In Seventeen Seventy Sherman Street v. Comm’r (T.C. Memo 2014-124), the Tax Court held that an understanding between the taxpayer and a development company under which the taxpayer would grant certain conservation easements if the development company assisted in obtaining variances constituted a quid pro quo, resulting in a complete loss of the deduction for such conservation easement.

The property at issue in Seventeen Seventy Sherman Street v. Comm’r, (T.C. Memo 2014-124) included the El Jebel Shrine, a structure in Denver, Colorado which was completed in 1907 and designated as a landmark.  The property also includes an adjacent parking lot.  The taxpayer (a Colorado LLC) intended to turn the structure into condominiums.  To that end, the taxpayer needed a change to the PUD to allow such development and a variance to allow for the building of a structure on the parking lot.   In 2002, the taxpayer began negotiating with Community Planning and Development Agency (“CPDA”) regarding the (1) the proposed PUD change, (2) the imposition of interior and exterior easements, (3) the application for a variance, and (4) rehabilitation of the property.  The taxpayer and CPDA entered into a development agreement, under which the CPDA would recommend approval of the proposed PUD and variance request and, if the PUD change was approved, the taxpayer would donate interior and exterior easements to Historic Denver, Inc., a charitable organization.  In addition, the taxpayer agreed to undertake certain rehabilitation projects if the variance request was granted.  The PUD change would have to be approved by the Denver City Council, and the variance would have to be obtained from the Denver Planning Board.

The taxpayer donated the interior and exterior easements to Historic Denver in December 2003, after obtaining the PUD change and the variance, and claimed a deduction of $7,150,000 as the value of the easements.

At trial, the IRS contended that because the taxpayer received consideration in exchange for the easement, which the taxpayer failed to disclose, the charitable contribution had no value.  The IRS further argued that the interior easement served no conservation purpose and the value claimed by the taxpayer of the easements was overstated.  The taxpayer contended that the consideration received was limited to the PUD change, which was only worth $2,025,000, thus the taxpayer was entitled to a deduction of $5,125,000.  The taxpayer further contended that it was not required to disclose the consideration received because the consideration was not received from the donee organization – instead it was received from the city of Denver in the form of a PUD change.

The Tax Court held that the charitable deduction must be completely disallowed because the taxpayer received a quid pro quo for the donation of the easements.  The Tax Court explained that the consideration need not be financial; it can be any other benefit that vitiates charitable intent.  The Tax Court further explained that the taxpayer bears the burden of demonstrating that he or she intended to make a charitable contribution in excess of any consideration received.

The Tax Court held that the development agreement as a whole demonstrated that the taxpayer received CPDA’s recommendation as to both the PUD change and the variance request in exchange for the easement.  In so holding, the Tax Court dismissed the taxpayer’s argument that only the value of the PUD change should be viewed as “consideration” for the easement, which the taxpayer valued at just over $2 million.  The Tax Court observed that the nature of the negotiations between the taxpayer and CPDA showed that both recommendations should be viewed as consideration for the easements, despite the fact that CPDA could not approve either the PUD change or the variance.  The Tax Court further held that since the taxpayer failed to demonstrate or identify the value of the consideration received in the transaction, the taxpayer was not entitled to any deduction.

As the case related to penalties, like in many other recent cases, the burden of proof impacted the Tax Court’s decision.  While the FPAA mailed to the taxpayer challenged the deductibility of the subject conservation easements, the Commissioner asserted in an amendment to his answer that even if the easements were deductible, the fair market value of the easements was only $400,000 (compared to $7,150,000 claimed by the taxpayer).  The amended answer further asserted that an accuracy related penalty applied to the underpayment in the form of a gross valuation misstatement, or, alternatively, (i) because of negligence or disregard of rules or regulation under Section 6662(b)(1), (ii) a substantial understatement of income tax under Section 6662(b)(2), or (iii) a substantial valuation misstatement under Section 6662(b)(3).

Since the assertion of penalties was raised in an amended answer, the Tax Court assigned the burden of proof on the “new matter” under Rule 142(a) to the Commissioner.  As to the proposed gross valuation misstatement, the Tax Court did not accept the Commissioner’s expert’s opinion that the subject easements had no value, which testimony was refuted at trial by representatives from both the City of Denver and Historic Denver, the recipient of the easement.  While concluding that one of the easements at issue had value, the Tax Court found that the Commissioner failed to meet his burden of establishing that the value of the subject conservation easements exceeded 400% of the correct value of the easements, meaning that the gross valuation misstatement penalty could not apply.

With respect to the other (non-valuation) accuracy related penalties asserted in the amended answer, the Tax Court found that, because the deductions were disallowed, the Commissioner had met his burden of establishing that the taxpayer acted negligently or with disregard to Section 170 and the regulations thereunder.

To prove that the taxpayer had acted with reasonable cause and good faith through reliance on professional advice, the evidence offered at trial included testimony from the taxpayer’s tax advisor that he had advised the taxpayer that he had to reduce the value of the claimed deduction by the consideration received in the quid pro quo exchange.  Of course, the taxpayer failed to follow that advice.  Accordingly, the Tax Court found the Taxpayer’s disregard of the advisor’s advice was not reasonable and in good faith.

This case is instructive to developers and property owners who are considering the grant of a conservation easement in connection with a request for zoning changes to develop property underlying or adjacent to the eased property.  Carefully structuring and reporting these transactions can avoid the unfortunate result where the easement is disallowed in total and the property owner is hit with penalties.

Seventeen Seventy Sherman Street also is important because it illustrates the confusing differences between the application of the valuation misstatement penalties and the accuracy related penalties and shows how important the burden of proof can be in a court’s determination of whether these very potent penalties are applicable.