. The Tax Court avoids circuit precedent when possible, but as the number of cases rises the Tax Court may not be able to hide much longer. The IRS may eventually have to concede that SCEs are technically valid conservation easements. When that happens, the IRS will fall back on one of its original arguments—conservation easements overvaluation. Thus, valuation is the real issue and it is extremely fact-intensive and differs from case to case.
Currently, The IRS’ primarily attacks SCE’s by arguing that the taxpayers did not make a “qualified conservation contribution.” This is required for the taxpayers to receive the deduction for donating a conservation easement. There are three necessary requirements for a contribution to be considered a “qualified conservation contribution”:
- The contribution must be of a qualified real property interest (“QRPI”).
- The contribution must be made to a qualified organization.
- The contribution must be “exclusively for conservation purposes.”
The qualified organizations requirement is rarely litigated. This article shall discuss the relevant pro-IRS and pro-taxpayer cases on the other requirements below. Further, this article discusses the current state of the law surrounding syndicated conservation easements and the factors taxpayers will need to consider as they make decisions in this area.
Qualified Real Property Interest: Section 170(h)(2)© of the IRS Code
The determinative issue in some conservation easement cases has been whether a QRPI was contributed as a part of the deal. At its core, this attack on the easement deed is an attack on the perpetuity on the conservation easement. While the perpetuity of an easement is typically challenged under the “exclusively for conservation purposes” element, the QRPI argument still rears its head every now and then. This is evidence that the IRS is looking to exploit even the slightest of deficiencies in easement deeds. However, the decline in recent cases decided on this issue may be due to transaction organizers adapting to adverse case law in their drafting.
Section 170(h)(2) defines a QRPI as: “. . . a restriction (granted in perpetuity) on the use which may be made of the real property.” The applicable regulation provides that a “perpetual conservation restriction” is a qualified real property interest. A “perpetual conservation restriction” is a restriction granted in perpetuity on the use which may be made of real property—including, an easement or other interest in real property that under state law has attributes similar to an easement (e.g., a restrictive covenant or equitable servitude). It is critical that conservation easement exists in perpetuity. There is only one, extremely narrow exception to the perpetuity of such easements. As we will see in Part III, the Treasury Regulations provide for the judicial extinguishment of conservation easements in situations where the conservation purpose becomes either impossible or impracticable to carry out.
The seminal case on the issue of QRPI and perpetuity in the context of conservation easements is Belk v. Commissioner. In Belk, the taxpayers purchased a 410-acre tract of land, then transferred such land to their own limited liability company. The taxpayers then developed the land to include a golf course surrounded by residential lots. A few years later, the taxpayers executed a conservation easement over the portion of the tract which included the golf course. The easement was granted in perpetuity, but was subject to certain “reserved rights.” One of those rights, the centerpiece of the case, essentially allowed the taxpayers to modify which parcels of land were or were not covered by the conservation easement, as long as the change was proportionate and did not adversely affect the conservation purpose of the easement.
The Tax Court held, and the Fourth Circuit affirmed, that the taxpayers had not donated a QRPI. Therefore, they lost the entire deduction. The Tax Court reasoned that because the conservation easement allowed the taxpayers to change the boundaries of the easement, the easement was not granted in perpetuity. The taxpayers contended that since the provision required them to maintain a certain proportion of land within the conservation easement, the value of the easement does not change—thus, it exists in perpetuity. The Fourth Circuit rejected this argument by emphasizing the plain language of the statute: “a [QRPI] includes a restriction (granted in perpetuity) on the use . . . of the real property.” The Fourth Circuit held that the perpetuity of a restriction is inevitably attached to the real property originally designated as a conservation easement. “Thus, while the restriction [in this case] may be perpetual, the restriction on ‘the real property’ is not.” Therefore, the taxpayers had not donated a QRPI and the easement did not qualify as a “qualified conservation contribution.”
Conservation Easement Pro-Taxpayer Cases
While Belk continues to spearhead the dismantling of many conservation easements, some cases have come out in the taxpayers’ favor as the courts wrestle how to interpret and distinguish Belk. In 2013, the Tax Court decided Gorra v. Coissioner. In Gorra, the taxpayers donated a conservation easement on the façades of a townhouse in New York. The Commissioner contended that the easement was not perpetual because “there are facts to indicate that the [one] was willing to terminate the [e]asement upon [the taxpayers’] request.” The court ignored this argument—focusing exclusively on the language of the easement deed. Accordingly, the court differentiated this case from Belk because the deed clearly defined the property donated under the easement and restricted the easement to that property in perpetuity. Thus, the taxpayers had donated a QRPI and the easement donated qualified as a “qualified conservation contribution.”
Importantly, the court affirmed that the term “QRPI” includes the perpetuity requirement. In other words, for a parcel of land to be considered a QRPI for purposes of a conservation easement, the interest must be set aside in perpetuity. The taxpayer cannot switch what land is protected and what is not—that would violate perpetuity. Additionally, it is important to note that although the taxpayers prevailed in securing their deduction, they ultimately lost on valuation. The court held that the easement was overvalued by over 400%. Therefore, the taxpayers lost over 80% of their deductions and were also assessed the maximum accuracy-related penalty of 40%.
A couple of years later, the Tax Court decided Bosque Canyon Ranch, LP v. Comm’r. In this case, two related partnerships sold a tract of land to its partners for the purposes of development and conservation. Part of the land was developed, while the other was donated as a conservation easement to a charity one land trust. Crucially, the easement deed allowed the partners to slightly modify the easement boundaries by mutual agreement with the one. The Tax Court agreed with the IRS that this provision was similar to the provision in Belk. Therefore, the Tax Court held that the taxpayers had, in turn: violated perpetuity, not donated a QRPI, and not made a “qualified conservation contribution.”
Interestingly, the 5th Circuit reversed in Tax Court’s decision two years later in favor of the taxpayers. The 5th Circuit held that the instant case was different from Belk because the easement could only be modified if it left the original exterior boundaries intact and if the total acreage of the easement remained the same. To illustrate, picture of a slice of Swiss cheese. The piece of cheese is the tract of land and the holes represent the parts of the land that the easement does not cover. In this case, the 5th circuit is saying that the sizes of the holes can change as long as the total amount of cheese remains constant (i.e. when one hole gets bigger, another hole or holes must get smaller to compensate) and the external square shape of the slice also stays intact. Additionally, the court recognized that the modifications at issue were “de minimis at most.” Finally, although the taxpayers won at the appellate level, the case was remanded to the Tax Court for valuation analysis. The dispute overvaluation is ongoing.
Anti-Taxpayer Conservation Easement Cases
Gorra and Bosque Canyon Ranch are unique cases. Belk is typically interpreted by the Tax Court to leave no room for error regarding the QRPI requirement. In 2015, the Tax Court decided Balsam Mountain Investments, LLC v. Commissioner. In that case, the taxpayers executed a conservation easement with a provision allowing the taxpayers to shift the easement boundaries up to five percent in the first five years of the easement’s existence. The court held that while this provision was slightly different and much less dramatic than the provision in Belk, the difference is not enough for the easement to qualify. The court held that the taxpayers had not contributed a perpetual QRPI sufficient to receive the desired deduction. Importantly, the court further asserts that under Section 170(h)(2)© there must be an “identifiable, specific piece of real property.”
The most recent case on the QRPI issue is Pine Mountain Preserve, LLLP v. Commissioner. The easement deed in Pine Mountain is similar to the deed in Bosque Canyon Ranch in that it permitted slight changes to the interior boundaries of the easement, but not to the total acreage or exterior boundaries of the easement. The court explicitly acknowledged that the facts in this case are similar to those in Bosque Canyon Ranch, but chose not follow the 5th Circuit’s precedent because this case was not appealable in the 5th Circuit.
The court uses the Swiss Cheese analogy from the dissent in Bosque Canyon Ranch to illustrate its decision and how it believes this case, along with Bosque Canyon Ranch, should be treated the same as Belk. The court claimed that Belk and Bosque Canyon Ranch are the same in that they make new holes in the cheese. Regardless of whether or not the acreage proportion is the same, creating new holes or changing the sizes of each hole is not permissible under Belk and violates perpetuity. Accordingly, the court held its ground on the QRPI issue in this case.
Qualified Real Property Interest Case Analysis
While the issue of whether a QRPI is contributed is not usually the main issue in conservation easement cases, taxpayers (and drafters) should take a second look at their deeds to make sure that they are truly contributing a QRPI in perpetuity given recent caselaw. These cases reveal multiple key insights to help with this analysis. First, for the Tax Court, there must be an “identifiable, specific piece of real property” that is restricted and perpetual in size and shape. Additionally, the Tax Court is very skeptical of any provision in the easement deed which allows for modifications of the easement boundaries. The appellate courts might be more taxpayer friendly. However, the court also noted in Pine Mountain (and affirmed in Oakbrook) that the retained powers of all parties to change contractual terms does not by itself deprive a deed of easement of its required perpetuity.
Conservation Easement Cases Primarily center on “Exclusively for Conservation Purposes”
The majority of conservation easement cases center on whether the contribution is “exclusively for conservation purposes.” There are three main categories of challenges by the IRS under this issue: environmental/wildlife, exchange, and perpetuity.
Section §170(h) of the IRS code defines “conservation purpose” as:
- the preservation of land areas for outdoor recreation by, or the education of, the general public,
- the protection of the relatively natural habitat of fish, wildlife, or plants, or similar ecosystem,
- the preservation of open space (including farmland and forest land) where such preservation is—
- for the scenic enjoyment of the general public, or
- pursuant to a clearly delineated Federal, State, or local governmental conservation policy, and will yield a significant public benefit, or
- the preservation of a historically important land area or a certified historic structure.
Conservation Easements: Environmental & Wildlife Protection
IRS Cases Challenging conservation easements
The IRS has challenged conservation easements on section §170(h)(ii), “the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.” The regulations add the word “significant” before the word “relatively.” Thus, to the extent the Code allows, the protection at issue must be “significant.” Significance is subjective and is typically decided on a case by case basis.
The most recent case challenging the significance of the protection of environmental and wildlife interests is Champions Retreat Golf Founders, LLC v. Commissioner. In that case, the taxpayers bought a 463-acre tract of land in 2002. Two-thirds of the parcel was used as a golf course. The other third was either used for homesites or was undeveloped. In 2010, the taxpayers executed a conservation easement on a 348-acre portion of the land including the undeveloped land and the golf course. The easement land “is home to abundant species of birds, some rare, to the regionally declining fox squirrel, and to a rare plant species, the dense flower knotweed.”
The issue in the case was whether the taxpayers contributed the easement for “the protection of a [significant] relatively natural habitat of fish, wildlife, or plants, or similar ecosystem,” or for “the preservation of open space . . . for the scenic enjoyment of the general public [that] will yield a significant public benefit.” The Tax Court held that it did. The 11th Circuit reversed. The 11th Circuit took a broad approach to the regulations, ultimately deciding that at least part of the easement was exclusively for conservation purposes and that it protected both a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem and open space for scenic enjoyment under §170(h)(ii) and (iii). The IRS argued that the presence of a golf course on most of the easement property prohibited the land from being considered “natural.” The court rejected this argument, saying that what matters under the regulation is not that the land is natural, but that the habitat is. Thus, the court acknowledged that the taxpayers are entitled to a deduction if the easement is made to protect the habitat of a “rare, endangered, or threatened species.” Since the easement includes the habitat of some rare, endangered, and threatened species of plants and animals, the court found that the Tax Court’s finding otherwise was clearly erroneous and wrong as a matter of law. Additionally, the court found that but for the golf course being built on the property, the easement would clearly be the preservation of open space for public enjoyment. Again, while the taxpayers prevailed on appeal, the case has been remanded to the Tax Court for valuation analysis.
Analysis of Tax Court rulings on conservation easements
In general, the Tax Court will be much more hesitant to find that easements are made exclusively for conservation purposes. As seen in Champions, the Tax Court relies on the term “significant” in the relevant regulation to justify its analyses. The Tax Court seems to want to weigh the particular facts and circumstances for itself in each case. However, the Tax Court fails to create any sort of identifiable or objective framework for deciding what is “significant” under the regulation. Accordingly, it seems like that Tax Court’s standard for what is “exclusively for conservation purposes” is both high and unpredictable.
Although circuit courts, like the 11th Circuit in Champions, have generally been more sympathetic to taxpayers and have interpreted the applicable regulations quite broadly, the Tax Court has resisted at every point that it can. The Tax Court has insisted on construing the regulations narrowly. Any ground given up on the regulations is given to the IRS by deference to the administrative agency. Additionally, the Tax Court’s eagerness in Pine Mountain voice its disagreement with the 5th Circuit’s Bosque Canyon opinion shows how strongly the Tax Court feels about its positions regarding conservation easements. That is not likely to change soon. Thus, it is likely that if a case like Champions came through the Tax Court from outside the 11th Circuit, the Tax Court would maintain its position against the taxpayer. Perhaps most importantly, even if taxpayers win on this issue, valuation remains a significant hurdle going forward.
Exchange or Gift: exclusively for conservation purposes
To be exclusively for conservation purposes, the taxpayer can receive no other consideration from the donee and can place no conditions on the gift. While this argument is not usually made within the context of Section §170(h), it is implicit in the analysis. Section §170(c) defines a charitable contribution as a contribution or gift to or for the use of various specified entities or other types of entities for certain approved purposes. This means a charitable contribution—eligible for a deduction—cannot include a quid pro quo arrangement. A few conservation easements have been defeated in cases where the donor conditioned the gift or received something in return. For example, in Pollard v. Commissioner, the Tax Court denied a deduction related to a conservation easement because the taxpayer had given the conservation easement to the county in exchange for a subdivision exemption. The court held that there was a quid pro quo arrangement and therefore there could be no deduction for a charitable contribution.
Moreover, in Graev v. Commissioner, the taxpayer made a side deal with the donee which placed a condition on the conservation easement. The side deal provided that in the event the IRS disallows the taxpayer’s charitable deduction, the taxpayer would recoup his investment and both parties would work together to extinguish the conservation easement. The court pointed to Reg. §1.170A-1(e) which “clarifies that . . . no deduction for a charitable contribution that is subject to a condition . . . is allowable, unless on the date of the contribution the possibility that a charity’s interest in the contribution [would be defeated] is “negligible”. The court held that since the possibility of the donee’s interest in the land being defeated was not “so remote as to be negligible.” Thus, the taxpayer’s deduction is not allowable.
Therefore, while contributions of conservation easements do not usually run into this issue, it is important to note that for a contribution to be considered a “qualified conservation contribution,” it must first be a charitable contribution. Only under rare circumstances can a charitable contribution be subject to a condition and remain charitable. If a contribution is not charitable, it cannot be a “qualified conservation contribution” because it would not be “exclusively for conservation purposes.” Therefore, taxpayers with conservation easements that are subject to one or more conditions or are a product of a quid pro quo arrangement are likely to lose their entire deduction if challenged.
Perpetuity: core aspect of what makes a conservation easement work
Conservation easements, to be made exclusively for conservation purposes, must exist in perpetuity. Perpetuity is the core aspect of what makes a conservation easement work and it is central to the policy considerations that underlie its existence. This is the most common way the IRS targets deductions attached to conservation easements. It is their recent victories on this issue that have prompted the recent SI.
There are over twenty cases that have been decided on the issue of perpetuity, and of those cases, the taxpayers prevail in only three. This disparity shows the importance of perpetuity as the cornerstone of conservation easements. It also displays the painstaking determination IRS and the Tax Court have to make sure that conservation easements are truly perpetual in existence if they are to allow accompanying deductions. The IRS and the Tax Court have demonstrated their willingness to go great lengths to find that a certain aspect of a conservation easement deed violates perpetuity. Once they have this hook into perpetuity, they can drag the entire deduction down.
Pro-Taxpayer Cases: conservation easements have to be perpetual in order to be valid
Two of the three pro-taxpayer cases on this issue, Gorra and Bosque Canyon Ranch, have already been discussed in the context of QRPIs. This is because perpetuity applies to both the first and third elements of a “qualified conservation contribution.” We have seen how a QRPI necessarily includes a restriction in perpetuity. However, outside of the QRPI issue, recent cases simply recognize that conservation easements have to be perpetual in order to be valid. If they are not perpetual, they are not “exclusively for conservation purposes.”
The other pro-taxpayer case is Irby v. Commissioner.Irby was a unique case decided in 2012. In that case, the IRS tried to challenge the extinguishment clause of the conservation easement deed, claiming the conservancy would not get its fair share upon extinguishment. Thus, the deed was “superficial” and not exclusively for conservation purposes. Unlike the other extinguishment clause cases discussed below, this clause provided for the donee (a government funded organization) to repay the government upon extinguishment of the easement. The IRS argued that this deprived the donee of their proportionate share under the regulation. However, the court reasoned that this situation was different because the donor would not receive a windfall as a result of the extinguishment of the easement. Thus, what happens to the donee’s proportionate share apart from the donor is beyond the scope of the regulation. Therefore, the court disagreed with the IRS and upheld the clause and the easement.
Conservation Easement IRS Anti-Taxpayer Cases
The most influential conservation easement case as of late is Oakbrook Land Holdings, LLC v. Commissioner. While this case is currently on appeal in the 6th Circuit, it has been used to strike down many conservation easements in the past couple months. In Oakbrook, the taxpayers bought a 143-acre piece of land. The taxpayer set aside 37 acres for development, and donated the remaining 106 acres to a local conservancy. The IRS took issue with the extinguishment clause of the easement deed. Extinguishment clauses are commonly found in conversation easement deeds. These clauses outline the division of hypothetical proceeds from a future hypothetical extinguishment of the easement. To understand how these clauses work, a closer look at the regulations is helpful.
Although conservation easements must exist in perpetuity, the law does provide a very limited avenue to dissolve them. The relevant regulation provides:
If a subsequent unexpected change in the conditions surrounding the property that is the subject of a donation under this paragraph can make impossible or impractical the continued use of the property for conservation purposes, the conservation purpose can nonetheless be treated as protected in perpetuity if the restrictions are extinguished by judicial proceeding and all of the donee's proceeds . . . from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.
The following section governs how the proceeds of the extinguishment are distributed between the parties:
. . . for a deduction to be allowed under this section, at the time of the gift the donor must agree that the donation of the perpetual conservation restriction gives rise to a property right, immediately vested in the donee organization, with a fair market value that is at least equal to the proportionate value that the perpetual conservation restriction at the time of the gift, bears to the value of the property as a whole at that time. . . . For purposes of this paragraph (g)(6)(ii), that proportionate value of the donee's property rights shall remain constant. Accordingly, when a change in conditions give rise to the extinguishment of a perpetual conservation restriction under paragraph (g)(6)(i) of this section, the donee organization, on a subsequent sale, exchange, or involuntary conversion of the subject property, must be entitled to a portion of the proceeds at least equal to that proportionate value of the perpetual conservation restriction, unless state law provides that the donor is entitled to the full proceeds from the conversion without regard to the terms of the prior perpetual conservation restriction. (Emphasis added).
In other words, even though conservation easements with extinguishment clauses may not be perpetual in fact, they can be “treated as protected in perpetuity” if the extinguishment clause complies with the regulations. Accordingly, the regulations provide that upon extinguishment, the donee is entitled to a “proportionate share” of the subsequent proceeds. In Oakbrook, the IRS argued that the deed’s extinguishment clause did not provide for the donee to get their “proportionate share.”
The easement deed in Oakbrook provided that upon extinguishment and subsequent sale, the donee “shall be entitled to a portion of the proceeds equal to the fair market value of the [c]onservation [e]asement.” The IRS argued that this provision did not comply with the regulation because the donee should get a “proportionate share”—a fraction, not a fixed value. The taxpayers argued that the regulation says “value” not “share.” Therefore, the whole number they provided for in their deed is permissible.The court ruled that the IRS interpretation is correct without relying on deference to the agency’s interpretation. Thus, the regulation prohibits any scenario in which a donor gets to recover compensation other than a proportionate share (a fraction) of the proceeds, with the proportion defined by the easement’s FMV over the FMV of the unencumbered and unimproved property.
In sum, the court disallowed the deduction because the extinguishment clause in the easement deed did not comply with the applicable regulations. Because the clause existed (jeopardizing the perpetuity of the conservation easement) and did not comply with the regulations, it cannot be treated as protected in perpetuity as the regulation permits. Thus, a small defect in the easement deed cost the taxpayers lost their entire deduction.
This case is likely to be appealed to the Sixth Circuit, and the outcome is uncertain based on 6th Circuit precedent. There are two relevant cases in the 6th Circuit: Hoffman Properties II, LP v. Commissioner and Glass v. Commissioner.Glass was decided in 2006, in favor of the taxpayers. In Glass, the court affirmed the Tax Court’s decision that the easement in that case was protected in perpetuity, but offered little analysis on the issue. In April of 2020, the court decided Hoffman in favor of the IRS. In that case, the easement deed gave the donor the ability to make changes to the easement as donee permits. Thus, the circuit court affirmed the Tax Court’s decision that this provision defeated the perpetuity of the conservation easement.
Although appellate courts have generally been more sympathetic towards taxpayers, the 6th Circuit has typically deferred to the Tax Court on these issues. Additionally, neither of these cases made a sincere attempt to analyze the relevant regulations and apply them to the easement deed. Further, neither of these cases involved an extinguishment clause. Thus, an appellate decision in Oakbrook is a wild card. Nonetheless, many cases have come out of the Tax Court in the past month following Oakbrook and striking down conservation easements over defective extinguishment clauses. Even if the 6th Circuit reverses Oakbrook, the Tax Court is likely to maintain course in cases ineligible for appeal in the 6th Circuit.
Analysis: conservation easement deductions
Right now, the IRS is hanging its hat on improper extinguishment clauses, which render conservation easement deductions wholly invalid. Some believe the IRS is engaging in scare tactics by issuing a SI before the courts have truly settled these issues, but the IRS also knows that it has valuation as a backstop. Moreover, Oakbrook differs from Irby in that the issue in Irby was how the donee’s “proportionate share” was allocated after distribution. However, in Oakbrook, the issue was whether the donee received their “proportionate share.” In Oakbrook, the court was worried about the donor obtaining a windfall upon extinguishment. Conversely, in Irby, the donor would never receive a windfall from the extinguishment of the easement because the donee would be repaying the government, not the donor.
Finally, it is also worth noting the Tax Court’s approach to the applicable regulations in Oakbrook. The court recognized that both parties’ interpretations of the regulation at issue were not plain readings of the text. The court also acknowledged that the 5th Circuit previously found the regulation to be ambiguous. The 5th Circuit recognized that when a regulation is ambiguous, courts should defer to the agency that issued it. However, the Tax Court in Oakbrook specifically concluded that this type of deference was unwarranted in this case. Curiously, the court asserts that although the Commissioner’s interpretation is “not a plain reading,” it is the correct conclusion based on “traditional tools of construction.” Thus, the court held that deference to the agency was unnecessary. Interestingly, this is not the first time in which a circuit court deferred to the IRS while the Tax Court did not.
In recent cases, the Tax Court seems almost merciless their insistence that the IRS wins even without any deference to the IRS. The Tax Court appears to be almost an IRS ally in the war on SCE transactions. However, speculation and technicalities seem insignificant when taxpayers realize that even if they win on these issues, the dispute over valuation lurks around the corner.
Valuation: IRS’ attack on SCE deductions
Once the dust settles on the IRS’ attack on SCE deductions, taxpayers are still not in the clear. It now seems like the imperfections in the various deeds from these cases can be fixed and adjusted by those still seeking to create a SCE transaction. Future drafters now know the pitfalls to avoid. For example, do not allow changes to the easement boundaries and make sure any extinguishment clause complies with the Treasury Regulations. Assuming this happens, there will likely be a time where the IRS can no longer win these cases on such technicalities—disallowing entire deductions. However, when that time comes, the IRS will likely turn to valuation as the main issue. Objectively, this is the real reason why the IRS dislikes SCE schemes. In fact, the IRS said they don’t care if they lose on everything else—they believe they will win on value. The IRS has no issue with conservation easements or the conjunctive deductions. The IRS is targeting those it believes to be abusing conservation easements for large tax savings.
The valuations of SCEs are problematic because they directly relate to the amount of the subsequent deductions—which is arguably the main goal of SCE transactions. Thus, there is an incentive for taxpayers to obtain an inflated valuation. The value of a conservation easement is the difference between the fair market value of the land before the easement and the fair market value of the land after the easement. Theoretically, this value should reflect the forgone value of development rights on the land. It is standard practice to value property at its most valuable reasonably probable use—or “highest and best” use. However, such a determination is highly subjective and thus highly contestable.
The IRS must believe the taxpayers in these cases have no reason to pursue a conservation easement other than tax savings. If not, the IRS would not have attempted to disallow the entire deduction in recent cases. The IRS would have gone straight to disputing the valuation. However, assuming certain fact patterns in which taxpayers would prevail on the “qualified conservation contribution,” the IRS will have to settle for arguing for a reduced valuation. In that case, the outcome of each case will truly depend on its own facts and circumstances. Unfortunately, the Treasury Regulation does not provide helpful guidance on the valuation of conservation easements. In short, the regulation states that 1) the value of the easement is the fair market value, 2) if there are relevant comparable transactions, the fair market value should be based on those, 3) if there are no relevant comparable transactions, the fair market value equals the difference between the value before the easement and the value after the easement, and 4) that this value is the value of the deduction.
A new methodology has emerged by those appraising SCEs which has not yet seen significant challenge by the Tax Court. This methodology applies four main criteria pulled from the Uniform Standards of Professional Appraisal Practice: what is legally allowable, physically possible, financially feasible, and maximally productive. The “maximally productive” element is the most controversial. The regulations require an “objective assessment” of such development’s likelihood. Critics suggest that many SCE valuations do not contain this “objective assessment” to substantiate their valuation. Thus, typical SCE valuations reflect a hypothetical value derived from inappropriate assumptions about the land’s maximum productivity. Thus, a discounted cash flow analysis will project a value which no buyer would ever pay. This directly conflicts with the definition of fair market value—which requires a willing buyer and seller.
Recently, the Tax Court has seldom addressed the issue of valuation as it has found other ways to extinguish these conservation easements completely. However, many of the cases pending and those remanded from the appellate level are currently being decided on the issue of valuation. Past results in the Tax Court have varied. In most cases, the court leans toward the valuation of the IRS which is usually far less than the taxpayers’ valuation. There are a couple of favorable outcomes for taxpayers, but far from an outright victory on valuation. Therefore, even if taxpayers successfully retain their deduction, they face an uphill battle on the amount of such deduction. Adding insult to injury, taxpayers could still face a hefty penalty for overvaluing their deduction. Altogether the return on investment for those involved in SCE transactions seems bleak.
Conservation Easement: Penalties and the IRS Settlement Initiative
Generally, there is a 10%-20% penalty applied to gross misstatements of deductions. The IRS routinely goes for the maximum of 40% in conservation easement cases. It is either all or nothing. In most of the cases, the Tax Court has upheld the 40% penalty. However, there is a considerable amount of circumstances, like Oakbrook, in which the court disallows the entire deduction but does not impose a penalty at all. This is based on the reasonableness of the taxpayers’ actions and assumptions. If the court decides the taxpayers acted reasonably, then no penalty will be assessed. However, in most cases in which the Tax Court invalidates a conservation easement and decides the partners acted unreasonably, the court imposes the 40% maximum penalty. This might be different for cases in which valuation is the only issue. Since the taxpayers would be overvaluing a deduction rather than claiming one they do not have, the penalty might be less severe—like the typical 10%-20%.
The uncertainty regarding penalties is a crucial issue for those contemplating the recent SI offer. There are four key terms of the settlement agreement—one condition and three effects. To accept the settlement, “[a]ll partners must agree to settle, and the partnership must pay the full amount of tax, penalties, and interest before settlement.” Once the taxpayers accept the offer:
- The deduction for the conservation easement is disallowed in full;
- “Investor” partners can deduct their cost of acquiring their partnership interests and pay a reduced penalty of 10% to 20% depending on the ratio of the deduction claimed to partnership investment;
- Partners who provided services in connection with any SCE transaction (promoters) must pay the maximum penalty asserted by the IRS (typically 40%) with no deduction for their costs.
The settlement offers only the 10-20% penalty and gives a deduction for the partner’s initial investment. This might be intriguing, but the promoters get nothing and are subject to the maximum 40% penalty.
At the end of the day, the SI pits investor partners against promoters. This puts additional pressure on taxpayers because participation in the SI requires the unanimous consent of all partners. Litigation promises only uncertainty, but settlement might only offer minimal relief for investors while ensuring disappointment for promoters. Taxpayers should carefully consider the strength of their cases, the durability of their valuations, the penalties at stake, and the costs of litigation as they contemplate the SI offer.
Although the IRS’ legal position on conservation easements is questionable, it may not be worth the fight. Those taxpayers with subpar easement deeds or extremely inflated valuations will likely find the SI to be an attractive option. However, those taxpayers who are confident in the viability of their conservation easements and believe their valuation is accurate enough for them to break-even on their investments might resist folding to the IRS’ demands.
Furthermore, appraisers themselves are currently at a heightened level risk of being assessed a penalty for their valuation of conservation easements. Normally, appraisals are a matter of judgment guided by certain valuation procedures and standards such as the Uniform Standards of Professional Appraisal Practice mentioned in Part IV. Such judgment is typically subject to a review process before an IRS penalty is applied. This process would usually include input from at least five experienced opinions from IRS employees and a second opinion from another appraiser. However, the IRS recently eliminated this review process entirely. Thus, “under the revised IRS procedure, a single IRS employee, who may have no background whatsoever in the land appraisal, could advance a penalty assessment.” This action destroys all checks and balances in the review process, meaning appraisers now have little ability to defend their valuations. In the end, the IRS gets to make an arbitrary decision on the validity of valuations.
Such an aggressive regulatory change tips the IRS’ hand. It seems that the IRS may not actually care about the true valuation of conservation easements. Rather, it seems the IRS would prefer to eliminate the deduction for conservation easements entirely. However, as the saying goes, “deductions are a matter of legislative grace.” The IRS does not have the right to decide what deductions a taxpayer is entitled to. It may disagree with the value, but not with the deduction itself. Effectively, this is what the IRS is attempting to do. The agency does not like the way taxpayers and appraisers are playing under the statutory and regulatory rules, so it simply changes the rules to stack against the taxpayer. The commandeering of authority on conservation easement valuations shows that the IRS cares more about winning on all SCE audits than it does about solely targeting abusive SCE transactions.
Conclusion: The IRS is waging war on SCE transactions
The IRS is waging war on SCE transactions. Moreover, the Tax Court seems skeptical—if not hostile—towards these transactions as well. The two main attacks on SCEs are (1) that they do not contribute a “qualified real property interest” and (2) that they are not made “exclusively for conservation purposes.” Both of these are required for the donation of a conservation easement to be considered a “qualified conservation contribution.” If there is no “qualified conservation contribution,” there is no deduction allowed for the donors. While some taxpayers have been able to fend off these attacks, the IRS has mostly been successful in these attacks in the Tax Court. Appellate courts have been more sympathetic towards taxpayers, but the Tax Court has maintained course when possible.
Taxpayers will eventually figure out how to construct their easement deeds to avoid the pitfalls of the recent cases (e.g. extinguishment clauses). When that happens, valuation will be the main issue. Unfortunately for taxpayers, the road gets even foggier at this point as it is difficult to predict how the courts will come out on valuation. Regardless, we do know that such a determination is extremely fact intensive and will vary from case to case. On top of everything else, taxpayers must worry about the possibility of significant penalties if they lose their cases.
For those contemplating the current settlement offer, they likely cannot do anything about issues with their deeds, if they have them, considering Oakbrook. Since those taxpayers are facing a likely disallowance of the entire easement, the SI is probably a better deal even without considering the possibility of a 40% penalty. However, there could easily be multiple scenarios where there is a proper extinguishment clause and where the rest of the deed complies with the regulations. In those cases, valuation will be the key issue. If so, the decision on whether to take the SI offer becomes more complicated than it already is—considering litigation fees and the strength of the taxpayers’ valuation.
The evidence is mounting that the IRS’s attack on SCEs is overly aggressive. The cumulative effect of recent IRS actions such as eliminating the appraisal penalty review process, attempting to completely strike down conservation easements, and offering a one-sided SI, has the effect of heavily discouraging the donation of conservation easements. This cuts against congressional intention to incentivize the conservation of land and it is arguably a regulatory over-step by the agency. The IRS is demanding surrender on syndicated conservation easements. They may or may not be well-positioned to make such demands. Regardless, the battle ahead for taxpayers is long, treacherous, and unforgiving. Some might lose their entire deduction. Some of those might wind up paying an additional 40% penalty. Others might successfully defend their deduction, but many of those will lose on valuation. The likelihood of a taxpayer escaping with their full deduction is slim to none. The last time that happened was in 2009, before the dramatic rise of SCE transactions. The fate of SCE transactions will be revealed in due time. For now, taxpayers have a difficult decision to make—potentially premature surrender or a tedious gamble.
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 Beckett G. Cantley, Esq. teaches International Taxation at Northeastern University and is a shareholder in Cantley Dietrich, P.C. Prof. Cantley would like to thank Melissa Cantley and his law clerk, Austin Young, for their contributions to this article.
 Geoffrey C. Dietrich, Esq. is a shareholder in Cantley Dietrich, P.C.
 See 26 USCA § 170 (West).
 See id. at § 170(h).
 26 CFR § 1.170A-14.
 Guinevere Moore, IRS Settlement Program For Syndicated Conservation Easements Announced, Forbes (Jun. 26, 2020, 12:23 PM), https://www.forbes.com/sites/irswatch/2020/06/26/irs-settlement-program-for-syndicated-conservation-easements-announced/#33ea36f7e3cf.
 IRS News Release IR-2020-130 (Jun. 25, 2020) (hereinafter “IR-2020-130“).
 Listing Notice--Syndicated Conservation Easement Transactions, 2017-4 IRB 544 (2016).
 IRS News Release IR-2019-182 (Nov. 12, 2019).
 See e.g. Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018); see also Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 TCM (CCH) 1352 (TC 2020).
 Kaustuv Basu and Aysha Bagchi, IRS Land Deal Offer Has Little to Entice Challengers to Settle, Bloomberg Law (Jul. 9, 2020, 3:46 PM), https://news.bloombergtax.com/daily-tax-report/irs-land-deal-offer-has-little-to-entice-challengers-to-settle.
 Nancy Ortmeyer Kuhn, INSIGHT: Charitable Conservation Easements—IRS and Tax Court Act To Shut Them Down, Bloomberg Law (Jul. 22, 2020, 3:01 AM), https://news.bloombergtax.com/daily-tax-report/insight-charitable-conservation-easements-irs-and-tax-court-act-to-shut-them-down.
 See, e.g., Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013).
 In 2009, the taxpayers won a near outright victory. Kiva Dunes Conservation, LLC v. Comm'r, 97 T.C.M. (CCH) 1818 (T.C. 2009).
 See Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).
 See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020) (remanded to Tax Court for valuation).
 See Oakbrook.
 See, e.g., compare Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018), with BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).
 26 USCA § 170(h) (West).
 See §170(f)(3)(B)(iii).
 See §170(h).
 Kuhn, supra note 14.
 26 USCA § 170(h)(2) (West).
 26 CFR § 1.170A-14
 See infra Part III(C).
 Belk v. Comm'r, 774 F.3d 221 (4th Cir. 2014).
 Id. at 223.
 Id. at 223-24.
 Id. at 230.
 See id.
 Id. at 225-26.
 Gorra v. Comm'r, 106 T.C.M. (CCH) 523 (T.C. 2013).
 Id. at 1.
 Amended Reply Brief for Respondent at 93, Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013) (No. 15336-10).
 Gorra at 9.
 Id. at 8-9.
 Id. at 24-25.
 Id. at 25.
 BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).
 Id. at 549-51.
 Id. at 552.
 Bosque Canyon Ranch, LP v. Comm'r, 110 TCM (CCH) 48 (TC 2015), vacated and remanded sub nom. BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).
 BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).
 Id. at 552-53.
 See id. at 562.
 See id. at 552-53.
 Id. at 554.
 Id. at 560.
 Balsam Mountain Investments, LLC v. Comm'r, 109 TCM (CCH) 1214 (TC 2015).
 Id. at 2.
 See id. at 3.
 Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).
 See id. at 256-60.
 See id. at 272-73.
 See id. at 273-74.
 Balsam Mountain Investments at 3.
 See Balsam Mountain Investments; see also Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).
 See BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017).
 Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).
 See Pine Mountain.
 26 USCA § 170(h)(4)(A) (West).
 Id. at (ii).
 26 C.F.R. § 1.170A-14(d)(3)(i).
 See id.
 Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020).
 Id. at 1034-35.
 Id. at 1034.
 The word “significant” is added to account for the regulation; see supra note 80.
 See generally, Champions.
 See Champions.
 See id 1036-38.
 Id. at 1038.
 Id. at 1039.
 Id. at 1041.
 See, e.g., Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).
 See 26 U.S.C.A. § 170(c) (West).
 Pollard v. Comm'r, 105 T.C.M. (CCH) 1249 (T.C. 2013).
 Graev v. Comm'r, 140 T.C. 377 (2013).
 Id.; 26 C.F.R. § 1.170A-1(e).
 Graev at 409.
 See 26 U.S.C.A. § 170 (West).
 26 C.F.R. § 1.170A-1(e).
 26 U.S.C.A. § 170(h)(5) (West).
 See Ann Taylor Schwing, Perpetuity Is Forever, Almost Always: Why It Is Wrong to Promote Amendment and Termination of Perpetual Conservation Easements, 37 Harv. Envtl. L. Rev. 217, 221 (2013). There is only one limited exception to perpetuity, discussed infra note 131 and accompanying text.
 See IR-2020-130.
 See, e.g., BC Ranch II, LP v. Comm'r of Internal Revenue, 867 F.3d 547 (5th Cir. 2017); Gorra v. Comm'r, 106 TCM (CCH) 523 (TC 2013).
 See, e.g. Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).
 See infra Part II(A).
 See, e.g. Oakbrook.
 Irby v. Comm'r, 139 TC 371 (2012).
 Id. at 380. As we will see later, this is a typical IRS argument on this issue
 Id. at 376-77.
 Id. at 380.
 Id. at 380-85.
 Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (T.C. 2020).
 See, e.g., Plateau Holdings, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-093 (TC 2020); Lumpkin HC, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-095 (TC 2020).
 Oakbrook at 3.
 Id. at 5.
 Id. at 11.
 Id. at 2.
 26 C.F.R. § 1.170A-14(g)(6)(i) (emphasis added).
 26 C.F.R. § 1.170A-14(g)(6)(ii) (emphasis added).
 See id. at (i) and (ii).
 Oakbrook at 11.
 Id. at 6-7.
 Id. at 21-22.
 Id. In a companion case, Oakbrook challenged the validity of the regulation and failed.
 Id. at 25.
 See id.
 See id.
 Hoffman Properties II, LP v. Comm'r of Internal Revenue, 956 F.3d 832 (6th Cir. 2020), reh'g and suggestion for reh'g en banc denied, No. 19-1831, 2020 WL 3839687 (6th Cir. June 17, 2020).
 Glass v. Comm'r, 471 F.3d 698 (6th Cir. 2006).
 Hoffman Properties II.
 See Glass; Hoffman Properties II.
 See id.
 See id.
 See, e.g., Plateau Holdings, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-093 (TC 2020); Lumpkin HC, LLC v. Comm'r of Internal Revenue, TCM (RIA) 2020-095 (TC 2020).
 See Oakbrook; see also IR-2020-130.
 Kristen A. Parillo, Criticism of Easement Settlement Deal Doesn’t Worry IRS, taxnotes (Jul. 15, 2020), https://www.taxnotes.com/tax-notes-today-federal/charitable-giving/criticism-easement-settlement-deal-doesnt-worry-irs/2020/07/15/2cqf4.
 See Oakbrook; Irby v. Comm'r, 139 T.C. 371 (2012).
 See Oakbrook.
 See Oakbrook.
 See Irby.
 Oakbrook at 23.
 Id. (citing PBBM-Rose Hill, Ltd. v. Comm'r of Internal Revenue, 900 F.3d 193, 205-07 (5th Cir. 2018).
 Id. at 25.
 See, e.g., Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012); PBBM-Rose Hill, Ltd. v. Comm'r of Internal Revenue, 900 F.3d 193, 205-07 (5th Cir. 2018).
 See Kuhn, supra note 14.
 Parillo, supra note 164.
 See IR-2020-130.
 26 C.F.R. § 1.170A-14(h)(3)(i).
 See Frazee v. Comm'r, 98 TC 554, 563 (1992).
 See 26 C.F.R. § 1.170A-14(h)(3)(i).
 See id.
 William E. Ellis, Syndicated Conservation Easements, Valuation Abuse, and Penalties, taxnotes (July 27, 2020) https://www.taxnotes.com/tax-notes-federal/appraisals-and-valuations/syndicated-conservation-easements-valuation-abuse-and-penalties/2020/08/03/2csc2.
 See, e.g., Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).
 See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020).
 26 U.S.C.A. §6662(a) (West).
 26 U.S.C.A. §6662(h) (West).
 See, e.g., Gorra v. Comm'r, 106 T.C.M. (CCH) 523 (T.C. 2013).
 See Oakbrook.
 See id.
 See id.
 See e.g., Plateau Holdings, LLC, Waterfall Development Manager, LLC, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, T.C.M. (RIA) 2020-093 (TC 2020).
 Moore, supra note 6.
 For example, those deeds that will lose in the Tax Court following Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 T.C.M. (CCH) 1352 (TC 2020).
 Jeff Kauttu, Conservation Easements at Risk Because of IRS Appraisal Penalties, taxnotes (Aug. 12, 2020) https://www.taxnotes.com/tax-notes-federal/appraisals-and-valuations/conservation-easements-risk-because-irs-appraisal-penalties/2020/07/27/2cqkj.
 Internal Revenue Service, Memorandum for All LB&I and SB/SE Employees (Jan. 22, 2020) https://www.irs.gov/pub/foia/ig/lmsb/lbi-20-0120-0001.pdf.
 Kauttu, supra note 206.
 New Colonial Ice Co. v. Helvering, 292 US 435, 440 (1934).
 See id.
 See, e.g., Belk v. Comm'r, 774 F.3d 221 (4th Cir. 2014).
 See, e.g., Champions Retreat Golf Founders, LLC v. Comm'r of IRS, 959 F.3d 1033 (11th Cir. 2020); see also Oakbrook Land Holdings, LLC, William Duane Horton, Tax Matters Partner, Petitioner v. Commissioner of Internal Revenue, Respondent, 119 TCM (CCH) 1352 (TC 2020).
 26 USCA § 170(h) (West).
 See, e.g., Pine Mountain Pres., LLLP v. Comm'r of Internal Revenue, 151 TC 247 (2018).
 See supra, note 16.