The Fifth Circuit Court of Appeals has continued its pattern of siding with the IRS in syndicated conservation easement cases, upholding penalties against taxpayers who participated in transactions that the court found lacked economic substance beyond the tax benefits. The decision in Faulconer v. Commissioner reinforces the message that the IRS and the courts are taking an increasingly hard line against conservation easement deductions that are based on inflated appraisals and structured primarily to generate tax benefits for investors.^[1]

Background: Syndicated Conservation Easements

A conservation easement is a voluntary legal agreement in which a landowner permanently limits the use of their property to protect its conservation values. When a properly structured conservation easement is donated to a qualified organization, the donor is entitled to a charitable deduction under IRC § 170(h) equal to the fair market value of the easement. Legitimate conservation easements serve important land preservation purposes and have long been recognized as appropriate subjects of charitable deductions.

Syndicated conservation easement transactions, however, operate differently. In a typical syndicated deal, a promoter identifies a property, forms a partnership or LLC, and sells interests to investors. The entity then donates a conservation easement over the property and claims a charitable deduction that is allocated to the investors. The deductions typically exceed the investors' purchase price by a factor of four to one or more, generating substantial tax benefits that far outpace the investors' economic investment. The IRS has identified these transactions as abusive tax shelters and has listed them as "transactions of interest" requiring disclosure.^[2]

The Faulconer Decision

In Faulconer, the taxpayers participated in a syndicated conservation easement transaction involving rural property. The promoter obtained an appraisal valuing the conservation easement at a figure substantially in excess of the property's acquisition cost and the investors' total investment. The IRS disallowed the deduction in its entirety and asserted a gross valuation misstatement penalty under IRC § 6662(h), which imposes a 40 percent penalty when the claimed value of property is 200 percent or more of the correct value.

The Tax Court found for the IRS on both the deduction disallowance and the penalty, and the Fifth Circuit affirmed. The court's analysis focused on several factors. First, the court found that the appraisal supporting the easement deduction was unreliable, having been prepared by an appraiser selected by the promoter who used questionable comparable sales and development assumptions that were inconsistent with the property's actual market conditions. Second, the court found that the transaction was structured primarily to generate tax benefits, with the investors having no genuine interest in the property's conservation values or development potential beyond the deduction.^[3]

The Fifth Circuit's opinion also addressed the reasonable cause defense under IRC § 6664(c), which can shield taxpayers from penalties if they demonstrate that they acted in good faith and with reasonable cause. The court rejected the taxpayers' reliance on the promoter's materials and the commissioned appraisal, finding that a reasonable person in the taxpayers' position would have recognized that a deduction four to five times greater than the purchase price warranted additional scrutiny. The court noted that the taxpayers had not obtained an independent appraisal, had not consulted independent tax counsel, and had not conducted any due diligence into the reasonableness of the claimed deduction.

Implications for Taxpayers

The Faulconer decision is consistent with a growing body of case law in which the Fifth Circuit and other courts have upheld the IRS's position in syndicated conservation easement cases. For taxpayers who have already participated in these transactions, the decision reinforces the urgency of evaluating their exposure and considering their options.

The penalty exposure is substantial. The gross valuation misstatement penalty under § 6662(h) adds 40 percent to the underpayment attributable to the disallowed deduction. For a taxpayer who claimed a $1 million easement deduction in the 37 percent bracket, the tax underpayment is $370,000, and the penalty adds another $148,000—before interest. The IRS may also refer cases involving fraudulent appraisals for criminal investigation, and appraisers who participate in these transactions face their own penalties under IRC § 6695A.

For taxpayers who are currently under examination or who have pending cases in Tax Court, the Faulconer decision narrows the range of viable defenses. The reasonable cause defense requires more than reliance on the promoter's assurances—it requires independent due diligence that most participants in syndicated transactions did not perform. Taxpayers in this position should consult experienced tax controversy counsel to evaluate their options, which may include settlement with the IRS or participation in the IRS's global settlement initiative for conservation easement cases.^[4]

For taxpayers who are considering participating in a conservation easement transaction, the Faulconer decision serves as a cautionary tale. Legitimate conservation easement deductions remain available and valuable, but the transaction must be structured properly, the appraisal must be defensible, and the taxpayer's motivations must extend beyond the tax benefits. Any transaction in which the claimed deduction substantially exceeds the taxpayer's economic investment should be scrutinized carefully with the assistance of independent tax advisors before the deduction is claimed.