The Internal Revenue Service (IRS) recently announced a new settlement initiative for syndicated conservation easements (SCEs) that are currently under review and have not yet been litigated in Tax Court. This new settlement initiative provides significantly more favorable terms than the IRS’s settlement initiatives for SCEs currently litigated in Tax Court. Both settlement initiatives essentially reduce the deduction to the capital the partner investor contributed to the fund and require the investor/partner to pay back taxes and penalties on the amount due. However, the new settlement initiative imposes a 5% penalty for gross valuation errors and a 21% tax rate at the partnership level (compared to the previous 10% penalties), and provides for the highest individual marginal tax rate (typically 37%) in the settlement initiative for litigated cases.

Until now, tax advisors have been able to assure their clients that they would not receive a better deal from the IRS. However, with this new initiative offering better terms than those previously offered by the IRS, that certainty seems to have been shattered.

At first glance, the new conditions may be attractive for many partners, especially in view of the 5^th The Circuit Court’s findings in Brooks and in recent tax court cases (Big K and Oconee). In addition, taxpayers who do not participate in the settlement must sue in tax court, where the Commissioner will undoubtedly look for fraud even if he does not seek fraud penalties. The findings of fact in Oconee, for example, mirror the allegations in the Justice Department’s landmark prosecution of the executives of Inland Capital. (Inland Capital)

Notably, investors in the highest tax brackets who have invested in SCEs that offer the highest deduction per dollar invested (e.g., InvestCo ratio) will fare better than comparable investors who have invested in SCEs that offer lower returns. Some investors who are in the highest tax bracket and have invested in aggressive SCEs may still be at an advantage because the tax rate is 21% instead of 37%.

Although the financial conditions of the new regime are significantly better for investors, two provisions could make its implementation impractical.

First, the new settlement initiative creates a classic free-rider problem. The new settlement initiative requires the partnership to make a one-time payment of the entire amount due. Limited partnerships, including SCEs, typically do not have the ability to compel partners to contribute additional capital. If a partner refuses to contribute, the typical response is to dilute the recalcitrant partner’s share in the partnership. That’s not a big hammer to threaten with. So if an individual member does not want to settle, the partnership agreement may simply allow him to refuse to contribute. The remaining partners will have to pay more or face an increasingly hostile tax court.

Secondly, the agreement creates a^th Modification dilemma for some partners. The agreement requires the partners to cooperate fully “during the resolution.” Cooperation includes, but is not limited to, providing “additional information as requested by the IRS.” This undefined obligation may ultimately derail the deal, considering that the agreement specifically not prevent the IRS from investigating related criminal conduct or recommending the prosecution of any person or entity that participated in an SCE transaction or assisted or advised others to participate in an SCE transaction for violation of criminal law.

Partners who play a larger role, such as some of the Oconee partners, must assess the risk of “full cooperation.” It is unclear whether the IRS will reject a settlement if a single partner fails to meet his or her 5^th Rights to amend or refuse to respond to a problematic document request. As noted above, the IRS’s allegations in Tax Court mirror the DOJ’s allegations in the indictment in Inland Capital. Time will tell whether the Tax Court cases – and the information gathered during the audits and trials – foreshadow the next round of indictments from a more emboldened Justice Department (Law360: Convictions to embolden DOJ). In the meantime, some individual partners will face a dilemma: sign and hope the IRS doesn’t request additional information, or reject the settlement and hope the winds change direction in Tax Court.

It’s too early to tell if the new settlement is genuine or an IRS ploy. On the one hand, the IRS should be commended for offering favorable financial terms that encourage settlement, especially in light of Brooks. On the other hand, if the IRS is serious about settling a significant number of cases before they go to tax court, it should allow partnerships to make full payment even if some of the members refuse to participate or cooperate.