Economic substance doctrine applied to conservation easements

By Kathryn Proper, CPA, Cleveland; Trina Pinneau, J.D., LL.M, Washington; and John Deininger, J.D., LL.M., Los Angeles

Editor: Mo Bell-Jacobs, J.D.

On Dec. 23, 2016, the IRS issued Notice 2017-10, announcing that certain syndicated conservation easement transactions are listed transactions for purposes of Secs. 6111 and 6112 for transactions entered into on or after Jan. 1, 2010. Listed transactions, and substantially similar transactions, are transactions that the IRS has determined are tax avoidance in nature and have identified them as such by notice, regulation, or published guidance. Taxpayers who participate in these transactions and are required to file a tax return must disclose their participation in them to the IRS.

A typical transaction covered by Notice 2017-10 involves the advertised investment in a passthrough entity that owns real property or acquires real property for the purpose of granting to a tax-exempt entity a conservation easement encumbering the property. The property is commonly appraised for an inflated value and, when the easement is donated, the investors claim an inflated charitable contribution deduction. In addition, the investors rely on the passthrough entity's holding period in the underlying real property to treat the donated easement as a long-term capital gain (Sec. 170(e)(1)). In a typical transaction, a promoter would receive a fee, often in the form of an interest in the passthrough entity. In the notice, the IRS stated that it would challenge the tax benefits of these types of transactions, based on various doctrines, including the economic substance doctrine.

Penalty risks

Engaging in a listed (or substantially similar) transaction can result in significant penalties. Participants and material advisers of listed transactions are required to disclose the transactions on the appropriate form. Participants who fail to disclose the transaction are subject to penalties under Sec. 6707A. Additionally, participants may also be liable for accuracy-related penalties under Sec. 6662A for understatements on reportable transactions or Sec. 6662 for substantial understatements that are not subject to Sec. 6662A penalties. Finally, Sec. 6501(c)(10) extends the statute of limitation on the assessment period by one year when a taxpayer fails to disclose a listed transaction.

Promoters and material advisers of abusive tax shelters can be subject to myriad penalties for promoting transactions, aiding and abetting understatements of tax associated with the transactions, failing to disclose advice relating to listed transactions, and failing to maintain lists of advisees of reportable transactions. A return preparer who prepares a tax return that includes an unreasonable position is subject to penalties under Sec. 6694.

Sec. 6662(b)(6) applies a 20% accuracy-related penalty on the understated tax for disclosed transactions that lack economic substance, while Sec. 6662(i) increases that penalty to 40% if the transaction is undisclosed. Generally, under Sec. 6664(c), taxpayers subject to underpayment penalties may request a penalty abatement based on reasonable cause if they can demonstrate that they acted in good faith. However, for penalties related to transactions that lack economic substance, penalty abatement through reasonable cause is specifically disallowed by Sec. 6664(c)(2). As a result, the accuracy-related penalty assessed under Sec. 6662 due to a transaction that was disallowed because it lacks economic substance is, effectively, imposed on the basis of strict liability.

Codified economic substance doctrine: Two-prong test

The judicial economic substance doctrine, codified in Sec. 7701(o)(5)(A), provides that in the case of a transaction to which the economic substance doctrine is relevant, the transaction has economic substance if the transaction changes the taxpayer's economic position in a meaningful way (the objective prong) and if the taxpayer has a substantial purpose for entering into the transaction (the subjective prong). Both prongs of the economic substance doctrine are analyzed apart from the transaction's federal income tax effects. Determining whether the economic substance doctrine is relevant to a transaction is done as if the doctrine had never been codified.

Notice 2010-62, as amplified by Notice 2014-58, provides that the IRS will continue to rely on relevant case law decided under the common law economic substance doctrine when applying the two-prong test. The notice also confirms that the codified two-prong test is a conjunctive test that requires both prongs to be met. Further, the IRS will challenge taxpayers that rely on prior case law when the transaction in question is treated as having economic substance merely because it satisfies either, but not both, of the prongs.

The objective prong: The objective prong in the codified economic substance doctrine asks whether the transaction at issue changes the taxpayer's economic position in a meaningful way. Neither the Code nor Treasury regulations define the standard for changing an economic position in a meaningful way. Further, courts have been inconsistent in their treatment of the precodified objective prong.

Some circuits have relied on a narrow view of the precodified objective prong, finding that the taxpayer must realize a benefit or profit from the transaction rather than just a change in position. The broader views focus on an objective evaluation of the taxpayer's economic change in position, apart from the tax benefits. This broader view is more in line with the codified economic substance doctrine.

In deciding whether a transaction had economic effect, the Second Circuit in Gilbert, 248 F.2d 399 (2d Cir. 1957), found that if a taxpayer enters into a transaction that does not appreciably affect its beneficial interest, other than to reduce its federal income tax liability, the transaction should be disregarded. Citing Gilbert, the Supreme Court in Knetsch, 364 U.S. 361 (1960), invalidated a taxpayer's transaction that "did not appreciably affect his beneficial interest except to reduce his tax." In ACM Partnership, 157 F.3d 231 (3d Cir. 1998), aff'g and rev'g T.C. Memo. 1997-115, the Third Circuit, partially affirming and partially reversing the Tax Court, determined economic substance by examining whether the transaction caused a net change in the taxpayer's economic position. The Eleventh Circuit in Winn-Dixie Stores Inc., 254 F.3d 1313 (11th Cir. 2001), aff'g 113 T.C. 254 (1999), affirmed the Tax Court's finding that economic substance should be determined by an objective analysis of changes in the taxpayer's economic position, aside from tax benefits. This last interpretation is the closest match to the codified economic substance doctrine.

The subjective prong:The subjective prong of the economic substance doctrine inquires into the taxpayer's purpose for entering into the transaction. To satisfy this prong, the taxpayer must have a nontax purpose for entering into the transaction. Courts have found that the subjective prong requires a subjective analysis of the taxpayer's intent. The Tax Court in Packard, 85 T.C. 397, 417 (1985), determined that an inquiry into the taxpayer's business purpose is a subjective test that "simply concerns the motives of the taxpayer in entering the transaction."

IRS approach in applying the doctrine

Following codification of the economic substance doctrine, the commissioner for the Large Business & International (LB&I) Division issued LB&I-4-0711-015, "Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties." This directive instructs LB&I examiners and managers how to determine when it is appropriate to seek approval to raise the economic substance doctrine in an examination.

The directive outlines a process for LB&I examiners to follow. Examiners evaluate the appropriateness of raising the economic substance doctrine in the context of the transaction based on 17 criteria, including the promotion by outside advisers, the level of structuring in the deal, and whether the transaction creates a meaningful economic change on a pretax basis.

If, after completing the preliminary steps, the examiner believes it is appropriate to apply the economic substance doctrine, the examiner must develop the case for approval by the director of field operations (DFO) with jurisdiction over the matter. The DFO manages LB&I operations within a particular geographic area or subject-matter area. Additional inquiries must be made before seeking approval through a written submission to and consultation with the DFO. If the DFO believes approval is appropriate, and before making a final determination, he or she should seek guidance from IRS counsel and allow the taxpayer an opportunity to substantiate the position taken on the return.

Economic substance applied to a conservation easement

If the economic substance doctrine is applied to a syndicated conservation easement transaction, the taxpayer has a difficult task in trying to refute the notion that the transaction had no economic substance. Because the taxpayer cannot seek penalty abatement by claiming reasonable cause, it must meet both the subjective and objective prongs of the economic substance doctrine to avoid accuracy-related penalties under Secs. 6662(b)(6) and 6662(i).

A taxpayer taking part in a syndicated conservation easement must show that its economic position objectively changed. At the time that a conservation easement is appraised, it is assigned a value representing its utility, which, in reality, it is unlikely to achieve, as the property owner's primary intent is the land's donation and charitable contribution deduction, not development. The property's appraisal often assumes that the parcel of land is usable in a manner that is highly valuable, such as for mining or retail development, when the owners of the land have no such plans. The transaction results in a deduction that is not matched by an equivalent economic loss or expense. As a result, the taxpayer's economic position never actually changes upon donation of the land, and thus it fails the objective prong. The subjective prong of the economic substance doctrine is an even greater challenge for syndicated conservation easements.

The subjective prong looks at an individual taxpayer's motivation for taking part in a transaction. A key feature of syndicated conservation easements is that the transaction is often promoted and advertised as providing a substantial economic benefit that far exceeds the investment in the transaction, with a promised return on investment greater than 2½ times the amount of the initial investment (Notice 2017-10). Because of the way a syndicated easement is promoted, a substantial return on investment shortly after the initial investment and without any material difference to the land, looks strikingly as if it is the taxpayer's sole motivation for taking part in the transaction. Unfortunately, facts supporting a credible business purpose that would allow a taxpayer to refute the application of the economic substance doctrine and avoid strict liability for penalties are difficult to imagine in the typical syndicated conservation easement transaction.

Nonetheless, avoiding penalties resulting from the IRS's application of the economic substance doctrine is only possible by showing a credible business purpose. As it relates to avoiding a transaction being labeled as a syndicated conservation easement and classified as a listed transaction, a taxpayer must substantiate that a plan to develop the land for economic purposes in line with the appraisal is both realistic and was actually a consideration before making the donation. An investment scheme advertised by a promoter is unlikely to avoid the application of the economic substance doctrine. A transaction's business purpose could be supported by demonstrating that the investment began as a legitimate development plan advanced by a credible land developer and later resulted in a donation of encumbered land to a tax-exempt entity. A taxpayer should remember that all of the facts and circumstances surrounding the transaction are relevant to determining whether the economic substance doctrine applies to a conservation easement.

Limiting the risk of penalties

Taxpayers who have taken part in a transaction that could be classified as a syndicated conservation easement are at risk of being assessed accuracy-related penalties because the transaction lacks economic substance. The strict-liability nature of the penalty provides that the only hope a taxpayer has for avoiding it is by demonstrating that the transaction was for a legitimate business purpose and that the taxpayer's economic position in the transaction was changed in a meaningful way. Tax practitioners advising clients on syndicated conservation easements are wise to become familiar with guidance on the application of the economic substance doctrine to begin building a case to show that the transaction does not warrant application of the economic substance doctrine. At a minimum, an at-risk taxpayer should disclose the transaction to limit the potential penalty amount.


Mo Bell-Jacobs is a manager, Washington National Tax, for RSM US LLP.

For additional information about this item, contact the authors at,, or

Unless otherwise noted, contributors are members of or associated with RSM US LLP.

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