The ongoing Whitehouse saga reaches what is likely to be its final resting place following the second decision by the Fifth Circuit (Whitehouse IV) upholding the Tax Court’s valuation finding on remand (Whitehouse III), but vacating the Tax Court’s decision to impose gross valuation misstatement penalties due to lack of reasonable cause. While expressing sympathy for the taxpayer’s arguments that the Tax Court got “highest and best use” wrong, the Fifth Circuit concluded that the Tax Court’s decision did not rise to the high standard of “clear error,” thus the Fifth Circuit could not overturn the Tax Court’s decision to reduce the value of the façade easement by $5.5 million. For a complete history of the Whitehouse case, see our previous post Conservation Easement confusion in the Tax Court and the Fifth Circuit.
The Fifth Circuit’s decision will be helpful to many taxpayers seeking penalty relief in the conservation easement context. Typically taxpayers donating easement undertake extensive due diligence to determine the proper value of the easement, including consulting with tax professionals and obtaining a qualified appraisal from a qualified appraiser. While these actions should be sufficient to establish reasonable cause (a defense to accuracy related penalties in most cases), the Tax Court in Whitehouse III said that this was not enough because there was no evidence that the taxpayer made an independent good faith investigation of value or asked its professionals to investigate value. In addition, the Tax Court said that such an investigation was warranted because the taxpayer should have known that value reached in the appraisals it relied upon was too high. The Fifth Circuit disagreed, stating “that the tax court imposed an excessively high standard of proof for actual reliance on the advice of competent professionals with respect to this statutory defense.” Instead, establishing “reliance on tax professionals was enough.” The Fifth Circuit observed that valuing assets is a difficult task, and especially so in the context of an easement where “the valuation is divorced from a negotiated transaction between buyer and seller. . . . The easement was a gratuitous transfer; the [charity] did not haggle over price and did not pay a final sale price.”
Notably, the Fifth Circuit was “particularly persuaded” by the argument that the Commissioner, the Commissioner’s expert and the Tax Court all reached different conclusions. Looking at all the facts and circumstances, the Fifth Circuit held that “[o]btaining a qualified appraisal, analyzing that appraisal, commissioning another appraisal, and submitting a professionally-prepared tax return is sufficient to show a good faith investigation” as required by the reasonable cause exception.
However, the Fifth Circuit’s failed to discredit the Tax Court’s unusual “highest and best” use analysis inWhitehouse III. As we noted previously, the Whitehouse III “second-best use” decision appears to be contrary to the law and the regulations. The taxpayer contended that the Tax Court’s unusual decision that second highest and best use could determine fair market value violated the Fifth Circuit’s previous instruction that a determination of highest and best use other than a luxury hotel must be clearly justified. While the Tax Court’s highest and best use remand finding appeared to run afoul of the Fifth Circuit’s previous guidance, that determination was left undisturbed on review. “Though we did call [the IRS’s expert’s] opinion ‘implausible,’ we did not instruct the tax court that it was forbidden to accept it.” The Fifth Circuit concluded that “we remanded for the tax court to establish explicitly the highest and best use of the parcel for valuation purposes. . . . it did make the finding we requested.” While the Fifth Circuit certainly did not condone the Tax Court’s highest and best use determination, it refused to go the extra step of finding clear error. Certainly this “second highest and best use” is something that taxpayers will need to be concerned about in the future, as we anticipate the IRS will be using this standard in earnest to drastically reduce conservation easement deductions.
The Whitehouse IV decision will be hailed by both taxpayers and the IRS. Taxpayers now have another weapon in their arsenal to defend against penalties, while the IRS will attempt to use the Whitehouse IIIdecision to undermine highest and best use claims by taxpayers. While it is not known whether either side will appeal, we will continue to monitor the Whitehouse case and all other conservation easement cases.