A River Runs Through It

Ag & Rural Law Roundup

June 17, 2005

John R. Heronimus, Esq.

Choice of Entity

Why use an entity when acquiring real property?

To limit the extent of any liabilities associated with the property to the assets contributed to the entity.

To protect any other personal assets of the purchaser not associated with the property.

To help secure certain tax benefits that may not otherwise be available to the individual.

Choice of Entity - General Partnership

A general partnership is an association of two or more persons to carry on a business for profit. (C.R.S. § 7-64-202)

A general partnership can be formed orally, without any formal documentation or filing.

All partners are agents of the general partnership, with the authority to bind the partnership by their actions.

All of the partners are jointly and severally liable for all partnership liabilities.

There is no limitation to the liability of the general partners in a partnership. The partners personal assets are not insulated from the creditors of the general partnership.

Pass-through entity: profits and losses pass through to the partners with only one level of taxation.

Choice of Entity – Corporation

A corporation is a distinct legal entity formed in accordance with the Colorado Business Corporation Act. (C.R.S. § 7-101-101, et seq.)

Shareholders generally do not have any personal liability for the debts and losses of the corporation.

Must adhere to corporate formalities or risk losing limited liability protections for its shareholders.

Centralized management vested with the board of directors who are elected by the shareholders.

Subject to double-taxation: profits income of the corporation itself is taxed at entity level, then any distributions made to shareholders are taxed again at the individual shareholder level.

Choice of Entity – S-Corporation

An S-corporation is identical to a regular corporation (C-corporation), except that it has elected to be taxed pursuant to subchapter S of the Internal Revenue Code.

Will be treated as a pass-through entity subject to only one level of taxation if it meets certain restrictions: Can have no more than 75 shareholders. Shareholders can only be individuals, or certain forms of trusts or

non-profit entities. Can only have one class of stock. Can not make special allocations of profits and losses among

shareholders.

Possible danger with an S-corporation is that the S-election could be “blown” by breaching any of the above-listed restrictions, putting the corporation back into the standard C-corporation category subject to double-taxation.

Choice of Entity – Limited Liability Company

An LLC is formed pursuant to the Colorado Limited Liability Act (C.R.S. § 7-80-101, et seq.)

An LLC has the limited liability benefits of a corporation, and the pass-through taxation benefits of a general partnership.

Colorado LLCs can also be set-up as single-member LLCs, which are disregarded for tax purposes.

LLCs have much more flexibility than S-corporations: No restrictions on number of members. No restrictions on who, or what entity, can be a member. Can have multiple classes of membership interest. Can make special allocations of profits and losses among members.

Choice of Entity – The Winner Is: LLC

An LLC is generally the entity of choice to use as an acquisition vehicle for the purchase of real property in Colorado. Its pass-through tax treatment, flexibility, and ability to limit the liability of its members make it a very attractive choice.

Current facts: Client has significant assets outside of the real property

being purchased so limitation of liability is desirable. Pass-through tax treatment is an important benefit. Flexibility should be maintained to address possible

conservation easement, subdivision, and sales options.

Conservation Easements

Specific Question in fact pattern: Can our client donate a conservation easement on the property and take a tax write off?

Generally, a conservation easement is a contribution of the legal right to further develop one’s real property beyond its current use to a qualified charity for conservation purposes.

Conservation Easements – Benefits:

Receipt of a federal income tax deduction in an amount up to the fair market value of the contributed conservation easement.

Exclusion of the fair market value of the contributed conservation easement from landowner’s gross estate.

Possible reduction in overall property taxes.

Landowner retains the right to continue to use and sell property, subject to conservation easement restrictions.

Conservation Easements -Legal Source:

26 U.S.C. § 170(h) provides a federal income tax deduction to a landowner for the donation of a “qualified conservation contribution.”

A “qualified conservation contribution” means: A contribution of a “qualified real property interest,” To a “qualified organization,” Exclusively for “conservation purposes.”

Conservation Easements -Legalities:

Qualified Real Property Interest:

A negative (restrictive) easement granted in perpetuity, on the use of the real property.

The restrictive easement must be legally enforceable.

Recorded in the real property records of the County.

Any mortgages or deeds of trust must be subordinated to the restriction, so that the restrictive easement can’t be extinguished through foreclosure proceedings.

Conservation Easements -Legalities:

Qualified Organization:

A governmental entity; or

A publicly supported charity receiving a substantial portion of its support from the government or from the general public; or

A tax exempt (§ 501(c)(3)) organization receiving at least 1/3 of its support from gifts, grants, contributions, membership fees, and funds generated by its charitable activities.

Conservation Easements -Legalities:

Conservation Purposes:

The preservation of land areas for outdoor recreation by, or the education of, the general public.

The protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.

The preservation of open space (including farmland and forest land) where such preservation is - (I) for the scenic enjoyment of the general public, or (II) pursuant to a clearly delineated Federal, State, or local governmental conservation policy, and will yield a significant public benefit.

Conservation Easements – Valuation

Reg. 1.170A-14(h)(1) states that the value of the donated conservation easement is its fair market value.

Reg. 1.170A-14(h)(3) provides for two methods to establish the fair market value of a conservation easement: Comparable Sales method, and Before and After method.

Conservation Easements – Valuation

Comparable Sales Method

Fair market value of the conservation easement is determined by comparing the attributes of the subject conservation easement with the attributes of comparable conservation easements that have recently sold in the area.

Comparison should include size of property, location, development potential, etc.

Difficult to use this method, because there is not sufficient data of conservation easements to compare to.

Conservation Easements – Valuation

Before and After Method

Fair market value of the conservation easement is the difference between the “highest and best use”, and its allowable use under the conservation easement agreement.

“Highest and best use” is the reasonable and probable use that supports highest present value of the property.

“Highest and best use” is typically the value of the property if it was developed to its maximum permissible density.

Determining the value of the “highest and best use” should include an objective assessment of the likelihood of such development, and the impact of any existing zoning laws.

Conservation Easements – Valuation

Appraisal Required

Reg. 1.170A-13(c) requires the taxpayer to substantiate deductions claimed over $5,000.

Among the documents needed to substantiate the deduction is an appraisal of the fair market value of the deduction.

It is critical to use a qualified appraiser with experience valuing conservation easements in the area to put your client in the best position to defeat any audit inquiries.

Conservation Easements – Valuation

Percentage Limitation

§170 limits the amount that can be claimed as a deduction in any given year.

For individuals, the maximum deduction per year is 50% of the taxpayer’s adjusted gross income.

This amount could be reduced, based on the characterization of the deduction and the type of charity, to 20-30% of the taxpayer’s adjusted gross income.

If the amount of the deduction to be claimed exceeds the annual limit, the unused portion can be carried forward for up to five years.

Conservation Easements – Valuation

Long Term Capital Gain vs. Ordinary Income:

If the sale of the underlying property would result solely in long-term capital gain, the taxpayer can deduct 100% of the fair market value of the conservation easement.

However, if the sale of the underlying property would result in the recognition of ordinary income, a percentage of that gain, based on the fair market values of the easement and the underlying property, must be allocated to the easement and the amount of the deduction must be reduced by that same amount.

Bottom Line: It is probably desirable to wait at least a year after acquisition of the property before granting the conservation easement to ensure long term capital gains treatment as opposed ordinary income treatment.

Conservation Easements – Valuation

Audit Risk

Due to the substantial tax benefits associated with the donation of conservation easements, some taxpayers have been abusing the system to generate large deductions with only marginal conservation benefits.

For example, a developer purchases 1,000 acres of rural land for $1,000,000, then syndicates ownership interests in the land and claims a $50,000,000 conservation easement based on a questionable appraisal, with the intention of passing percentages of the deduction on to investors.

In July of 2004, the IRS issued Notice 2004-41 announcing that it would scrutinize charitable contributions of conservation easements for the possibility of valuation abuse.

Conservation Easements - Colorado Gross Conservation Easement Credit Generally:

A Colorado State income tax credit of up to $260,000 is available for the donation of a conservation easement on property located in Colorado. This credit can be carried forward for a maximum of 20 years from the year the credit is originally claimed.

Conservation Easements - Colorado Gross Conservation Easement Credit Requirements Similar to §170 Requirements:

Amount of credit is based on the fair market value of the easement granted. (C.R.S. §39-22-522(4))

Easement must be granted to a governmental entity or a tax exempt (§ 501(c)(3)) organization. (C.R.S. §38-30.5-104(2))

Donation of easement must qualify as a charitable contribution for federal income tax purposes under §170(h). Qualified Real Property Interest Qualified organization Conservation Purposes

Conservation Easements - Colorado Gross Conservation Easement Credit Who can claim the credit?: (C.R.S. §39-22-522(1))

Colorado residents C-corporations Trusts or estates Pass-through entities (Partnerships, LLCs, S-Corps, etc.) Members of pass-through entities regardless of whether

such members are Colorado residents.

Note: A single member LLC is a “disregarded entity,” as opposed to a “pass-through entity”, and the single member would therefore not qualify as a “taxpayer” for Colorado credit purposes, unless such member qualified for other reasons (i.e., a Colorado resident).

Conservation Easements – What does this mean for our

Client? Our client could grant a conservation easement restricting future development

on a portion of the ranch to a nonprofit conservation group and receive a federal income tax deduction, provided that our client waits at least a year to capitalize on the most favorable tax treatment.

If our client uses an LLC as an acquisition vehicle and adds his wife as an additional member, our client can also use the Colorado Conservation Easement Credit with respect to any Colorado income tax he may have even though he is a resident of another state.

The location of the property is ideal to meet the conservation purpose of preserving forest land, with National Forest Land to the east and BLM land to the west.

Best of all, our client can continue to enjoy that portion of the property that is encumbered by the conservation easement under its current use as a ranch.

Subdivision of Ranch

Specific question in fact pattern: Can our client subdivide the property and create four 10 acre parcels for his children and a 500 acre parcel to be used as a company retreat?

Subdivision of Ranch

Subdivisions are governed generally by the County Planning Code and Building Code (C.R.S. §30-28-101 et seq.), and specifically by the subdivision regulations of the county where the property is located. (i.e., The Routt County Subdivision Regulations)

Subdivision of Ranch

35 Acre Rule: Generally, a land owner must go through a rigorous plat approval

process with the Board of County Commissioners for any “subdivision”.

However, the term “subdivision” does not apply to any division of land that creates parcels that contain 35 or more acres of land, as long as each parcel so created is not intended for use by multiple owners. (C.R.S. §30-28-101(10)(b))

This 35 acre exclusion is duplicated in §2.2.54(b) of The Routt County Subdivision Regulations (“Routt Regulations”).

Subdivision of Ranch

Results for Ranch 500 acre retreat parcel can be created without obtaining the approval of the

Board of County Commissioners.

10 acre parcels would require the subdivision to be registered through the approval process set forth in the Routt Regulations: Sketch Plan Preliminary Plan Subdivision Improvement Agreement Final Subdivision Plat Approval

Recommendation: With 12,000 acres in the ranch, the easiest solution may be for our client to simply increase the acreage of the parcels to be given to his children from 10 acres each to 35 acres each.

Access Issues-370 Acre Private Parcel

Access Issues-370 Acre Private Parcel Possible Title Issue:

370 Acre Private Parcel is surrounded by forest, and was carved out by current owner.

No road runs directly to the parcel, although one runs close to it.

An implied easement of necessity across the ranch property has probably been created by the current owner for the benefit of the owner of the private parcel. This easement will be a burden on the ranch when our client purchases it.

Access Issues-370 Acre Private Parcel Implied Easement of Necessity:

Elements (Thompson V. Whinnery, 895 P.2d 537 (Colo. 1995): Common ownership of land, followed by severance into two or more

parcels. Necessity for the easement must exist at severance. Necessity for the particular easement must be great.

Location of easement will be the same as the traditional means of access to the severed parcel.

If there is no traditional means of access (as in our case), the owner of the servient estate (our client if the ranch is purchased) can delineate a reasonable way of access.

Access Issues-Hunter Access to Forest The facts indicate that the current owner has allowed hunters to use a private

ranch road to access the forest. Can our client put a gate up?

While this issue requires additional investigation, it appears as if the current owner has granted a mere license to the hunters to use the road.

A “license” is a consent granted by a landowner for an act which would otherwise constitute a trespass.

A license is not an interest in land, and may be created by an oral grant.

A license is revocable at the will of the licensor (property owner).

A license is personal to the licensee (the Hunters) and therefore, unassignable.

Conveyance of the servient land (the ranch) by the licensor automatically terminates the license.

Access Issues - Public Road under R.S. 2477 The issue of placing a gate up on the private road could also

implicate an R.S. 2477 Public Road argument.

R.S. 2477 was passed in 1866 to give rights of way for miners, farmers and homesteaders to develop the American west. It was repealed in 1976, but any roads that were open for public use under R.S. 2477 prior to the repeal retain their public status.

R.S. 2477 stated that “The rights-of-way for the construction of highways over public lands, not reserved for public uses, is hereby granted.” (43 U.S.C. § 932)

Access Issues - Public Road under R.S. 2477 Elements:

A “highway” must have been formed… “Highway” can include any trails or roads formed for the passage of wagons, etc.,

over soil.

While the land was publicly owned and not reserved for public use… This is purely a question of fact that can be difficult to prove.

That was accepted by sufficient use on the part of the general public. In Colorado, mere use of the highway is sufficient.

Due to the close proximity of the private road and the national forest, this issue needs further investigation to give comfort to our client that recreational users won’t try and claim that this private road over the ranch is actually a public road pursuant to R.S. 2477.