It is not unusual for a closely-held business or for its owners to issue or transfer equity in the business to a third party in order to raise necessary funding for the business or to secure the services of someone with a certain expertise. In most cases, where the equity transfer is made by the existing owners of the business, such owners may realize a gain on which they will be subject to tax for income tax purposes.
Often overlooked in such transfers, however, is the potential for incurring other, non-income taxes, including, in the case of a business that owns an interest in real property, state and local real estate transfer taxes.
Even when the owner-transferors are aware of this potential, they may, nevertheless, become liable for the tax where their individual transfers are aggregated by the taxing authorities for purposes of determining its application. The owners of one LLC recently had a close call in such a situation.
Brother A and Brother B each held a 46.5% interest in LLC-I. The other 7% interest was held by B’s son, C. In turn, LLC-I owned a 96% interest in LLC-II, which owned real property located in NYC (“Property”). Property was managed by B and had been in the family for some time. The remaining 4% interest in LLC-II was owned by an unrelated party. Both LLC-I and LLC-II were treated as partnerships for tax purposes.
Brother B planned to develop the Property, but LLC-I needed additional funding and construction expertise for this purpose. In August of 2005, LLC-I transferred a 30% interest in LLC-II to the Transferee. LLC-I used the proceeds to purchase the lot adjacent to Property. This was followed by LLC-I’s transfer, in October 2005, of an additional 18% interest in LLC-II to the Transferee. At that point the Property was beneficially owned 48% by LLC-I, 48% by the Transferee, and 4% by the unrelated party, and there were no plans for further transfers.
After the Transferee’s entry, Brother A became uncomfortable with the investment because he could not get answers to his questions about the status of the development and, although it was an income-generating property, he received no income. He was also concerned that, if additional funding were needed, there would be capital calls, which he could not meet, which would result in the dilution of his interest or his being “squeezed out of the deal completely and [he’d] rather get something than nothing.”
Brother A offered to sell his interest in LLC-I to Brother B and to the Transferee. Because Brother B did not have sufficient funds to purchase A’s interest, Brother A transferred his entire beneficial interest in the Property to the Transferee in March of 2006. Rather than Brother A’s selling his interest in LLC-I, however, the transfer of his interest in the Property was effectuated as a transfer by LLC-I of a 22.32% interest in LLC-II to the Transferee, following which LLC-I distributed the sales proceeds to Brother A. It appears that the transfer was done in this way because it had the same economic effect as a sale of Brother A’s interest in LLC-I, but it kept investors who were not related to A and B’s families in LLC-II, rather than admit them into LLC-I.
After these three transfers, the Property was beneficially owned 70.32% by the Transferee (the sum of the three transfers by LLC-I), 25.68% by LLC-I, and 4% by the unrelated third party. The Transferee had obtained its entire interest in eight months.
The Transfer Tax Dispute
LLC-I determined that NYC real property transfer tax (“RPTT”) was due on the third transfer, apparently concluding that it should be aggregated with the previous two transfers. It was also determined that Brother A would pay the tax because the sale of his interest in LLC-I had provided him with the necessary funds. A transfer tax return was filed for the transaction, reporting that a 70.32% interest had been transferred and identifying LLC-I as the grantor.
The amount paid for RPTT, interest, and penalty was withheld from Brother A’s proceeds and paid by LLC-I to the City. LLC-I thus acted as a withholding agent and Brother A, not LLC-I, paid the RPTT, interest, and penalty at issue. A claim for refund was filed with NYC, which was disallowed. A request for conciliation conference was then filed, but the Conciliation Bureau sustained the disallowance of the refund claim. A petition was then filed with the Administrative Law Judge (ALJ) Division of the New York City Tax Appeals Tribunal.
The ALJ considered the following issue: Whether the third transfer (by Brother A) of an economic interest in real property (LLC-II) should be aggregated with the two earlier transfers (by A and Brother B) to determine whether a controlling interest was transferred.
The NYC Administrative Code imposes a tax on the transfer of a controlling interest in an entity that owns real estate in NYC. A controlling interest is defined as 50% or more the stock of a corporation or of the capital, profits or beneficial ownership of a partnership.
A “transfer” is defined to include transfers of interests in entities “whether made by one or several persons, or in one or several related transactions, which shares of stock or interest or interests constitute a controlling interest in such corporation, partnership, association, trust, or other entity.”
The applicable regulation provides that related transfers “are aggregated in determining whether a controlling economic interest has been transferred.” It also provides that “[r]elated transfers include transfers made pursuant to a plan to either transfer or acquire a controlling interest in real property.”
This section also contains a presumption: “Transfers made within a three year period are presumed to be related and are aggregated, unless the grantor(s) or grantee(s) can rebut this presumption by proving that the transfers are unrelated.”
Because the three transfers at issue took place within a three-year period, they were presumed to be related. The taxpayer had the burden to rebut this presumption.
Neither the statute nor the regulation define a “related transaction” or explain what showing must be made to rebut the presumption. However, the regulation contains several illustrations that provide some guidance. In one illustration, A, B, and C each own 1/3 of a corporation. A sells his 1/3 interest to D, and within 3 years, B sells his 1/3 interest to D. The illustration concludes: “The transfers made by A and B are presumed to be related because they were made within a three year period” and tax will apply. The illustration does not mention the rebuttable nature of the presumption, but it also does not state that transfers to the same transferee are necessarily related and not subject to the rebuttable presumption.
In another illustration, A and B each own 50% of a corporation. A sells 20% to C and, within 2 years, B sells 30% to C. The illustration concludes, “Since these transfers occur within a three year period, they are presumed to be related, and thus, subject to the transfer tax.” Again, the rebuttable nature of the presumption is not referenced to, but here, too, the parties could show that the transactions are unrelated.
A final illustration provides an example of unrelated transactions. A, B, and C each own 1/3 of a corporation. In Year One, A transfers her 1/3 interest to satisfy a judgment. In Year Three, B transfers his 1/3 interest to his spouse pursuant to a separation agreement. The illustration concludes: “The transfers by A and B will not be aggregated because the transfers are not related. Thus no tax is due.” This illustration presents a scenario of two transferors making transfers to two unrelated transferees for independent reasons. It concludes that they are unrelated, apparently because the non-identity of the transferors and transferees, and the reasons for the transfers, establish the independence of the transactions and rebut the presumption that they be aggregated simply because they occurred within three years of each other. This illustration suggests that transfers that are unplanned and independent of each other are not related, and that facts demonstrating this can rebut the presumption.
The ALJ’s Decision
In the case at hand, the ALJ found that, at the time of Brother A’s transfer, the Transferee owned 48% of the entity, there was no plan to make any further transfers, and the third transfer was for reasons unrelated to the initial transfers. The first two transfers were made to gain the funding and expertise of the Transferee, and were limited to a 48% interest. The third transfer was prompted by Brother A’s desire to exit the investment. The third transfer was unplanned, unexpected, and occurred for reasons unrelated to the first two transfers. NYC argued that the three transfers were related because they were all transfers of interests in the same entity that resulted in the transfer of a controlling interest. (Interestingly, it does not appear that NYC claimed that the third transfer had been part of a plan, or even that it was reasonably contemplated at the outset, so as to justify a claim that it was related to the earlier transfers.)
There is nothing in the regulation, the ALJ stated, to indicate that transfers of interests in the same entity were by definition related and that the presumption may not be rebutted in such a case. Indeed, the last illustration, above, was directly contrary to such an interpretation. According to the ALJ, to interpret the regulation as NYC argued would eliminate both the requirement that transactions be related to be aggregated, and the ability to rebut the presumption. The ALJ rejected this approach. For these reasons, the ALJ concluded that the third transfer was not related to the earlier transfers and, thus, should not be aggregated with them in determining if a controlling interest was transferred. Accordingly, the transfers were not subject to the RPTT, and the claim for refund was allowed.
In the case described above, the LLCs were clearly real estate companies. The RPTT, however, is not limited to transfers of companies the values of which are attributable primarily to the values of their real properties. On the contrary, the transfer of a controlling interest in an operating company that owns a relatively small interest in real property will be subject to the tax, and the amount of the tax will be based upon the gross value (not reduced by any indebtedness) of the underlying real property.
A taxable transfer can turn into an expensive proposition given NYC’s top 2.625% tax rate, plus the State rate of 0.40%, so it would behoove the owners of a business that owns an interest in real property to “control” or plan for such transfers as best they can. In some cases, this will not be possible, in which case the consideration payable for the transfer should be negotiated taking into account the projected tax liability.
In other cases, however, a shareholders agreement or a partnership agreement can help to reduce the risk of a taxable event by restricting the transferability of the equity in the business. Of course, there should also be bona fide business reasons for the restrictions – the owners should not impair their interests solely to avoid a transfer tax.