Writers Comment on Tax Treatment of State Incentives for Charitable Contributions of Land

We understand that the federal tax treatment of state tax benefits (specifically, state income tax credits) offered in recognition of charitable contributions of land or interests in land for conservation purposes is under consideration by the Service. We understand that one point of departure for this consideration could be Chief Counsel Advice "Colorado Conservation Easement Credit," issued July 24, 2002, Document 200238041.

The following comments are respectfully submitted on behalf of the two of us as individuals. We believe these views reflect concerns shared by many members of the public in general, and the community of tax-deductible land conservation organizations in specific, but those groups are not responsible for the views expressed herein.

First, we submit that this is an area of very broad public interest and potential policy impact. Further, it is an area in which important changes are rapidly occurring. On August 17, 2006, H.R. 4 was enacted and made substantial modifications to the Internal Revenue Code in this area. Since the issuance of ILM 200238041, several states with important programs in this area have also enacted statutes that fundamentally affect the core federal tax principles involved.

Second, we submit that in this area many states have acted to add their particular incentives, in addition to existing federal incentives -- and at the states' cost-for voluntary individual charitable contributions of land or interest in land for qualified conservation purposes. Those incentives created by the states to supplement existing federal incentives should not be substantially reduced by administrative action of the Service.

Beyond consideration of our own views as expanded below, we submit that, before the Service prepares or issues novel guidance on this area:

• A much more comprehensive call for public input and participation should be issued, and --

• An invitation for a meeting between concerned conservation specialists and the Service should be issued. We have a long history working with conservation easements and the Virginia tax credit incentive, and we would welcome an opportunity to meet with Service staff. Of course, any such meeting should be open to and noticed to all other interested parties as well.

These comments address federal income tax issues related to tax benefits (largely against a state's income tax) granted by states to encourage taxpayer behavior. We are interested specifically in credits against the states' income taxes for the donation of property, whether as an easement or as a fee interest, for conservation purposes.

Our comments are first directed to tax issues related to a charitable donor of conservation property who qualifies for state income tax credit ("the donor"). Thereafter, we turn to questions related to a prospective transferee of such credit.

The answer to this question is a resounding no. There are several reasons.

1. The Granting of State Tax Credits Has Never Been an Income Realizing Event.

The law has long been settled that the making of a charitable contribution is not a realization event. Writing a rule that purported to require income to be realized on the making of a charitable donation would flow against longstanding authority that a donation is not a realization event. If this shock is to be administered to charitable deductions, the Legislature is the one to do it, not the Service.

A change of treatment of the magnitude contemplated in Memorandum 200238041 should not be done administratively. A reversal of multi-decades-long practice should be made only the Legislature. Deference to the Legislature is particularly important because the Congress has indicated through several Code provisions that it has an interest in determining the nature of tax credits.

The value of state income tax credit at the time of a conservation donation is very uncertain. Income usually is not deemed received if the valuation of the receipt is uncertain. Lehman v. Commissioner, 17 T.C. 652 (1951); cf., Internal Revenue Service Press Release, IR-98-56 (Sept. 8, 1998) stating that the person who caught the 62^nd homerun off Mark McGwire's bat did not have income on catching the ball. Burnet v. Logan, 283 U.S. 404 (1931). There is no reason to move away from this rule in the case of tax credits because their tax effect will soon be determined without the need to override decades of history dealing with property that is hard to value.

3. Administrative Problems of Treatment as Income at Time of Donation

The finding of income at the time of the donation would be an administrative nightmare for the Internal Revenue Service. Value may not be determinable at the time of the donation because the time of donation will almost always be separated, perhaps by many months or even decades (given the length of state carry-forward provisions), from the moment the credit is used. The IRS would have to determine, that is, speculate, whether the donor of the conservation interest will have taxes in the future to offset the credit. If the credit were bigger than current liability, the rate of use would have to be guessed, and some arbitrary interest rate would have to be used to establish a present value. Of course, if a value were set and included in income, and the use never occurred for any number of reasons, there would be questions about the tax effect of the failure to use the credit. A loss seemingly would be proper at that moment. Apparently, the taxpayer might have to await the expiration of a carryover period, and if death were reason for the loss, would the loss be reflected on the deceased's last return?

All of these problems may be avoided by simply waiting until the credit is used or disposed of. At that juncture, all the facts are in, and the use will determine whether a taxable event has occurred.

4. Other Problems of Treatment of Donation as Taxable Event

If the donation were found to be a taxable event, and if a proper value could be attributed to the credit, several other questions would arise. Certainly, the amount included in income would become the basis of the credit, and both the taxpayer and the Internal Revenue Service would thereafter have to track the basis as the credit is dissipated. Rules for use of the basis would have to be written. The effect of having property with a basis used to reduce state taxes would have to be considered.

5. Complexity of Treating Tax Credit as Income on Donation

If the credit is income, it quite clearly is produced by the transfer of the conservation interest, and the receipt of income on a contribution in exchange for property would be a bargain sale. All donations in states with tax credit incentives would become bargain sales leading to the allocation of basis of whatever was sold between the donated portion of the contribution and the contributed portion of the contribution. If realized upon the donation of property, the nature of the resulting income would turn on the nature of the interest sold, and some of the gain likely would be capital gain, possibly some gain falling under IRC section 1231, perhaps some recapture gain, and finally perhaps even some ordinary income.

These concerns can be avoided by refusing to find any income at the time of the donation. The use of the credit then becomes the event, and treating it as a reduction of state taxes will give it effect when the taxpayer realizes the economic consequences of the credit and result in appropriate treatment under the federal income tax.

B. Is the Credit Sufficient Benefit to be a Quid Pro Quo for the Contribution?

The answer again is decidedly no.

1. Same Question as Discussed Above

This question is to large extent the same as asking whether the donation produces income. That was dealt with above.

Some observers might say that the two questions are not the same. This question merely asks whether state tax benefits can be a quid pro quo, not what the amount of it is, and thus the question is different. In ILM 200238041, the IRS Chief Counsel argued that a quid pro quo could be available without quantification and thus the many problems arising with treating the contribution as an income-producing event do not arise.

The short answer to that suggestion is that quantification cannot be avoided. The reason for finding a quid pro quo is to deny or at least reduce the amount of the charitable contribution for federal tax purposes. The statement of the purpose, of course, tells us that we are once again set on the trail of all the vagaries previously discussed. That has to be because if a bargained-for consideration is received as in a bargain sale, the deduction is reduced only by the amount of the consideration. The contributor who has not bargained but simply takes advantage of state tax benefits should be treated at least as well, and that can occur only by determining the value of the quid pro quo. Once one determines the value of the quid pro quo, the transaction apparently becomes a bargain sale.

2. Tax Benefits as a Quid pro quo

Tax benefits should never be considered a quid pro quo. Tax benefits have long been recognized as an important incentive to the making of charitable contributions. The point at which a tax benefit might cease to be an incentive and become a quid pro quo probably differs as much as human minds differ. Bright lines would be arbitrary.

Quid pro quo is not an easy concept even when the donee or the mere making of the contribution confers some benefit on the donor. But with tax benefits the benefit usually will be conferred by a third party (a government who usually is not the donee) in amounts that are not fixed, may depend on future events, and have a variable value depending on characteristics of the donor. Some tax benefits may be easily quantifiable and thus appear to rise to an inducement to the contribution, but as a general rule, and a simple, general rule serves administration of the law, quantification is all but impossible and should not be undertaken.

This does not seem a good area for the IRS to draw bright lines and say, for example, that a deduction against a tax rate of 50 percent or more is a quid pro quo but a deduction against lower rates is not, just an incentive. The Internal Revenue Code once had tax rates of 91 percent, and there was no suggestion that a deduction that returned 91 percent of the donation to the donor was a quid pro quo.

Guidance that tax benefits of some specified value are a quid pro quo will undoubtedly draw arbitrary lines and be subject to litigation at some point. The litigation is likely to be successful, and in the meantime, numerous worthy contributions will have been discouraged, and the Internal Revenue Service will have spent resources chasing a will-o'-the-wisp.

C. What are the Consequences of Use of the state Tax Credit?

1. What are Federal Tax Consequences to a Non-Itemizer of state Tax Credits?

In the vast majority of cases, a donor of a conservation interest will be a taxpayer who itemizes federal deductions. But there will be cases, particularly when carryovers of state tax credits are considered, that a credit is available to a taxpayer who does not itemize. For that person, the state tax credit has no value whatsoever.

2. What are Federal Tax Consequences to an Itemizer of state Tax Credits?

If a taxpayer itemizes federal deductions, including state income tax deductions, the state credit will reduce the amount of the federal deduction for state income taxes. To the extent that the taxpayer gets any benefit from the state tax credit, a federal income tax consequence equal to the benefit has resulted. The credit has been effectively included in income through the reduction of the deduction for state income taxes.

D. Sale of Credit

Generally, tax benefits offered by either the state or the federal government can be effectively transferred. Quite frequently, those benefits are transferred through the use of a pass-through entity that gives the donor some economic benefit in exchange for the donor's placing the tax benefit in a pass-through that allocates the tax and other economic benefits to its members.

1. The Case of Pass-Throughs

The use of pass-throughs for the distribution of tax benefits is sufficiently diverse and particular that nothing more than general remarks can be made. In most cases, the economic benefit allocated to the donor in exchange for the tax benefit will be either ordinary income, or in many cases, capital gain earned over a number of years. There may be no immediate effect on the donor's state taxes, but other members of the pass-through will take some part of the tax benefits and reduce both state and federal taxes as are appropriate from the tax benefit being conferred.

2. Sale of Tax Benefits When Permitted Under State Law

This discussion focuses on a sale of a credit against state taxes as is permitted by the Commonwealth of Virginia for conservation credits. The tax result to the donor will differ depending on whether the receipt of the credit has been treated as income or has been left to later developments and the use of the credit. Because we think that only the latter treatment is proper, we discuss only that alternative.

Perhaps, a few words on the sale transaction will clarify some of the comments on the federal income tax consequences of the sale. The discussion below reflects the Virginia conservation tax credit as effective in 2007. The 2006 law does not differ in principle. In a typical sale, the donor will have donated a conservation easement to a conservation organization. That donation will be made after an appraisal, which we shall assume is correct, has been made of the interest. Under the Virginia statute, the donor then will have earned a credit equal to 40 percent (effective 1Jan07) of the value of the donated interest. If the donation occurs through a bargain sale, the credit will be earned only on the value of the interest in excess of the value of the consideration received by the donor/seller. The donor is required to apply to the Department of Taxation for it to issue a tax credit in the proper amount. This issuance is not acceptance of the value, and the Department has the authority later to examine the transaction and propose changes. Once the credit is issued by the Department, the donor has a credit to market. (After 2006, there are some more elaborate procedures for credits that exceed a floor of $1 million, that is, for a donation in excess of $2.5 million as adjusted for inflation after 2006.) The donor either seeks or will be sought out by a broker who has ties to persons desiring to buy credit for use, usually against the buyer's current year's state income tax. Practice shows that many donations are commenced early in the year but closed later in the year. Experience demonstrates that buyers will generally not want to enter the market for the credit until, at the very earliest, the fall of the year, and many will wait until December.

The broker is the key. With an inventory of credits from willing donors, the broker contacts potential buyers and offers credits, say in $10,000 increments, at a discount. Discounts vary from month to month and year to year. Let's assume that the broker convinces the buyer to pay $0.75 on the dollar. That is, if the buyer buys $10,000 of credit, the buyer has a credit against state income taxes for $10,000, and the buyer pays the seller/donor $7,500. From this latter amount, the seller of the credit pays the broker some agreed part of the $7,500.

This paradigm raises several federal tax questions. All of them are bottomed on the premise that the sale is a taxable transaction for the donor/seller of the credit.

a. What Basis, If Any, Does the Donor Have?

Because no amount has been taken into income by the donor, the donor has no basis for the credit. There seems no ground to support an assertion that some of the basis of the contributed property should be attributed to the credit. The credit is simply conferred, usually by a party not involved in the contribution transaction, and it does not appear to be a gift though a zero basis would still seem appropriate even if the state's allowance of the credit were treated as a gift.

The fact that the credit has no basis should have no effect on the other questions arising out of this transaction. Some property simply has a zero basis. For example, a note receivable previously deducted as a bad debt will have a zero basis. Also, property received from a decedent at a time when the property was thought valueless would have a zero basis. The amount of the basis should have no effect on either the holding period or the nature of the property. The credit is what it is even with a zero basis.

b. What is the Holding Period of the Credit?

Because received in a nontaxable transaction, some observers might be prepared to say that the credit is entitled to a pro-rata portion of the basis of the donated interest. That seems inappropriate. The credit was created at the time of the donation, and is fundamentally different from the property donated. Because no part of the basis of the property transferred is assigned to the credit, there is no argument that IRC section 1223, which allows the tacking of holding period in some circumstances, applies. The holding period should commence at the time of the donation.

c. What is the Nature of the Credit?

The IRS has ruled that the credit is not property and thus cannot be a capital asset. See TAM 200211042. This holding conflicts with ITA 200126005 which held that application of the purchased credit to a state tax liability was the extinguishment of a liability by the use of property and thus a full deduction for the state tax extinguished by the credit was allowed. The ITA did not expand to deal with the question whether gain or loss was recognized on the application of the credit to the state tax liability, but that certainly seems the natural consequence of the ITA. As between the TAM and the ITA, the ITA seems to announce the better law.

The credit seems property for the code provisions on realization of gain, and the only question is whether it is a capital asset. The easy answer is to say that it is not a capital asset because it is only a bundle of future ordinary income (because it reduces a deduction) and thus cannot be gain under cases such as Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958). There is also case law that the sale of asset which would produce ordinary income if collected does not produce capital gain if sold. See, Commissioner v. Ferrer v. Commissioner, 304 F.2d 305 (2^nd Cir. 1962) for a lengthy discussion of this issue.

This conclusion may be strengthened by cases dealing with the assignment of income. An assignment of future income is taxed to the assignor of the income, here the contributor of the conservation easement, and any amount received would be a realization of that income and thus ordinary income. Estate of Stranahan, 472 F.2d 867 (1973), taxed the assignor only when the assignee received the income, but the court there found the transaction to be a loan to the assignor with no income realized until the dividends subject to the assignment were received by the assignee. The facts of this transaction would not support that construction, and the amount paid by the buyer would be ordinary income. Cf. Commissioner v. Banks, 125 S. Ct. 826 (2005).

But, except for Banks, a case of very murky impact, those cases were decided before Arkansas Best Corporation v. Commissioner, 485 U.S. 212 (1988), and this latter case teaches that anything that can be sold is a capital asset unless it is explicitly described in the statutory exclusions under IRC section 1221. Recently issued proposed regulations, section 1.1221-1 (REG- 109367-06), and the Preamble to them make quite clear that the IRS wants few extrastatutory exceptions to the definition of a capital asset. Properly, the credit seems a capital asset.

Of course, if the credit is defined as a capital asset, its sale in the year of the donation will produce short-term capital gain while sales of carryover amounts in subsequent years could produce long-term capital gain. Currently, most credits are sold in the year of origination. If that practice continues, the characterization of the credit as either capital asset or asset producing income is of little significance. While a holding that the credit was a capital asset might cause donors to hold the credit off the market until the credit had been held a year, the experience in Virginia has been for early sale because of substantial donor fear that the conservation scheme might be subject to legislative revision. This fear is not without some foundation. Legislation had been introduced every year, and revision took place in 2006.

E. Conclusion Regarding the Donor

The state tax credit is a reduction in state income taxes. To the extent that it reduces a deduction against federal income, it is taken into income (perhaps watered down a little for the phase-out of itemized deductions). That benefit is taxed to the donor.

The donor, of course, usually will have transferred an asset that may be appreciated and will not have paid a tax on the appreciation. That result flows from the way we treat charitable contributions, and it occurs whether or not a credit is involved. To the extent that the credit gives economic benefit, that benefit is subject to tax at ordinary income rates.

The credit should not be included in income nor treated as a quid pro quo. These results follow because the donor's wealth is not increased by the credit until the credit is either used or disposed of. Whether either of those will occur is uncertain at the time of the creation. Avoiding this uncertainty by not including the credit in income avoids a morass of administrative problems that arise if a different conclusion is reached.

A. Pass-throughs

In some cases, a tax benefit earned by a donor will have greater value if transferred to another person. Transfers have routinely occurred through pass-throughs for a great number of deductions and credits. We believe that pass-throughs have a very limited use in some circumstances, and our primary interest lies in conservation credits that are earned at the time of donation. They generally have a very limited economic life and are extinguished when used on the tax return for the year of donation unless the benefit exceeds the tax and a carryover is allowed. For those credits, we think that pass-throughs do not work well because they exist for the sole purpose of transferring the credit and have no reason for any continuing life. Their existence is so transitory that they are not true economic units. We leave comment to others more familiar with the law on pass-throughs.

B. Purchase of Tax Credits

Virginia legislation permits the contributor who earns a credit for contribution of a conservation interest to transfer that credit to another person. The typical transaction has been described above. A purchase of a credit raises a few issues for the buyer though most of these questions have an easy answer.

1. The Purchase and Use of the Credit

The purchase of a tax credit should have no tax consequences to the buyer at the time of purchase. The buyer has simply purchased an interest in property.

The disposition of the credit is a taxable transaction, and the buyer must know the basis and the holding period of the credit as well as whether the credit is a capital asset.

a. Basis

The basis for the credit is the amount paid to the seller. The purchases are by their very nature cash transactions, and few questions about basis should ever arise.

b. Holding Period

i. Commencement of the Holding Period

The holding period should begin on the date that the transfer of the credit is completed, not on the date the credit is used.

ii. Termination of the Holding Period

The termination of the holding period may be a bit more problematic.

At least mild controversy may surround the question when the holding period of a credit is terminated. The easy answer is 'when the credit is used,' and that answer then forces us to ask when the credit is used.

One might logically argue that the credit is used when the taxpayer reduces estimated state taxes in reliance on the credit, when the taxpayer signs a tax return claiming the credit, or when the taxing agency accepts the return and provisionally allows the credit.

Because each of these may require a determination difficult to make, they are not good candidates for an administratively simple rule, and simplicity should be highly valued on this kind of an issue.

The simplest rule would end the holding period of the credit on the due date of the tax return on which the credit is used to reduce the filer's tax liability. And that is what we recommend. That date is the date that taxes are deemed paid. Prior to that date, the taxpayer has not effectively put the credit out of the taxpayer's control and submitted it to the tax agency because a return filed before the due date can be effectively revoked by a subsequent return filed before the due date of the return. The latest return filed before the due date of the return is deemed the taxpayer's return. Positions on that return can be changed only by filing an amended return after the due date of the original return, and positions on amended returns are changed only if the tax agency receiving the return acquiesces in the change.

This rule might appear to conflict with ILM 200445046 which said that the taxpayer would have made a payment on taxes when it files its state tax return and uses the purchased credit to reduce its state tax liability. But we think this conflict is more apparent than real. Until the due date passes the credit has not reduced the taxpayer's tax liability. So, we think that termination of the holding period on the due date of the tax return claiming the credit is consistent with the ILM.

But simplicity can also be established by finding that the use of the credit occurs on the extended due date of the tax return. For any other property other than a tax credit, a taxpayer is free to choose the date of payment. Payment of cash on an extended return is payment when the check is negotiated. The same freedom should exist for tax credits. The taxpayer has not lost control of them until the extended return is filed, and that should be the date of payment with the due date used rather than the filing date to have an easily administered rule. The transfer of the tax credit is complete only with the filing of the return, not some prior date when the return was due.

Should late-filed returns be treated as extended returns? Some might argue that the failure to file should reduce the delinquent's options. This would be augmented by pointing out that even on late- filed returns, the tax liability will be reduced by the credit as of the date the return was due. Interest and penalties will be calculated on the liability on the due date of the return, not as of the date that the return is filed. The answer to this argument is that a taxpayer who has filed a return late may be derelict and subject to the penalties prescribed by law, but the taxpayer should not be visited with other burdens simply because the return is late. Because late-filed returns are few in number, a rule of simplicity does not have to be adopted. The date of filing the return, and for this purpose, the date stamped on the face of the return by the taxing agency should be used.

3. Nature of the Asset

A purchaser might argue that the credit is clearly a capital asset for the purchaser, and the logic of the Arkansas Best opinion offers strong support for that position. But the credit may be viewed as an obligation issued by the state, and the purchaser has purchased it at a discount. The credit is not an interest paying obligation, and the authorities discussing whether a debt of the state meets the terms of IRC section 103 are not relevant.

4. Taxable Event

The use of the credit is a taxable event, and the amount realized should be face value of the credit that reduces the state tax liability.

This disposition clearly seems a retirement of a state obligation under IRC section 1271 and should be treated as a sale or an exchange.

5. Reduction of State Taxes

The Internal Revenue Service in a technical assistance opinion held that a buyer of the tax credit should treat the use of the credit as a payment of taxes. ITA 200126005. The credit on this theory does not reduce the tax payment made by the buyer. Rather, the use of the credit is the transfer of property in payment of the taxes.

We propose that current tax policy, with the inclusion of:

• Reduction of section 164 deduction when state income tax is paid with credit granted to the taxpayer in recognition of a conservation donation by the taxpayer;

• Taxation as federal ordinary income of any proceeds from the sale of state income tax by the original charitable donor / recipient of the credit; and

• Treatment as capital gain / loss of any gain / loss by the user of purchased transferable state income tax credit on any difference between basis and realized value --

However, the public policy goals supported by federal tax deductions for land conservation donations under section 170 and 170(h), and by state tax incentives, are clouded by the uncertainty created by ILM 200239041. We urge the Service to remove this cloud by clearly affirming that the discretion of the states to provide incentives for private action through state income tax credit will not be diminished through counteractive federal taxation, and by disavowing the views of ILM 200239041.

We thank you for your consideration.