Income Tax Impact of Transfer Taxes

We noted earlier that state transfer taxes are often viewed as a “sideshow” to federal income tax considerations in structuring a deal.  Despite this perception, state transfer taxes represent real economic cost to the payor.  To appreciate their “true” cost, however, one must also consider their income tax consequences.

In the case of the seller or transferor who pays the tax, the transfer tax is treated, for income tax purposes, as a reduction in the amount realized in the sale, thereby reducing the income tax burden from the sale.

In the case of the buyer who pays the tax, the transfer tax is added to the basis of the property acquired.  Thus, it may be depreciable (and recoverable) over a period of time, depending upon the nature of the asset acquired.

In the case of a stock purchase (without an IRC Sec. 338(h)(10) or Sec. 336(e) election), it will reduce the gain on a subsequent sale of such stock.

That being said, on a net basis, it is generally better, if possible, to avoid the transfer taxes entirely.

The Purchase & Sale Agreement

There are a number of items to consider where the transfer tax on the sale cannot be avoided.  The issue of liability should be addressed.

In a state like New York, which imposes the payment obligation on the seller, practical impediments may prevent a buyer from collecting the tax from the seller after a transaction is closed.  It is good practice for the buyer to ensure that the tax is paid by the seller at closing, perhaps by holding back the amount of transfer tax determined to be owed. The purchase agreement should expressly provide for the seller’s timely payment of the tax, as well as for the preparation and timely filing of the transfer tax return, in accordance with the parties’ agreed-upon allocation of the purchase price (or, in a stock deal, their agreed value for the real property owned by the target entity).

It should be noted that nothing prevents a buyer and seller from allocating responsibility for the transfer tax in connection with a business acquisition.  For example, the purchase agreement may provide that the seller and its owners shall be responsible for any transfer tax liabilities arising out of the transaction, or that any transfer tax returns will be prepared by the buyer.  It is also not unusual for the parties to agree to split the costs (for example, 50-50).  Although a contractual provision will not prevent the taxing authority from proceeding against any party it can legally pursue, as between each other, the buyer and seller will be bound by their agreement.

The agreement may also include an indemnification provision for any breach thereof.  Be mindful, however, that  not all indemnifications are equal.  The value of the contractual protection will vary depending on the financial condition and the integrity of the seller.  A holdback (escrow) or deferred payment (installment note), or other form of security arrangement, can enhance the buyer’s protection.

If a significant transfer tax may be applicable to the sale transaction, it is generally advantageous, from a transfer tax perspective, to allocate purchase price away from taxable assets in order to reduce the liability.  Of course, the allocation must be supportable, and it must be consistent with the allocation made for income tax purposes (see, e.g., IRC Sec. 1060; IRS Form 8594).  Additionally, note that the preferences for one tax may be at odds with those of the other.

Conclusion

The foregoing highlights the importance of the real estate transfer tax in assessing the overall economic benefits and burdens of a purchase and sale transaction.  In evaluating such a transaction, it behooves both the seller and the buyer to consider, as early as possible, the amount and impact of such tax and to plan for it accordingly.