Note #6: “Syndications” of Conservation Easement Deductions – Or, There’s Trouble in River City
Some readers of Notes will be a little familiar, or very familiar, with conservation easement syndication deals; I know because I have had calls and emails from many of you, and I have had many calls over the years about these deals from landowners you pointed in my direction. And some readers of Notes will know nothing at all about such deals. So I have tried to write this Notes as more introductory and basic. That having been said, it is impossible to write about syndications simply. Some of this gets complicated.
Here is one very fundamental point to keep in mind. When Aunt Sally, or any other owner, wants an income tax deduction for donating a conservation easement on her property, the tax “issues” are very simple: she needs to meet the requirements of the tax code for a deduction (protecting, in perpetuity, the conservation values of her property), and she needs a “qualified appraisal” to substantiate the value of her gift. When Aunt Sally, or any other owner, wants to try to share, sell, or otherwise transfer some of her deduction to others who have not previously been owners, that’s when the trouble begins.
Let’s start with a few examples.
Example 1. Aunt Sally owns a ranch, just outside of River City. Aunt Sally paid $300,000 for the ranch in 1977. The ranch is now worth $5 million, and Aunt Sally donates to the local land trust a conservation easement that lowers the value of the ranch to $1.5 million (assume these numbers are all correct and fully supportable). Sally has a $3.5 million federal income tax deduction for the donation of the conservation easement.
Aunt Sally’s income, or “adjusted gross income,” is roughly $100,000 a year. Without going into any other tax code rules or details on this point, Aunt Sally simply will not be able to take advantage of any significant portion of her income tax deduction. But she is fine with that, and she is very very happy that her ranch is now protected in perpetuity. (The conservation easement also lowers the value of the ranch for estate tax purposes, which may or may not be relevant in Sally’s case.)
Example 2. Assume the same facts with one big difference. A local advisor with a connection to a group of consultants who “put together conservation easement deals” gets wind of what Sally is doing and contacts her.
“I can make you some money,” he says. “We will syndicate out the conservation easement deduction, and investors will pay you something for it. You will be able to put some extra money in your pocket. And you don’t need to trust me – I can get an opinion letter from a reputable attorney that the deal works. Just sign these papers and I’ll take care of everything.”
My friends, there’s Trouble in River City. That’s Trouble with a capital T that rhymes with P and that stands for Partnership Syndications. (For you young ‘uns out there, that’s a bit of a takeoff on a number from “Music Man”.) But before we get into details…
Example 3. Here is another example of syndicating conservation easement deductions, and this is probably the most egregious example I have seen. A few years ago some material on the following transaction crossed my desk. In fact, it came from the family office of a smart, wealthy, conservation-minded individual in the southeast, with the question “WHAT???” written in hand on the front page by one of his advisors.
The offering material advertised a property for sale for $50 million. The promoter was suggesting that a number of like-minded individuals throw money in the pot to purchase this “outstanding” property. The promoter also indicated that he had in hand an appraisal by a reputable appraiser that proved the value of a conservation easement on the property was $300 million. There are no typos in that last sentence.
Examples 4, 5, 6, etc. In most (but not all) “syndicated” conservation easement deals I have seen, the package includes an appraisal that grossly inflates the value of the conservation easement deduction. A more common example (than in Example 3), with lower numbers, would be a property that investors (for example, through a limited liability company) could purchase for say $5 million, with a pre-packaged appraisal concluding the value of a conservation easement is $25 million.
A grossly inflated appraisal, of course, changes the entire tax analysis of the transaction. Since I want to concentrate on the “syndication” part, and why that doesn’t really work, we will go back to the points behind the first three examples.
I would add for the record that there are all sorts of other variations that get built into conservation easement syndication deals. Sometimes investors will buy in to ownership of Aunt Sally’s ranch, and an easement will be donated, but there will be some agreement to the effect that Sally will always be in charge of everything, forever. Sometimes investors will buy in to ownership of Aunt Sally’s ranch, and an easement will be donated, and there will be an agreement that Aunt Sally will buy out all of the investors for some nominal price three or five or seven years down the road. The point isn’t the variations; the point always is the discrepancy between what the investor pays and what the investor gets.
Finally, to cover one of the common elements of many syndicated deals, many, but not all, syndicated deals also have what’s known in the trade as a “special allocation” of tax benefits.
Here is a very simple illustration of what happens in a situation without special allocations: ten investors each contribute $500,000 to a new limited partnership (or limited liability company). The partnership buys an asset for $5 million. According to the partnership agreement, each partner gets a pro rata share (that would be 10% for each partner) or any income, losses, deductions, or tax credits, etc., generated by the activity of the partnership. Generally speaking, this works. The economics reflect the economics.
Here is a very simple illustration of what happens in a situation with special allocations. Ten investors each contribute $500,000 to a new partnership. The partnership buys an asset for $5 million. According to the partnership agreement, two of the investors each get 50% of any state income tax credits generated by the activity of the partnership and 30% of any income tax deductions generated by the activity of the partnership. The other partners each get 5% of any income and any other losses or deductions generated by the activity of the partnership. Generally speaking, this doesn’t work.
The Tax Court dealt with some special allocations in a few relatively recent cases. In one of them, a partner purchased a small interest in a partnership and was allocated 97% of the state income tax credits generated by the partnership’s charitable conservation contributions. The Tax Court said, “No.” (A longer discussion of these cases is beyond the scope of this Notes.)
Again, most syndicated conservation easement deduction deals also include a pre-packaged appraisal that grossly inflates the value of the easement and therefore grossly inflates the value of the easement deduction. I will cover easement appraisals in other Notes.
Over the years, I have been asked by very serious clients to see if there is a way to make transactions work in which the client owns a property and the client wants investors to put in money and get back in income tax deductions a significant multiple of the money invested. I am simply not comfortable that there is a way to make this work.
Let’s start with a rule of tax law and a question.
Here is the rule of tax law (with some generalizations to try to keep things simple). If you donate an asset (any asset) to charity, you get a federal income tax deduction for the “fair market value” of that asset. The tax rules, and the courts, define “fair market value” as what a willing buyer would pay a willing seller, both having knowledge of all relevant facts and neither under any compulsion to buy or sell. In other words, “fair market value” is what Aunt Sally would get if she puts her ranch on the open market and sells it. If Aunt Sally puts her ranch on the market, and sells it to an unrelated buyer for $5 million, the starting point for the analysis is that the fair market value of the ranch is $5 million. In fact, the courts have often said that the best evidence of fair market value is what the asset sold for recently in the open market.
If Bob buys Sally’s ranch for $5 million, and a year later donates the ranch to charity and claims it is worth $10 million, the IRS and the courts are likely to say, “Ummm, no. You and Sally negotiated what you both thought was a fair deal, you paid $5 million, real estate values have gone up 6% in the past year, we’ll give you a deduction of $5.3 million ($5 million plus 6% of $5 million).”
So the “bottom line” here is that fair market value is what you just paid for something. (Again, this is a generalization and does not apply in all situations. It may be that in a “distress” sale, in which a buyer simply must liquidate the property for financial or personal or other reasons, the purchase price may not be the same as the fair market value. Recall that the definition of “fair market value” includes the concept that the seller is not under any compulsion to sell. That sort of transaction is beyond the scope of this Note.)
Now, knowing about “fair market value,” let’s ask a question.
If the IRS and the courts allowed people to buy and sell federal income tax deductions (and they do not), what would you pay? Here are some specific numbers. If you could buy a $1 million income tax deduction (or, put another way, buy an asset that you could then donate to charity and claim a $1 million income tax deduction), what would you pay for that asset?
Again, trying to keep this simple, let’s assume you are in the highest federal income tax bracket. That means that if you make a $1 million charitable contribution, that would save you roughly $400,000 in federal taxes. So, what would you pay for that asset? Unless you are very philanthropic, you certainly wouldn’t pay $1 million; after tax savings of $400,000, you’d be out of pocket $600,000. In some states, with state income tax credits for conservation easement donations, in syndication deals the math gets much trickier but the fundamental syndication tax principles are the same: the dollar amount you pay is a very small fraction of the dollar amount of the tax writeoff you get back.
So, what would you pay? Would you pay $400,000 to buy an asset to donate to charity if the tax savings would be $400,000? If you answer yes, than I’d ask, “Why???” If all you want is a $400,000 deduction, why jump through all those hoops, pay fees, be subject to an audit? If all you want is a $400,000 deduction, just write a check for $400,000 to your favorite charity.
So, what would you pay? What would you pay for a deduction that in theory, or, as advertised, saves you $400,000 in taxes? Would you pay $300,000? Probably not – transaction fees, appraisal fees, audit risk, etc. Would you pay $200,000? Maybe, but maybe not; the risk/reward ratio might not be good enough for you.
Years ago, I had lunch with an attorney who was talking about syndicating historic preservation easement deductions.
“What do investors pay?” I asked him.
“We find we can sell income tax deductions for about 10 to 15 cents on the dollar,” he said.
“You mean, you can sell someone an interest in a deal for $150,000, and they get a deduction of $1 million?” I asked.
“That’s it,” he said.
“But,” I said, “these deals don’t work. You can’t sell income tax deductions. The law is quite clear on that.”
He changed the subject.
You can’t sell income tax deductions
For more than a few decades now, the tax code has had rules that essentially say that if there is no “economic substance” to a transaction, that is, if the ONLY reason someone enters into the transaction is to generate tax deductions, those deductions can be denied. Or, put another way, if the only reason a deal is put together is to sell income tax deductions, and there really is no other economic reason why an investor would enter into such a deal, if there is no risk of loss and no chance of gain, then there is no economic substance to the deal and the deduction is denied.
This is a very squishy tax concept, and of course people who put these deals together often spend quite a bit of time adding layer after layer to make it look like there is really some economic risk, and/or there is really some economic upside, in addition to the deduction that is being offered. Strangely enough, in most of the conservation easement deduction syndication deals I have seen, there are no additional layers: there is simply a purchase of an interest for an amount that is a mere fraction of the amount of the deduction that is generated for the investor by the deal.
You can’t sell income tax deductions. And you can’t win by trying to put a lot of other fancy clothes on a transaction that bottom line is actually just selling income tax deductions.
Without going into another set of technical tax rules and court cases, I would suggest there are at least a few ways the IRS could attack these cases, and win. There are advisors out there who will say, “He’s wrong. We can make this deal work.”
First, in a transaction in which really the only thing happening is that people are buying income tax deductions, the IRS could argue the transaction has no economic substance and either deny or sharply reduce (perhaps to the amount of the investor’s cash into the deal) the amount of the deduction, plus assess interest and penalties. This has apparently not been a favorite approach of the IRS, but it is on the menu.
Second, the IRS could recharacterize the transaction so that the amount of the deduction available to the investor more accurately reflects the percentage of the asset the investor really is buying. In other words, assume an asset in a partnership or limited liability company has a value of $10 million, and under the terms of the deal the investor purchases a 10% interest for $150,000, expecting to receive an income tax deduction of $1 million. The IRS could easily argue that for a purchase price of $150,000 the investor is actually purchasing a 1.5% interest, not a 10% interest, and is entitled to a deduction of $150,000, not a deduction of $1 million.
Third, in some recent cases (as mentioned very briefly above) the IRS has argued, and the court has agreed, that if there are “special allocations” of tax benefits (see “Examples 4, 5, and 6” above), the deductions do not go the way the parties intended because the investment vehicles were being used to shift tax (and tax benefits) away from some of the original owners/promoters/investors and shift tax benefits toward the new investors. (An analysis of these recent cases and the tax theories behind them, sometimes involving so-called “disguised sales” by partners, is way beyond the scope of this Note.)
This is very complicated tax stuff. A decade ago, the IRS announced it was going to take a harder look at promoters of certain conservation easement “deals,” and more recently the IRS has made it clear that it is going to take a harder look at transactions in which large income tax deductions are generated by partnerships (and limited liability companies).
Be forewarned. On a regular basis, I see material from proposed deals that look like and sound like the conservation easement syndication transactions I discuss in this Note. “No,” I tell people, “that doesn’t work. You can’t just sell income tax deductions, and you can’t just do special allocations of tax benefits the way this deal proposes. And,” I tell people, “there are advisors out there who will tell you, ‘He’s wrong. We can make this deal work.’”
If you or a friend are offered a $1 million deduction for an investment of $150,000, what would you do?
I’d stay away, but I’ll let you decide.