Conservation Easement Charitable Deduction Restriction In Omnibus Bill Becomes Law
Monte A. Jackel
December 30, 2022
(Updated from December 20, 23 and 29)
On December 20, 2022, the easement conservation disallowance provision of proposed section 170(h)(7) was added by the Senate as section 605 of Division T (the Secure 2.0 title) to H.R. 2617, the omnibus consolidation bill. Section 605 of the bill, as did section 1104 of S.4808, the prior proposal on this subject, contains a prohibition on charitable donations in kind of conservation easements by partnerships (and other passthrough entities) if the donation does not meet the requirements in the new statute. The Consolidated Appropriations Act, 2023, was sent to the president’s desk for signature on December 23, 2022. See Tax Notes story, and White House statement. The bill was signed into law on December 29, 2022.
Section 170(h)(7) will be added to provide that a contribution by a partnership (whether directly or as a distributive share of a contribution of another partnership) is not treated as a qualified conservation contribution (and thus not deductible under section 170) if the amount of such contribution exceeds 2.5 times the sum of each partner’s “relevant basis” in such partnership. (Proposed listing notice regulations, REG-106134–22, Dec. 8, 2022, would define the 2.5 times limitation in terms of “investment”, an undefined term. These proposed regulations will need to be conformed to the new statute if and when enacted into law. See Tax Notes story. This new rule has a cliff effect in that even one penny above the 2.5 times limitation will cause the disallowance of the entire deduction.
For this purpose, the term “relevant basis” means, with respect to any partner, the portion of such partner’s modified basis in the partnership which is allocable (under rules similar to the rules of section 755) to the portion of the real property with respect to which the contribution is made. And the term “modified basis” is defined to mean, with respect to any partner, the partner’s adjusted basis in the partnership as determine by the partnership after taking into account certain adjustments as provided by the IRS in guidance, specifically not including section 752 liabilities in modified basis. There is an exception for contributions made directly or indirectly outside of a 3-year holding period. There is also an exception for contributions made by certain so-called family partnerships.
There are to be regulations or other guidance relating to reporting of the contribution to the IRS and to prevent avoidance of the new rules.
The Omnibus bill adds an exception to the disallowance rule of new section 170(h)(7) for contributions to preserve certified historic structures unless, as provided in new section 170(f)(19), certain disclosure requirements (such as including on form 1065) are not met. Section 170(h)(7) would be applicable on a prospective basis from the bill’s enactment date with caveats of no inference for other situations.
The Omnibus bill at section 605(d) would also add a safe harbor to be issued within 120 days of the date of enactment of the bill (by April 28, 2023) to provide for corrective deeds, within 90 days of issuance of that guidance (by July 27, 2023), relating to extinguishment clauses and boundary line adjustments. However, the safe harbor is not to apply if the transaction is one described as a reportable transaction under section 6707A(c) or is a transaction described in IRS Notice 2017–10, relating to syndicated conservation easements or is in litigation or where a penalty relating to the contribution has been finally determined. This reference to the IRS notice could be viewed as Congressional disapproval of the case law that has required these listing notices to be subject to public comment under the Administrative Procedure Act (See IRS Asks Tax Court to Reconsider Decision Holding Notice Invalid, Tax Notes story, and see the Mann Sixth Circuit opinion (27 F. 4th 1138, 2022, in Mann , and the opinion of the Tax Court in Green Valley (159 T.C. No. 5, 2022, Green Valley.
The bill incorporates the penalty provisions of sections 6662 and 6664 which contain a strict liability penalty. Thus, even if you can prove that the claimed donation’s value is correct the penalty will still apply. The new statute does not excuse what I would call “excess true value”, meaning the penalty still applies even if where the taxpayer can prove that the actual FMV of the donation is greater than the statutory limit of 2.5 times.
How does partnership tax accounting work? The cap on the amount of the partnership donation creates a question as to how partnership tax accounting works in that context. Do the rules under the section 704(b) regulations, where it references FMV, mean actual FMV or the capped FMV? Or both? The section 704(b) regulations say tax accounting timing controls book accounting under the “N” rule (reg. section 1.704–1(b)(2)(iv)(n)). Thus, if and when section 170(h)(7) is added to the IRC, changes to the 704(b) regulations would seem to be required.
The potential distortion between book and tax already exists because the IRC says outside basis is reduced by only the tax basis of the donated property and not by its FMV, but the book donation presumably is with respect to the FMV of the donated property; or does the “N” rule’s reference to the “federal tax treatment” of the deduction mean that book basis is also only reduced by the tax basis of the property donated? That’s unlikely because it would cause an immediate distortion between book capital accounts and the actual post-donation FMV assets of the partnership. Current law does not address this issue because the stated facts of Rev. Rul. 96–11 (1996–1 C.B. 140) avoid both the section 704(c)(1)(B) issue as well as the section 704(d) issue relating to basis for loss limitation purposes. The ruling holds that outside basis is reduced only by the basis of the donated property. That principle is now incorporated into section 704(d)(3)(B).
Under regulation section 1.1001–2(a)(3), amount realized does not include liabilities incurred on acquisition that are not part of basis of the property. Does this apply to 170(h)(7) if the partnership borrows and the actual fair market value on the property exceeds the amount of liabilities when donated? The potential discontinuity arises because section 1011(b) references FMV whereas the section 170(h)(7) deduction would be 2.5 times the partners’ relevant basis in their partnership interests. And so, you can have a bargain sale that would apportion part of the basis of the property to the sale portion and what does this do, if anything, to the partners’ relevant basis in their partnership interests?
What if the partners donate their partnership interests to charity instead? That is unlikely as the cash partners are unlikely to have a long-term holding period and so a FMV deduction of property would not be allowed (the sponsor is likely to be the only one with a long-term holding period).
And what of the failure, as noted above, to address whether section 704(c)(1)(B) should seemingly apply in these donation cases? Specifically, left unaddressed by new section 170(h)(7) is what happens if the property donated by the partnership is property contributed by the sponsor to the partnership, so-called section 704(c) property. Many of the issues that arise in this context have been previously discussed, although several decades ago, and remain unaddressed in published guidance today. (See Monte A. Jackel, Glenn E. Dance, and John J. Rooney, 704(c) Article , 1 J. Passthrough Entities 8 (1998).)
The cause of this book-tax conundrum is that section 704(c)(1)(B) seems to be inapplicable to the donation because, it is argued, that statute requires a distribution “directly or indirectly” to another partner and it is asserted by some, probably many, that “indirectly” does not cover the case when the partners are in effect all treated as if the property was first distributed in kind to them and then donated by them to charity. However, the words of a statute, such as “indirectly” in this case, must have some meaning.
See Omnibus Budget Reconciliation Act of 1989, P.L. 101–239, Conference Report, Statement of Managers, H. Rep. No. 101–386, Title VII. This provision added the words “or indirectly,” but the explanatory material does not discuss what the term “indirectly” means or why it was added. The provision could be limited to cases when the section 704(c) partner also contributes an entity interest (such as stock in a corporation) and other partnership property is also contributed by another partner to the partnership (or purchased by the partnership) and is then contributed to the corporation and then the stock of the corporation is distributed by the partnership back to the section 704(c) partner. However, this strategy is a well-known section 737 avoidance technique and is addressed in the section 737 regulations. Rather, applying substance over form would seem to support this recast under current law without an act of Congress although Congressional action would be preferable.
Thus, there’s a question of whether the charitable donation of in-kind appreciated property within seven years of its contribution to the partnership by a partner triggers section 704(c)(1)(B) as if the donated property was first distributed to the partners and then donated by them. If it were triggered, book and tax would be equalized. Is this or should this be the case? Could section 704(c)(1)(B) be reconciled with new section 170(h)(7) being silent on this issue?
The IRS certainly could take the administrative position that the donation triggers section 704(c)(1)(B) gain because it’s indirectly a distribution to the partners because it’s done on their behalf. That administrative position would most certainly be challenged in court, but as tax administrator for the IRC, I thought that was one of the main jobs of the IRS as well as the policymakers at Treasury. But, once again, has new section 170(h)(7) put that to rest?
