Conservation Easement Deductions: How Recent Tax Law Developments Have Created A New Area of Legal Malpractice Litigation

The IRS has recently embarked on a recent change in how it enforces the requirements for conservation easement deductions.

Fall 2020

REAL TALK: The Robins Kaplan Business Law Update by the Women of Business Litigation.

I. Introduction

A recent development in tax law has created a new, fertile area for recovery of losses via legal malpractice litigation. For years, tax attorneys recommended conservation easements to their wealthy clients as a near-foolproof method for obtaining large tax deductions. The tax mechanism seemed too good to be true: after high-net-worth individuals donated easements on their land that restricted use for conservation purposes—a transaction that permitted the donor continued use of the land and ability to sell the land—they received the ability to claim large tax deductions that often exceeded the amount originally paid for the land itself. Although the Internal Revenue Code has long set out specific and highly technical rules for use of these conservation easement deductions, the IRS has failed to routinely enforce those stringent requirements. Tax lawyers have thus routinely made the mistake—costly to their clients—of being overconfident in recommending the deductions as ones that are highly unlikely to be denied.

After noticing decades of abuse of the conservation easement deduction, the IRS has begun cracking down on taxpayers. In recent years, it has begun strictly enforcing the technical requirements for the deduction via audits and tax court litigation, often many years after the deductions at issue were originally claimed. Many of those cases have since made their way through tax court and resulted in extremely adverse results for taxpayers, who have time and again been denied the tax benefits their lawyers guaranteed them. Those individuals and corporations now carry the financial burden of not just lost tax benefits, but also steep penalties, interest, and litigation costs. For many, one of the few ways to make themselves whole is through legal malpractice actions premised on the faulty legal advice that caused them to pursue the deduction in the first place. This article first examines the history and function of those deductions, and then turns to the legal malpractice litigation that may be available to make taxpayers whole of their losses.

II. The History and Function of Conservation Easement Deductions

The tax value of a conservation easement derives from Section 170(h) of the Internal Revenue Code, which permits hefty tax deductions for taxpayers who donate easements for conservation purposes, such as preservation of animal or plant ecosystems. Historically, some taxpayers pursued these easements directly, while others invested in “syndicated” conservation easements, in which entities called promoters packaged the easement and the accompanying deduction as a product that was subsequently parceled out to numerous investors. Without following the letter of the requirements set forth in the tax code, some tax attorneys highly recommended the easements as an easy way to secure large tax benefits, and many wealthy clients followed their advice, with some even purchasing land solely with the intent to donate easements and procure the deduction. As it turned out, the tax opinion letters offered by the attorneys were often faulty. Indeed, many lawyers in the field had become emboldened over the many years by the IRS’s lax enforcement of conservation easement deductions, and thus fell into the habit of neglecting to closely review the specifics of each transaction for compliance with the tax code. For example, some attorneys ignored the clear mandate that, to qualify for a deduction, the donation must be made “in perpetuity.” Despite that, the attorneys nevertheless advised their clients that there was neither risk of an IRS audit nor of a denial of the deduction.

Recently, the IRS began cracking down on a spate of such deductions, in many instances several years after they were first claimed. It vigorously enforced the tax code’s complex rules, including, in particular, the requirement that the easement be donated “in perpetuity.” In one instance, a company purchased a tract of land for approximately $300,000, donated an easement on it to a conservancy, and claimed a tax deduction of nearly $2.5 million, only for the IRS to subsequently disallow that entire deduction and impose additional penalties years later.1

The IRS has been winning its enforcement actions in tax court. In a recent string of decisions in such cases, the IRS has prevailed in deeming the deductions improperly claimed and thus fully denied. To say nothing of the exorbitant litigation expenses and lost tax benefits, the decisions require the taxpayers to pay significant penalties and interest. Further compounding these losses is the recent initiative of lawmakers, including the Senate Finance Committee, which has also begun investigating abuses of conservation easement deductions.2

In June 2020, fresh off its series of recent wins, the IRS offered a limited-time settlement to certain taxpayers to resolve conservation easements disputes. The offer was largely made to participants in syndicated easements: if a chosen taxpayer agreed to have the deduction disallowed in its entirety and to pay the full amount of taxes and interest, that taxpayer would receive a reduced penalty as well as a deduction for the original cost of acquiring the interest in the syndication. Despite these seemingly harsh terms, the IRS indicated that these settlements represented its best offer, declaring that “taxpayers should not later expect a better result.”3

III. Legal Malpractice Litigation as a Means for Taxpayers to Recover Damages and Minimize Losses

Taxpayers who have donated easements to secure deductions—including the many who purchased the underlying land for solely that reason—now find themselves in a difficult spot. They neither have unrestricted use of the property nor the tax benefits; they owe significant penalties and interest to the IRS; and many have incurred mountains of legal bills from the ensuing tax court litigation. Thankfully, many of these taxpayers do have the option to recover some of these losses by asserting malpractice claims against the tax attorneys who provided the faulty legal advice in the first place. This has led to a new legal malpractice specialty—and a burgeoning one in the pandemic-saddled economy, in which many are seeking ways to manage losses and deficits.

A legal malpractice claim can help stem a taxpayer’s losses, but it comes with its own set of considerations. Every case is different, and each demands careful analysis of the transaction at issue and the specific legal advice rendered. The strength of a legal malpractice claim may depend on the guidance offered by legal counsel’s underlying tax opinion letter. Such letters analyze the transaction and proposed deduction and then typically offer one of five possible levels of opinion to signal the level of legal confidence as to the permissibility of the claimed deduction. The lowest confidence is signaled by a “reasonable basis” opinion, followed by “substantial authority”; “more likely than not”; “should”; and finally, a “will” opinion. Whereas a “reasonable basis” opinion indicates only that there is reasonable basis to claim the deduction, and a 10-25% likelihood that it will be allowed, a “will” opinion suggests at least a 95% chance that the deduction will be deemed permissible—that is, no material risk that it will be disallowed.

Beyond this, assessing the malpractice claim also requires an examination of the specific analysis the letter undertook to reach the opinion rendered. Of course, a case will be stronger where a law firm renders a strong and confident opinion while failing to fully assess the requirement on which the IRS later prevailed in its challenge.

Further, legal malpractice claims premised on conservation easement deductions are different from other claims in that there will typically have been some corrective litigation in tax court, sometimes handled by the original, allegedly negligent counsel. Assessing and developing such malpractice cases can therefore benefit from close examination of the court rulings and any admissions that the original counsel may have already made in those prior and public proceedings.

As such, it serves taxpayers to consult legal malpractice litigators sooner rather than later, both to secure an assessment of the strength of the claim, and to minimize the chances that such a claim will be time barred. Further, where evidence of malpractice is clear and established in public court rulings or submissions, a firm may be eager to minimize the bad press and the concomitant business damage of the claim, particularly by settling within malpractice insurance policy limits. In such cases, legal malpractice specialists may be able to secure mutually agreeable settlements quickly and efficiently, sometimes even before the cases are publicly filed.

Early advice from counsel experienced with these claims is thus invaluable in assessing, preserving, and building the case. And it may be vital for taxpayers who need to resolve the claims promptly to recoup monumental losses.

1 Lumpkin One Five Six, LLC v. Comm’r of Internal Revenue, T.C.M. (RIA) 2020-094 (T.C. 2020).
2 https://www.finance.senate.gov/chairmans-news/grassley-wyden-launch-probe-of-conservation-tax-benefit-abuse.
3 https://www.irs.gov/newsroom/irs-offers-settlement-for-syndicated-conservation-easements-letters-being-mailed-to-certain-taxpayers-with-pending-litigation.

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Craig Weiner

Partner

Chair, New York Commercial and Financial Litigation Group

Qian Julie Wang

Associate

Pronouns: she/her

Alexander D. Newman

Associate

Pronouns: he/him

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