I’ll take My Chances
If I had a dollar for every time a client said to me “but they never audit real property transfer tax returns,” I’d be a client myself. I often hear this statement in the context of a transaction that a client insists should not be subject to the transfer tax, and it is often made in response to my analysis that the hoped-for result would not stand up to scrutiny. The prospect of incurring the NYC Real Property Transfer Tax (RPTT) on the sale of an interest in real property is no small matter for a business. The applicable rate of 2.625% of the consideration for a taxable transfer (plus the NYS transfer tax of 0.40%) represents a significant reduction in the net proceeds retained by the seller. For that reason, businesses and their owners will often try to structure a deal so that its form does not fall within the literal definition of a taxable “conveyance.” Well, guess what? Transfer tax returns do get audited and, for one taxpayer, the audit turned into an expensive proposition.
In 2007, Taxpayer and Partner acquired Tenancy in Common (TIC) Interests of 45% and 55%, respectively, in Property. They also entered into a Tenants In Common Agreement, which governed their respective rights and obligations as to the Property. In 2010, Taxpayer and Partner entered into the following agreements and transactions: (a) LLC was formed; (b) Taxpayer and Partner executed a Contribution Agreement pursuant to which Taxpayer and Partner agreed to contribute to LLC their TIC Interests together with their respective interests in a ground lease for the Property in exchange for, in the case of Taxpayer, a 45% Membership Interest in LLC and, in the case of Partner, a 55% Membership Interest in LLC. The Contribution Agreement contained several provisions that reflected the intended sale by Taxpayer to Partner of its new Membership Interest in LLC. For example:
- as a condition to closing under the Contribution Agreement, Taxpayer was to be released from obligations under certain loan documents relative to Mortgage;
- Partner’s obligation under the Contribution Agreement was conditioned on a title insurance company’s commitment to inure LLC’s title to Property;
- under the Contribution Agreement, only Taxpayer’s conveyance had to satisfy certain title requirements;
- Taxpayer alone assumed responsibility for the payment of any transfer taxes arising under TIC Contribution Agreement; and
- the Contribution Agreement contained representations made by Taxpayer to Partner but not to LLC.
Taxpayer and Partner executed deeds conveying their TIC Interests to LLC in exchange for their respective 45% and 55% Membership Interests in LLC, and also executed LLC’s Operating Agreement. Pursuant to the Contribution Agreement, LLC assumed the Mortgage and the ground lease. On their NYC RPTT returns, Taxpayer and Partner each reported that the transfer to LLC was exempt as a mere change of identity or form of ownership.
At the same time, Taxpayer and Partner executed both a Membership Interest Purchase Agreement pursuant to which Taxpayer agreed to sell, and Partner agreed to purchase, Taxpayer’s Membership Interest for $XXX (an obscene amount), as well as an Assignment and Assumption Agreement whereby Taxpayer assigned its Membership Interest to Partner and withdrew as a member of LLC. Taxpayer filed an RPTT return which described the “condition of the transfer” of its Membership Interest to Partner as “Other. Transfer of 45% interest in LLC” and reported that no transfer tax was due.
The Audit (that never happens)
NYC asserted that Partner’s ownership of 100% of the LLC resulted from a 55% non-taxable mere change and a 45% taxable change in beneficial ownership. The auditor calculated the taxable consideration based on the purchase price for Taxpayer’s Membership Interest plus a 45% pro-rata share of the Mortgage. Taxpayer asserted that the transfer of its 45% TIC Interest in exchange for its 45% Membership Interest was exempt from RPTT as a “mere change in form,” and that its sale of the Membership Interest to Partner was exempt from RPTT as a transfer of a non-controlling interest. NYC asserted that the contribution and sale (the Transactions) were subject to the step transaction doctrine. An administrative law judge (ALJ) agreed.
Mere Change in Form Exemption
NYC’s Administrative Code (the “Code,” with apologies to the one true Code, the IRC) imposes the obligation to pay the RPTT on the grantor. The Code provides an exemption from the RPTT where the deed conveying real property “effects a mere change of identity or form of ownership or organization to the extent the beneficial ownership of such real property or economic interest remains the same . . .” Taxpayer owned a TIC interest before acquiring an interest in an LLC. The “mere change” exemption has been applied in situations involving the conveyance of TIC interests in real property to an entity in which, based on the facts and circumstances specific to the particular case, the beneficial ownership of the property remained the same after the conveyance as it was before the conveyance. Thus, transfers of real property from TIC owners to LLCs are non-taxable mere changes in form where the beneficial interests of the parties remained the same before and after the transfer.
The Code imposes the RPTT on transfers of economic interests in real property. An “economic interest in real property” includes “the ownership of an interest or interests in a partnership . . . which owns real property.” When used in relation to an economic interest in real property, the term “transfer” includes the transfer of interests in a partnership whether made by one or several persons, or in one or several related transactions, which interests constitute a controlling interest in such partnership. A “controlling interest” in a partnership consists of “fifty percent or more of the capital, profits or beneficial interest in such partnership.”
Step Transaction Doctrine
Under the step transaction doctrine, “steps” in a series of formally separate but related transactions are treated as a single transaction if all of the steps are substantially linked. The purpose of the step transaction doctrine is to assure that tax consequences turn on the substance of a transaction rather than on its form, particularly if the form is without business purpose and “is merely a convenient device for accomplishing indirectly what could not have been achieved by the selection of a more straightforward route.” The tax consequences of an interrelated series of transactions, the ALJ said, are not to be determined by viewing each of them in isolation but by considering them together as component parts of an overall plan. Even where each step in the sequence, taken individually, may fit into “an untaxed transactional compartment,” the individual tax significance of each step is irrelevant when, considered as a whole, they amount to no more than a single transaction which in purpose and effect is subject to a given tax consequence. In order to determine whether the step transaction doctrine applies to a particular matter, courts have established two tests: an ‘interdependence test,’ and an ‘end result test.” Only one test must be satisfied in order for the step transaction doctrine to apply. The “interdependence test” inquires as to “whether, on a reasonable interpretation of objective facts, the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.” The “end result test” establishes a standard whereby purportedly separate transactions will be amalgamated into a single transaction where it appears that they were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result.
Taxpayer owned a TIC interest from 2007 until 2010. Only in 2010 did Taxpayer execute the Contribution Agreement and convert its TIC Interest to a Membership Interest. That conversion occurred on the same day that Taxpayer executed the Operating Agreement, the same day it executed the Membership Interest Purchase Agreement, and the same day Taxpayer sold its newly created Membership Interest to Partner. The Contribution Agreement included provisions that extended beyond the mere exchange of a TIC Interest for a Membership Interest, addressing matters relating to the conveyance of real property. Recitals in the Membership Interest Purchase Agreement described a sequence of events consisting of the formation of LLC, the execution and delivery of the Operating Agreement, the acquisition by LLC of the Property, and Taxpayer’s sale of its Membership Interest to Partner. Under these circumstances, since it was unlikely that either the conversion of Taxpayer’s TIC Interest to its Membership Interest, or the sale of its Membership Interest would have occurred without the other, the interdependence test was satisfied. It was also apparent that the events occurring in 2010 were components of one transaction, the end result of which was intended to achieve the sale by Taxpayer of its TIC interest to Partner while avoiding the payment of RPTT on such transaction and, so, the end result test is satisfied. The transfer of a less-than-controlling TIC interest (i.e., less than 50%) is subject to RPTT. Had Taxpayer directly conveyed its TIC interest to Partner, that conveyance would have been subject to RPTT.
What’s a Taxpayer To Do?
A central issue relating to the step transaction doctrine concerns the extent to which it is permissible for taxpayers to avail themselves of “planning possibilities.” Taxpayers have the legal right to structure a transaction to eliminate taxes to the extent permitted by law. The question is “whether the transaction under scrutiny is in fact what it appears to be in form.” Based on the facts in this matter, it did not appear to the ALJ that the Transactions were, in fact, what they appeared to be in form. In view of the body of law requiring taxes to be levied on the substantive transaction rather than on a series of formalized steps, Taxpayer was liable for the RPTT asserted by NYC, as the Transactions constituted step transactions and, as such, Taxpayer was not entitled to avail itself of either the mere change exemption or the exclusion applicable to the sale of a non-controlling interest.
The tax consequences of many transactions are determined by the form of the transaction, notwithstanding what the parties intended. In some cases, this may yield an unexpected taxpayer-friendly result. In most contexts, however, the substance of the transaction will control. The key is to assume that your transaction will be examined by the taxing authorities, to examine the transaction steps, to research the applicable legal authority, and to quantify the potentially adverse tax consequences. At that point, the client can make an educated decision.