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BC Ranch II, L.P. v. Commissioner of Internal Revenue

United States Court of Appeals, Fifth Circuit

August 11, 2017

BC RANCH II, L.P., also known as Bosque Canyon Ranch II, L.P.; BC RANCH I, INCORPORATED, Tax Matters Partner, Petitioners-Appellants
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee BOSQUE CANYON RANCH, L.P.; BC RANCH, INCORPORATED, Tax Matters Partner, Petitioners-Appellants

         Appeals from the Decision of the United States Tax Court

          Before WIENER, DENNIS, and HAYNES, Circuit Judges.

          WIENER, Circuit Judge.

         Petitioners-Appellants, BC Ranch I, L.P. ("BCR I"), and B.C. Ranch II, L.P. ("BCR II"), (collectively the "BCR Partnerships" or "Appellants"), claim that Respondent-Appellee, the Commissioner of Internal Revenue (the "Commissioner"), wrongfully disallowed their charitable deductions for two conservation easements. Appellants contend that in ruling for the Commission, the Tax Court wrongfully classified the sale of limited partnership interests as disguised sales and wrongfully imposed a gross valuation misstatement penalty. We vacate and remand.

         I. Facts and Proceedings A. Factual Background

         In 2003, BCR I, purchased a 3, 744 acre tract of land called Bosque Canyon Ranch (the "ranch"). On December 20, 2005, BCR I conveyed approximately 1, 866 acres of the ranch to BCR II.

         1. The Conservation Easements

         Beginning in 2003, the ranch developers worked with North American Land Trust ("NALT") to determine if the ranch would qualify for a tax-deductible conservation easement. NALT advised them that the ranch would qualify and that one benefit of such an easement would be to permanently protect the nesting areas and habitat of the gold-cheeked warbler, a listed endangered species.

         Extensive documentation was assembled from NALT's various site visits, including photographs from a 2003 visit, an aerial photograph of the ranch, numerous property maps, details of the site visit of a NALT biologist, and maps of the gold-cheeked warbler habitat. On NALT's recommendation, the ranch hired Integrated Environmental Solutions ("IES") to consult on plant ecology and avian biology and to provide recommendations for how the property should be developed to ensure compliance with the Endangered Species Act. IES completed a report that included detailed aerial photographs and topographic maps depicting the habitat surveys conducted in April 2004 and December 2005, showing the gold-cheeked warblers' probable nesting areas. Ultimately, NALT and the BCR Partnerships assembled two binders of "baseline documents" detailing the conservation easements.

         BCR I donated a conservation easement to NALT on December 29, 2005. BCR II donated a conservation easement to NALT on September 14, 2007. Both easements contained substantially identical terms. They protected and preserved (1) the habitat for the gold-cheeked warblers and other birds and game, (2) watershed, (3) scenic vistas, and (4) mature forest. The easements "voluntarily, unconditionally, and absolutely" granted NALT, its successors and assigns, "perpetual easement[s] in gross" over the conservation areas, subjecting the property to a series of "covenants and restrictions in perpetuity" that prohibit most residential, commercial, industrial, and agricultural uses. The easements reserved narrow rights to the grantors that NALT and the BCR Partnerships agreed "could be conducted . . . without having an adverse effect on the protected Conservation Purpose."

         The easements could be amended only with NALT's consent and then only to modify the boundaries of the homesite parcels, but not to increase their areas above five acres. NALT continues to monitor the conservation area and has repeatedly found it to be in good condition and in compliance with the terms of the easements.

         2. The Limited Partnership Interests

         Around February 2005, BCR I started to market limited partnership interests. It specified that limited partners could build ranch homes on select five-acre sites (the "homesite parcels") and reserved the rest of the land for conservation, recreational, and agricultural use. Each purchaser of a limited partnership interest was required to execute a subscription agreement and make a capital contribution of $350, 000 per unit to become a limited partner of BCR I. If BCR I elected to grant a conservation easement on the property, it would "at a later date convey" to each limited partner the fee simple title to one of twenty-four five-acre homesite parcels. BCR I also promised to convey to each limited partner "a membership interest" in the "to be formed Bosque Canyon Ranch Association" ("BCRA"), which would own all of the ranch property other than the homesite parcels.[1] Twenty-four limited partners were admitted to BCR I. In April 2006, one five-acre homesite parcel was deeded to each of them.

         Subsequently, BCR II offered partnership interests on substantially the same terms for capital contributions ranging from $367, 500 to $550, 000. Twenty-three limited partners were admitted to BCR II. Between October 2007 and January 2008, five-acre homesite parcels were deeded to the limited partners of BCR II.

         B. Procedural Background

         BCR I filed its federal partnership tax return for tax year 2005, claiming a charitable deduction of $8, 400, 000 for the value of the conservation easement that it had donated to NALT. BCR II filed its return for tax year 2007, claiming a deduction of $7, 500, 000 for the value of the conservation easement that it had donated to NALT. Each return listed the limited partners' capital contributions and their shares of the charitable deduction.

         The Commissioner disallowed the charitable deductions and asserted that the BCR Partnerships were liable for gross valuation misstatement penalties. Each partnership filed a separate petition for readjustment before the Tax Court, which that court consolidated.

         Following almost four weeks of trial, the Tax Court issued its Memorandum Findings of Fact and Opinion. It disallowed the charitable deductions, holding that (1) the conservation easements failed to qualify as deductible charitable contributions because they were not given in perpetuity, (2) the sales of the limited partnership interests were actually disguised sales of partnership property, and (3) the gross valuation misstatement penalty was applicable.

         The BCR Partnerships timely appealed the Tax Court's ruling. NALT filed a Brief of Amicus Curiae, also urging reversal of the Tax Court's rulings.[2]

         II. Standard of review

         We review the Tax Court's decisions using the same standards that are applicable to district court decisions.[3] We review issues of law de novo and findings of fact for clear error.[4]

         III. Analysis

         A. The Charitable Deductions

         1. Applicable Law

         A taxpayer has the burden of proving entitlement to a claimed deduction.[5] Congress has provided a tax deduction for the charitable contribution of a conservation easement, which has enjoyed decades of bipartisan support.[6] To be entitled to that deduction under § 170(h) of the Internal Revenue Code ("IRC"), which section governs conservation easements, a taxpayer must contribute a "qualified real property interest" to a "qualified organization . . . exclusively for conservation purposes."[7] Such a taxpayer may deduct the value of a contribution of a partial interest in property if the contribution constitutes a "qualified conservation contribution."[8] A "qualified conservation contribution" is defined as a contribution of "qualified real property interest" to an IRC § 501(c)(3) organization, exclusively for conservation purposes.[9] An easement qualifies under this section of the IRC if it is a "restriction (granted in perpetuity) on the use which may be made of the real property."[10]

         2. Analysis

         a. The Perpetuity Requirement

         As noted, both easements at issue in this case were created, at least in part, to preserve the habitat of the gold-cheeked warbler, an endangered species, as well as the habitats of other birds and animals. The BCR Partnerships "voluntarily, unconditionally and absolutely" granted NALT (a § 501(c)(3) organization), its successors and assigns, "perpetual easement[s] in gross." They subjected the land covered by the easements to a series of covenants and restrictions "in perpetuity" which prohibited residential, commercial, industrial, and agricultural uses over most of the property, including the cutting of trees, dumping, changing of topography, and the introduction of non-native plant or animal species in the conservation areas.

         The easements specified a few "reserved rights" that NALT and the BCR Partnerships agreed "could be conducted . . . without having an adverse effect on the protected Conservation Purposes." These reserved rights included constructing staff buildings, barns, recreational or meeting areas, swimming pools, ponds, shelters, pavilions, skeet-shooting stations, facilities for utilities, deer-hunting stands, roads, trails, and driveways.

         With NALT's consent, the property covered by the easements could be amended, but only to the limited extent needed to modify the boundaries of the five-acre homesite parcels, and even then wholly within the ranch property and without increasing the homesite parcels above five acres. For such a modification to occur, NALT, the BCR Partnerships, and the owner of the homesite parcel in question would have to be in agreement. Modification would be permitted only if: (1) "[t]he boundary line modification does not, in [NALT's] reasonable judgment, directly or indirectly result in any material adverse effect on any of the Conservation Purposes, " (2) "[t]he area of each Homestead Parcel [does] not increase, " and (3) the modification is properly documented and recorded.

         The Tax Court agreed with the Commissioner that the homesite boundary modification provision violated the perpetuity requirement of § 170(h)(2)(C). The court held that because the homesite parcel boundaries could be changed to include property within the original easement, the easement was not granted in perpetuity. It cited Belk v. Commissioner[11] for the proposition that an easement is not qualified real property if the boundaries of the property subject to the easement may be modified. We view Belk as distinguishable. In that case, the Fourth Circuit affirmed the Tax Court's holding that a provision which allowed the parties to substitute other land for the land that was originally restricted under the easement did not meet the perpetuity requirement of § 170(h).[12]

         Here, the Tax Court's reliance on Belk is misplaced.[13] The easements at issue in this case differ markedly from the easement in Belk. Among other distinctions, the instant easements allow only the homesite parcels' boundaries to be changed and then only (1) within the tracts that are subject to the easements and (2) without increasing the acreage of the homesite parcel in question. They do not allow any change in the exterior boundaries of the easements or in their acreages. Thus, neither the exterior boundaries nor the total acreage of the instant easements will ever change: Only the lot lines of one or more the five-acre homesite parcels are potentially subject to change and then only (1) within the easements and (2) with NALT's consent.

         Unlike here, the easement in Belk could be moved, lock, stock, and barrel, to a tract or tracts of land entirely different and remote from the property originally covered by that easement.[14] The court in Belk reasoned that, because the donor of the easement could develop the same land that it had promised to protect, simply by lifting the easement and moving it elsewhere, it was not granted in perpetuity.[15] The Belk court also reasoned that such parcel-swapping could undermine the "qualified appraisal of [the] property."[16]

         Those concerns are not present here. Only discrete five-acre residential parcels, entirely within the exterior boundaries of the easement property, could be moved - for example, to account for locations subsequently chosen as nesting sites by the warblers. Even the Commissioner's own expert confirmed that the unencumbered homesite parcels have roughly the same per-acre value as the rest of the ranch which is encumbered by the easements. Thus, changing the boundaries of some of the homesite parcels would not return any value to the easement donors.

         The easements in this case more closely resemble the conservation façade easements in Commissioner v. Simmons[17] and Kaufman v. Shulman[18]than the easement in Belk. In those cases, the circuit courts ruled that conservation easements were perpetual even though the trusts could consent to the partial lifting of the restrictions to allow repairs and changes to the façades of buildings. Both circuits held that, "clauses permitting consent and abandonment . . . have no discrete effect upon the perpetuity of easements . . . ."[19] Even though those cases addressed the perpetuity requirement in § 170(h)(5(A) rather than the one in § 170(h)(2)(C), the common-sense reasoning that they espoused, i.e., that an easement may be modified to promote the underlying conservation interests, applies equally here. The need for flexibility to address changing or unforeseen conditions on or under property subject to a conservation easement clearly benefits all parties, and ultimately the flora and fauna that are their true beneficiaries.

         The benefit to NALT is especially significant in this case in which the perpetuity of the easements is further ensured by NALT's virtually unrestricted discretion to withhold consent to any modifications. The easement grants in this case specify that NALT may withhold consent to adjustments in its "reasonable judgment." Furthermore, neither the BCR Partnerships nor individual limited partners may seek anything beyond declaratory relief to challenge NALT's withheld consent, and even then they must show that NALT acted in an "arbitrary or capricious manner."

         One final point: Most IRC provisions that intentionally create narrow "loopholes" to cover narrowly specific situations are deemed to have been adopted in an exercise of legislative grace and thus are subject to strict construction. That does not apply, however, to deductions for conservation easements granted pursuant to IRC §170(h). It was adopted (1) at the behest of conservation activists, not property-owning, potential-donor taxpayers (2) by an overwhelming majority of Congress (3) in the hope of adding untold thousands of acres of primarily rural property for various conservation purposes - acreage that would never become available for conservation if landowning potential donors were limited to the traditional method of conveyance, i.e., transferring the full fee simple title of such properties. Therefore, the usual strict construction of intentionally adopted tax loopholes is not applicable to grants of conservation easements made pursuant to §170(h). Rather, we analyze tax deductions for the grant of conservation easements made pursuant to that article of the IRC under the ordinary standard of statutory construction. And, when we apply that level of construction here, we are satisfied that our treatment of the issue of perpetuity stands the test.

         Mindful of the old proverb, "One picture is worth more than 10, 000 words, "[20] we attach to this opinion, as Exhibit 1, a copy of the Conservation Easement Plan of Bosque Canyon Ranch, prepared for NALT and filed as an exhibit in the trial of this case. It pictures the 3, 729.22 acre trapezoid that contains (1) the 2005 Conservation Area of 1, 750.1 acres, (2) the 2007 Conservation Area of 1, 731.63 acres, and (3) the 47 five-acre homesites totaling 235 acres. This exhibit makes immediately apparent the facts that (1) the vast majority of the homesites are tightly clustered, largely contiguous, and located in the northernmost tip of the ranch; (2) together, they closely resemble a typical suburban subdivision; (3) almost every homesite shares one or two common side line boundaries with one or more other homesites; and (4) most homesites are located on or in close proximity to the only road inside the easements, which road provides the sole access to the nearest public roads (Route 22 and County Road 1070). Given this subdivision-like layout and the homesites' contiguity or close proximity to each other and to the only interior road providing ingress and egress to and from the public roads, the Conservation Easement Plan of the ranch visually eschews any realistic likelihood of significant future changes in homesite location - at most, only theoretical or hypothetical changes. In sum, Exhibit A visually confirms that, realistically and practically, the perpetuity requirement of the Conservation Easement is not invalidated by the provision for homesite parcel adjustment. To conclude otherwise would be to violate the universally recognized maxim, de minimis non curat lex.[21]

         We are satisfied that any potential future tweaking of the boundaries of one or a few homesite locations cannot conceivably detract from the conservation purposes for which these easements were granted, especially in light of the requirement for NALT's prior approval of any such change. We therefore conclude that the homesite adjustment provision does not prevent the grants of the conservation easements here at issue from satisfying the perpetuity requirement of §170(h)(2)(C) and thus does not prevent the grantors of these easement from taking the applicable charitable deductions.

         b. The "Baseline Documentation" Requirements

         If the donor of a conservation easement retains rights to property subject to the easement "the exercise of which may impair the conservation interests . . . for a deduction to be allowable . . . the donor must make available to the donee, prior to the time the donation is made, documentation sufficient to establish the condition of the property at the time of the gift."[22] The purpose of this requirement, which is referred to as "baseline documentation, " is to "protect the conservation interests associated with the property, which ...

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