Esgar Corporation v. Commissioner: Navigating the minefield of claiming charitable donations of minerals
February 20, 2012
By: Robert J. Allen and R. Lee Stephens, Jr.
On February 6, 2012, the United States Tax Court issued its decision in Esgar Corporation v. Commissioner, 2012 Tax Ct. Memo LEXIS 32. The Internal Revenue Service had determined that Esgar Corporation and other taxpayers had overstated the value of conservation easements on land in Colorado that they donated in 2004 and the IRS sought penalties. The Tax Court found that the values of the conservation easements were too high and ruled that the taxpayers were liable for income tax deficiencies but not penalties. The decision provides an overview of some requirements applicable to charitable donations of subterranean minerals. We now have a map of sorts to help clients navigate this valuation minefield, which may yield them a richer valuation than a simple donation of the surface alone. It is not a trip for the unwary.
The taxpayers were owners of land covering 2,200 acres of real estate near Holly, Colorado. In 1998, the Colorado Division of Minerals and Geology issued a permit for mining gravel, rock and sand on 1,479 acres of the property. About 661 acres had been conveyed off in 1998 to a third party who had operated an alluvial gravel pit on the property since 1999. In 2004, a lease was executed that allowed a mining company to mine virtually all of the property covered by the mining permit. The royalty rate in 2004 was 45 cents per ton for rock and gravel and 22.5 cents per ton for sand and fill dirt. Several other wet gravel pits were permitted in the vicinity.
In December 2004, portions of the property were divided among the taxpayers in a series of like-kind exchanges after which each taxpayer owned about 55 acres. The property was zoned “irrigated, agricultural” and was historically used as farmland. Only one of the properties had legal access to public roads. None of the properties had mining permits but, at trial, the parties stipulated that the necessary permits could have been obtained. Each taxpayer donated a conservation easement on their property to the Greenlands Reserve, a 501(c)(3) land trust. Each easement specifically prohibited the mining or extraction of sand, gravel, rock or other minerals, which is required for a conservation easement to be deductible.
The taxpayers commissioned an appraisal of the subject properties. They retained a geotechnical engineering firm to perform core sampling to determine the amount of sand and gravel beneath the properties. The appraiser concluded that gravel extraction was the highest and best use for the properties and included the value of the mineral deposits in his appraisal. The taxpayers claimed a charitable conservation contribution in the amount of their appraisals.
The primary issue in Tax Court was the value of the easements, the difference between the before and after value of the property. The IRS had concluded that agriculture on the surface was the highest and best use, not subterranean gravel mining, and therefore the easements essentially had no value. The taxpayer’s entire deduction was disallowed by the IRS. The parties agreed about the value of the properties after the easement was granted but disagreed about the before value.
The trial was a classic example of a “battle of the experts.” The taxpayers first relied on the opinion of a licensed real estate broker to argue that no comparable sales existed. The taxpayers presented the testimony of a certified appraiser and professional geologist for their expert opinion that the highest and best use of the property was gravel mining. The taxpayer’s expert stated that the three parcels comprising the subject property could be assembled and used for mining. He further opined, without asking the coal companies, that the gravel could be backhauled on nearby coal trains. The taxpayers presented the opinion of another geologist as to the value of the gravel. He calculated value based upon quantity of gravel multiplied by the current market price; he did not consider the costs of extraction.
The IRS’s expert was a real estate appraiser with experience in appraising gravel operations and conservation easements. He determined that the highest and best use for the properties was agriculture. He found that there was an adequate supply of gravel in the area from other gravel mine operators and no additional demand for the foreseeable future. The IRS’s expert used the comparable sales approach to valuation.
The Court held that: “Where the asserted highest and best use of property is the extraction of minerals, the presence of the mineral in a commercially exploitable amount and the existence of a market ‘that would justify its extraction in the reasonably foreseeable future’ must be shown.” Esgar Corp. v. Comm’r, T.C. Memo 2012-35 (T.C. 2012) citing United States v. 69.1 Acres of Land, 942 F.2d 290, 292 (4th Cir. 1991). In a footnote, the Court found that it was acceptable to rely upon eminent domain and condemnation cases to determine fair market value in conservation easement cases. Esgar Corp., T.C. Memo 2012-35, FN 12. The Court agreed with the IRS that the highest and best use of the property before the easement was agriculture and rejected the idea that a hypothetical willing buyer in 2004 would have considered the properties for construction of a new gravel mine.
The Court found that the taxpayers’ experts did not analyze supply – namely the other gravel mines in the vicinity of the taxpayers’ property – and that they failed to opine as to when demand for the gravel would mature given the availability of other gravel supplies. In the absence of such evidence, the Court concluded that the projection of income from mining the property was “little more than speculation and conjecture.” The Court found that even if demand for gravel was increasing, there was no evidence that the other existing mines could not handle the increasing demand and that there was not an adequate supply of gravel to be mined elsewhere. The Court also identified several technical problems with the taxpayers’ idea for backhauling the gravel and found that the taxpayers’ plan for transporting the gravel was impracticable. Since the Court found agriculture to be the highest and best use for the property, it used comparable sales of agricultural land to determine fair market value.
Although the Court’s determination of the value of the easements was a fraction of that claimed by taxpayers, the Court declined to assess accuracy-related penalties, finding that the taxpayers had reasonable cause for the underpayment and they acted in good faith. This conclusion was based upon the fact that the taxpayers relied upon their advisors and an accounting firm, engaged an outside law firm to review the donation and its substantiation, commissioned a core sampling report of the underlying gravel, and obtained a qualified appraisal from a qualified appraiser. All of this expertise, however, did not provide the taxpayers the guidance to make their way through the valuation minefield.
While the Esgar decision does not spell out exactly what a taxpayer must show to claim a deduction for a charitable contribution of minerals, the decision does provide an outline of some of the elements of such a donation. The taxpayer must show that a hypothetical willing buyer would consider the property more valuable for mining and would pay more for the property because of its mineral reserves. As part of this showing, the taxpayer must establish the existence of minerals on the property. This requires core sampling and engineering reports to calculate the quantity and quality of underlying minerals. If there are sufficient comparable sales, those sales should serve as the basis for determining fair market value because courts have said that comparable sales are generally the most reliable indicator of value. If there are inadequate comparable sales, the taxpayer may use a discounted cashflow analysis which requires a good deal more evidence.
To establish value by using an income capitalization or discounted cashflow approach, there must first be a supply and demand analysis. The Esgar Court referred to this as “unfilled market” and “unmet demand.” In other words, the taxpayer must prove an inadequate supply to meet the demand for the present, or at least for the foreseeable future. The taxpayer must show that all details of the mining operation are feasible. The taxpayer is not required to have a mining permit in hand, however all necessary permits must be attainable. The taxpayer must establish such things as the availability of a mining company to operate the mine, transportation for the minerals and other logistics of the operation, even the angle of the mining walls and how much mineral that would leave in the ground. The mining operation must be analyzed in detail and its value must be consistent with any other mines in the area. The value of the mining operation considers the quantity and quality of the minerals and the probable royalties for the minerals. The anticipated cashflow from royalties must be discounted to its present value. If the taxpayer proposes to mine the property, the value must consider all costs associated with the mining, from permitting to extraction to delivering to the end user.
A taxpayer seeking to donate an easement on property that could be used for mining must assemble a unique team of professionals. At a minimum, the taxpayer must retain: a geologist to assess the mineral reserves, an accountant to put a present value on the mineral royalties, experienced legal counsel to properly prepare the deed of easement, and appraiser(s) experienced in appraising both mines and conservation easements. The taxpayer must navigate the various minefields to ensure that the donation satisfies the substantiation requirements of the Internal Revenue Code, Treasury Regulations and interpretative case law and tax memoranda. A few missteps along the way and the entire donation could blow up.
For more information on this case, please contact Robert Allen or Lee Stephens at rallen@spottsfain.com (804) 697-2087 or lstephens@spottsfain.com(804) 697-2085. Contact any member of Spotts Fain’s Conservation Easement practice group for conservation easement related questions.
