Premium for conservation-easement tax-loss coverage was not deductible

Plain-English summary

A partnership donated a conservation easement and bought a policy that could pay amounts calculated by reference to a later disallowance of the charitable deduction. The policy covered the partnership, its manager, and the manager's investors, but excluded the costs of investigating, defending, or appealing a tax proceeding. Counsel concluded that the premium was not deductible under IRC § 162 because the covered loss depended on action by a taxing authority, not on the partnership's business activities or expenses. It was not deductible under § 212(1) or (2) because neither the deduction nor a payout for its disallowance was tied to producing income or managing income-producing property. Section 212(3) also did not allow the deduction because the contract reimbursed nondeductible federal tax and penalties rather than professional costs of determining or contesting tax. The memorandum did not decide whether the arrangement was insurance for federal tax purposes or whether the partnership and its partners were bona fide.

Ruling snapshot

• Question: Could the partnership deduct the policy premium under IRC § 162(a) or § 212?
• Outcome: Advice given: no, the premium lacked the required business or income-production nexus and represented coverage of nondeductible tax
• Key authorities: IRC § 162(a), § 212(1)-(3), § 275, § 702; Treas. Reg. § 1.162-1(a), § 1.212-1(d); Rev. Rul. 55-264; Rev. Rul. 58-480

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202053010
       Release Date: 12/31/2020
       CC:ITA:B03:JWilliford
       POSTF-109608-20

UILC: 162.00-00, 162.27-00, 212.00-00

date: September 16, 2020

 to:   Kimberly B. Tyson
       General Attorney
       (Large Business & International)

from: Brinton T. Warren
Branch Chief
(Income Tax & Accounting)

subject: -----------------------------------------------------------------------------------

       This Chief Counsel Advice responds to your request for assistance. This advice may not
       be used or cited as precedent.

       LEGEND

       Taxpayer    =              -----------------------
       Date 1      =              ----------------------
       Member      =              --------------------------------------
       Location    =              ---------------------------
       Date 2      =              ---------------------------
       Date 3      =              --------------------------
       Conservancy =              -------------------------------------------
       Date 4      =              -------------------
       Date 5      =              --------------------------
       Date 6      =              ------------------
       Date 7      =              ---------------------------
       $a          =              -----------------
       $b          =              ---------------

POSTF-109608-20 2

ISSUES

Whether Taxpayer may deduct a “------------------------------------------Policy”1 (“Policy”)
premium under sections 162(a) or 212 of the Internal Revenue Code (“Code”). 2

CONCLUSIONS

The premium paid toward the Policy is not directly or proximately connected to any
trade, business, or income producing activity of Taxpayer. As a result, the premium is
not deductible under sections 162(a) or 212(1)–(2). Further, the premium, as part of a
contractual arrangement to pay non-deductible tax, is not deductible under section
212(3).

STATEMENT OF FACTS

On Date 1, Member began circulating a private placement memorandum (“PPM”) to
potential investors. The PPM promoted an opportunity to invest in Member. Member’s
purpose, as described in the PPM, was to acquire a membership interest in Taxpayer,
the soon-to-be owner of certain real property in Location (“Property”). The PPM
contemplated three possible uses for the Property: developing it -------------------------------
---------------------------------------------------------------------------, holding it for investment, or
conserving it.

Describing the conservation option as -------------- the PPM stated ------------------------------

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------- The PPM noted that the Property was --------------

The PPM also noted that Taxpayer might purchase a “---------------------------------------------
policy” in connection with the donation of a conservation easement. According to the
PPM, the purpose of this arrangement would be to -------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

1
Whether the ------------------------------------------Policy constitutes insurance for federal income
tax purposes is beyond the scope of this advice. As used in this advice terms such as
“insurance,” “policy,” and “premium” are for economy and not a suggestion that the -Policy is
insurance for federal income tax purposes.
2
Whether Taxpayer is a bona fide partnership or whether its partners are bona fide partners are
beyond the scope of this advice, as is the substance of Taxpayer and its transactions under
judicial doctrines.

POSTF-109608-20 3

On Date 2, following a series of transactions, Taxpayer acquired the Property and
Member acquired a ---% membership interest in Taxpayer. At that point, Member
became Taxpayer’s manager and tax matters partner.

On Date 3, Taxpayer conveyed a conservation easement encumbering the Property to
Conservancy. The deed of conservation easement reserved to Taxpayer rights that
generally reflected the uses identified in the PPM as possible under a conservation
easement, including:

  •   --------------------------------------------------------------
  •   -------------------------------------------------------------------------
  •   -----------------------------------------------------------------------------
  •   -------------------------------------------------------------------------------
  •   -------------------------------------------------
  •   -------------------------------------
  •   ----------------------------------------------------------------------------------------
  •   ---------------------------------------------------------------
  •   -------------------------------------------------------------------------
  •   -------------------------------------------
  •   ----------------------------------------------------
  •   ----------------------------------------------
  •   -----------------------------------------------------------------------------------

On Date 4, Taxpayer received confirmation of the Policy as contemplated in the PPM.
The Policy had a term of Date 5, to Date 6, and defined “loss” as follows:

  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  ----------------------------------------------------------------------------------------------------------

With respect to defending or settling any proceedings implicating the Policy (defined to
include actions brought by a taxing authority concerning the tax treatment of a
conservation easement), the Policy states:

  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  -------------------------------------------------------------------------------------------------------

  ------------------------------------------------------------------------------------------------------------
  ------------------------------------------------------------------------------------------------------------
  -------------------------------------------------------------------------

POSTF-109608-20 4

Moreover, the costs of investigating, defending, responding to, or appealing any such
proceeding are explicitly excluded from the Policy’s definition of “loss.”

The Policy’s named insured is Taxpayer. An endorsement to the Policy, however, adds
Member and its investors to those definitionally insured under the Policy.

On Date 7, Taxpayer filed its ------- federal tax return. The return reflected a charitable
contribution deduction in the amount of $a and other deductions in the amount of $b; a
portion of the latter appears to reflect a premium expense incurred in relation to the
Policy.

LAW AND ANALYSIS

Section 162(a) allows a deduction for ordinary and necessary expenses paid or incurred
during a taxable year in carrying on any trade or business. Section 212(1)–(2) allows
individuals to deduct ordinary and necessary expenses paid or incurred for the
production or collection of income, or for the management, conservation, or
maintenance of property held for the production of income. Section 212(3) allows the
deduction of expenses related to the determination, collection, or refund of any tax.

Given that the deductibility of Taxpayer’s Policy premium is, as explained below,
determinable regardless of whether Taxpayer engaged in a trade, business, or income-
producing activity, issues relating to Taxpayer engaging in a trade, business, or income-
producing activity are beyond the scope of this advice.

A. Section 162(a) – Trade or Business Nexus

To be deductible under section 162(a), an expense must be directly connected with, or
pertain to, the taxpayer’s trade or business. Treas. Reg. § 1.162-1(a); see also
Kornhauser v. United States, 276 U.S. 145, 153 (1928) (characterizing the required
nexus as a “direct” or “proximate” connection).

Two revenue rulings illustrate the nexus requirement for contractual arrangements that
are comparable to the Policy. These are Rev. Rul. 55-264 (1955-1 C.B. 11) and Rev.
Rul. 58-480 (1958-2 C.B. 62).

In Rev. Rul. 55-264, the Service determined that an insurance premium was deductible
where the policy reimbursed the taxpayer for business overhead expenses incurred
during prolonged periods of disability due to injury or sickness.

In Rev. Rul. 58-480, the Service ruled that that amounts outside of overhead expenses
were not deductible. The ruling reasoned:

   where the terms of an insurance policy provide that the benefit payments to be
   made are for loss of income, dismemberment, or loss of life, but do not
   specifically provide that the payments under the contract are to reimburse the
   policyholder for certain business overhead expenses incurred by him during a
   period of disability due to injury or sickness, the premiums paid on such a policy

POSTF-109608-20 5

   do not constitute business expenses and are not deductible under section 162 of
   the Code.

The reasoning of the revenue ruling was based in part on Blaess v. Commissioner, 28
T.C. 710 (1957). In that case, a medical doctor claimed a deduction for premiums paid
toward three health and accident insurance policies, each of which would provide
payments in the event the doctor became fully or partially disabled and, thus, unable to
perform his occupational duties. Id. at 711–12. The Tax Court disallowed the deduction
because, although the payments depended on the doctor’s inability to perform his
occupation, they were unrelated to his business: the doctor was entitled to receive
payments under the policies even if he incurred no business related expenses at all (if,
for example, he closed his practice). Id. at 714–15. The fact that the doctor intended to
use to the payments to pay his office expenses could not, the Tax Court said, be
determinative of the question. Id. at 715–16. These authorities establish that, in
analogous circumstances, the contingencies contemplated by the parties’ arrangement
must be directly connected with, or pertain to, the taxpayer’s trade or business to allow
the deduction of any related premium expense under section 162(a).

Applying the above described test to the facts of this case shows that Taxpayer’s
premium payments are not deductible under section 162(a). The reimbursable claims
under the Policy are unrelated to any purported trade or business activities of Taxpayer
(regardless of the trade or business in which it might be engaged). Under the terms, as
long as Taxpayer fulfills its obligations under the Policy (e.g., by promptly reporting
circumstances that might lead to a claim), it is entitled to payment for amounts
calculated with reference to the disallowed conservation easement deduction. This
outcome under the Policy occurs whether or not Taxpayer incurs any expenses related
to any trade or business, for example, -------------------, ------------------------------, or ----------
---------. The contingencies triggering a claim pertain not to business activities or
business needs of Taxpayer, but rather subsequent actions of the IRS or other taxing
authority. Taxpayer can suspend all business activities on the property without affecting
its entitlement under the Policy. Moreover, as any reimbursement under the Policy will
pass through to Taxpayer’s members—and the Policy, reflecting this, insures Member
and its investors—the Policy’s terms are necessarily unrelated to any trade or business
activities at the partnership level.3 As a result, similarly to circumstances involving the
doctor in Blaess, the premium paid toward the Policy is not deductible under section

3
The issue of whether the trade-or-business requirement of section 162(a) has been met is
determined at the level of the partnership, not the partners. See Brannen v. Commissioner, 78
T.C. 471, 502–05 (1982) (discussing Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521,
564–65 (1979), aff’d 633 F.2d 512 (7th Cir. 1980); Goodwin v. Commissioner, 75 T.C. 424,
434–39 (1980)).

POSTF-109608-20 6

162(a).4 This conclusion means that it is necessary to determine whether section 212
allows a deduction for the premium payments at issue in this case.

B. Section 212(1)–(2) – Income Production Nexus

Individuals are not limited to section 162 for investment-related deductions. Section 212
was enacted to create parity between nonbusiness expenses and similar business
expenses that had long been deductible under the predecessor to section 162(a). See
United States v. Gilmore, 372 U.S. 39, 45 (1963); Brown v. United States, 526 F.2d 135,
138 (6th Cir. 1975). As a result, sections 162(a) and 212 are generally considered in
pari materia, and the restrictions and qualifications applicable to the deductibility of
trade or business expenses are also applicable to income-production expenses covered
by section 212(1)–(2). Johnsen v. Commissioner, 794 F.2d 1157, 1162 (6th Cir. 1986);
Leigh v. United States, 611 F.Supp. 33, 36 (N.D.Ill. 1985).

Although not requiring engagement in a trade or business as section 162 does, section
212(1)–(2) requires a profit motive. Treas. Reg. § 1.183-2(a). The expectation of a profit
need not even be reasonable, but, to be deductible under section 212(1)–(2), an
expense must bear a reasonable and proximate relation to the production or collection
of income, or to the management, conservation, or maintenance of property held for
production of income. Treas. Reg. § 1.212-1(d); see Blaess, 28 T.C. at 716.

The Policy at issue here—and thus its related premium—is unrelated to any income
producing activity of Taxpayer.5 Neither the deduction itself, nor any insurance payout
for its disallowance, arises as a result of any purported investment activity, or is
correlated to the success or failure of such activity. This is true whether Taxpayer’s
investment strategy contemplates future sale of the fee or continued leasing of the
Property. As a result, the premium paid toward the Policy is not deductible under
section 212(1)–(2).

C. Section 212(3) – Expenses Related to Determination, Collection, or
Refund of a Tax

Section 212(3) allows the deduction of expenses related to the determination, collection,
or refund of any tax. The standards for allowing the deduction under 212(3) are less
strict in the sense that they do not have the nexus requirement of section 212(1)–(2). In
this vein, expenses under 212(3) are deductible regardless of whether directly or

4
Because the expense must be incurred “in” carrying out the trade or business, the premium at
issue here is nondeductible without regard to whether the Policy constitutes insurance for
federal income tax purposes. Accordingly, this advice need not address whether the premium at
issue here would be deductible if the expense was incurred in carrying out the trade or business
and the Policy was determined to be insurance.
5
Although section 702(a) requires each partner to take into account that partner’s distributive
share of a section 212 deduction separately, section 702(b) establishes that the characterization
of such a deduction is determined at the level of the partnership.

POSTF-109608-20 7

proximately connected to an income producing activity. See Stussy v. Commissioner,
T.C. Memo. 2003-232 at *4 (exception in section 212(3) was prescribed specifically by
Congress to allow taxpayers to deduct a personal expense that would otherwise be
nondeductible and allowing section 212(3) deduction despite absence of income
producing activity).

Significantly, however, section 212(3) does not encompass amounts representing
federal income tax. See section 275. Although, to date, no court has addressed the
deductibility of contracts resembling insurance under section 212(3), courts have denied
deductions under the analogous predecessor provisions for other types of contractual
arrangements, concluding that the purported expenses were, in fact, merely the
contractual relabeling of non-deductible tax. See Edwin J. Schoettle Co. v.
Commissioner, 3 T.C. 712, 718 (1944), aff’d 147 F.2d 549, (3d Cir.1945) (bond
represented amounts of tax); Globe Products Corp. v. Commissioner, 72 T.C. 609, 618–
19 (1979) (sharing agreement among former subsidiaries included amounts of tax).

In addition to these cases, the New York State Bar Association (“NYSBA”) in 1984
issued a report on “tax audit insurance” that considered the deductibility of premiums for
such insurance in light of section 212(3). N.Y. State Bar Ass’n Tax Section, A Report on
Tax Audit Insurance, reprinted in 22 Tax Notes 53 (1984). Like the Tax Court in Blaess,
the NYSBA assessed the deductibility of premiums paid for these policies by looking at
what exactly the policies were meant to reimburse:

    The Committee believes that under present law a premium paid for tax audit
    insurance is not deductible to the extent that it is allocable to the cost of providing
    reimbursement for tax deficiencies, since a taxpayer is not allowed any
    deduction, exclusion or credit for federal income tax. On the other hand, such a
    premium is probably deductible to the extent that it is allocable to the cost of
    providing reimbursement for professional fees, since a deduction is allowed
    under section 212 of the Code for the costs of contesting a proposed tax
    deficiency.

Id. at *7.

The NYSBA’s logic is sound, and it supports denying the deduction in the instant case.
There is no indication that any portion of the premium paid for the Policy is specifically
allocated to professional expenses incurred contesting a tax deficiency. In fact, while
the Policy requires Taxpayer to secure written consent from the insurer prior to entering
any settlement agreement that would result in a loss, the insurer has no obligation
under the Policy to defend or pay the defense costs of any proceeding against Taxpayer
related to the deduction. Moreover, the costs of such defense are excluded from the
Policy’s definition of loss. Because the insurer is under no obligation to perform any
services related to a tax proceeding, no portion of the premium can be regarded as
consideration for such services. Thus, we conclude the contract explicitly contemplates
the reimbursement of non-deductible tax and penalty amounts.

POSTF-109608-20 8

In view of the foregoing, the premium paid toward the Policy is not deductible under
212(3).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

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