July 10, 2017
On June 29, 2017, in a widely anticipated ruling, the Supreme Court of California held that a transfer of an interest in a legal entity that results in a change in ownership of real property held by the legal entity for property tax purposes triggers the California documentary transfer tax (the "DTT").[1] This decision affirms the lower court’s view that property tax "change in ownership" principles apply for purposes of the DTT.
As discussed in more detail in our prior Client Alert, Ardmore involved a series of transactions involving, over time, the transfer of an apartment building by a trust (Trust) to a wholly owned limited liability company (Ardmore), a transfer by the Trust of its interest in Ardmore to a "trust-owned partnership" (Partnership), a "distribution" of interests in the Partnership by the Trust to certain subtrusts of the Trust, and a "distribution" and "sale" of a 45% interest in the Partnership by the subtrusts to each of two other trusts formed for the grantor’s two sons (90% total transferred).
The Los Angeles County Assessor concluded that the transaction resulted in a change in ownership of the apartment building and reappraised the property on that basis. Ardmore did not dispute that the transactions resulted in a change in ownership of the property for property tax purposes and paid the supplemental property tax assessment. Following the property tax assessment, the Los Angeles County Registrar-Recorder/County Clerk demanded that Ardmore pay DTT, asserting that the change in ownership for property tax purposes also gave rise to liability under the Documentary Transfer Tax Act (the DTTA).[2]
California imposes real property tax based on the assessed value of real property. Real property is reassessed to its appraised value whenever there is a "change in ownership."[3]
As a general matter, property owned by a legal entity is not reassessed upon a transfer of interests in the entity.[4] The two most common exceptions to this rule relate to changes in control and original coowners.
A change in control occurs when a person obtains (directly or indirectly) more than 50% of the interests[5] in the entity.[6]
The "original coowner" exception applies only after property is transferred to an entity in an otherwise exempt transfer described in R&T Code section 62(a)(2).[7] Under this exception, the owners of the transferee entity immediately after the exempt transfer become "original coowners," and if cumulatively more than 50% of the interests in the transferee entity are subsequently transferred by the original coowners, the property is considered to have undergone a change in ownership regardless of the fact that no one person obtained more than 50% of the interests in the transferee entity.[8]
These rules were implemented following the passage of Proposition 13 in 1978. The DTTA, including the exemptions discussed below, was enacted in 1967.
The Supreme Court of California, in a majority opinion joined by all but Justice Leondra Kruger, affirmed the lower court in holding that the sale of 90% of the interests in the Partnership subjected Ardmore to DTT.
The Majority Opinion
Authored by Justice Carol Corrigan, the majority held that a written instrument conveying an interest in a legal entity that owns real property may be taxable under the DTTA "as long as there is a written instrument reflecting a sale of the property for consideration"[9] – "even if the instrument does not directly reference the real property and is not recorded."[10] The Court began with the text of R&T Code section 11911,[11] concluding that it, when read in context with other provisions of the DTTA, contemplates the application of the DTT to transfers of interests in a legal entity. This conclusion was based largely on the Court’s interpretation of R&T Code section 11925, which provides that, in the case of realty held by a partnership or other entity classified as a partnership for federal income tax purposes (a tax partnership), no DTT is imposed as a result of a transfer of an interest in the tax partnership as long as certain requirements are met (namely that the tax partnership continues to hold the property and no termination of the tax partnership occurs under Section 708 of the Internal Revenue Code (Section 708)). Without discussing the unique nature of partnerships and the "entity" versus "aggregate" treatment that has been applied to partnerships under both tax and non-tax law, the Court determined that the exception for continuing partnerships signified an intention by the legislature to apply the DTT to transfers of interests in entities.
Next, relying on federal authorities interpreting the former federal documentary stamp act (upon which the DTTA was based), the Court concluded that "federal courts often focused on whether there was a change in beneficial ownership of the real property" in determining whether the federal stamp act applied.[12] In doing so, the Court distinguished United States v. Seattle Bank, in which the U.S. Supreme Court held that the transfer of real property resulting from a statutory consolidation of a national bank and state bank was not taxable under the federal stamp act.[13] According to the Court, the U.S. Supreme Court in Seattle Bank did not decline to tax the transfer under the federal stamp act because there were no formal instruments directly referencing the real property transferred; rather, the transfer was not taxed "because the substance of the transfer did not involve the purchase or sale of property."[14]
Combining the above principles, the Court concluded that the "critical factor" in determining whether the DTT may be imposed is whether there was a sale resulting in a transfer of beneficial ownership of real property and that the rules describing what constitutes a change in ownership for property tax purposes also apply for purposes of the DTTA,[15] notwithstanding that the property tax rules were issued a decade following enactment of the DTT statute. Because certain transfers of interests in entities can constitute a change in ownership for property tax purposes,[16] the Court concluded that the DTT may be imposed "so long as there is a written instrument reflecting the sale of the property for consideration."[17]
Justice Kruger’s Dissent
In a dissenting opinion, Justice Leondra Kruger argued that the federal cases relied upon by the majority point to the conclusion that the DTTA should not apply to transfers in interests in legal entities that own real estate, that the DTTA and the property tax change in ownership rules were enacted at different times for different purposes, and that applying the change in ownership rules to the DTT raises difficult questions, including questions concerning valuation.
While some California jurisdictions, including San Francisco, have already amended the DTT provisions of their municipal codes to include as "realty sold" any acquisition or transfer of ownership interests in a legal entity that results in a change of ownership of the underlying property for property tax purposes, Los Angeles never amended its municipal code to link the DTT with the property tax change in ownership rules. Nevertheless, it is clear that Los Angeles will continue to apply the DTT to situations in which a property tax change in ownership occurs (assuming the exception in R&T Code section 11925(a), discussed below, does not apply). In addition, other jurisdictions that have not amended the DTT provisions of their municipal codes may now rely on Ardmore to similarly impose the DTT in such situations.
Worth noting is the exception in R&T Code section 11925(a), which remains intact. Under this exception, no DTT is applied with respect to property held by a tax partnership upon the transfer of interests in such tax partnership if it is considered a continuing partnership within the meaning of Section 708 and it continues to hold the property.[18] Thus, transfers of interests in a tax partnership should not result in a DTT if (a) the property is and continues to be held directly by the tax partnership, and (b) the transfer does not result in a termination of the tax partnership under Section 708. This should be the case even if the transfer results in a change in ownership for property tax purposes.[19]
Somewhat less clear is the result where the property is not held by the tax partnership directly, but rather is held by a subsidiary of the tax partnership, even if the subsidiary is disregarded for income tax purposes. While those were the facts in Ardmore, the Court did not address this issue.[20] If R&T Code section 11925 does not apply to property held in a subsidiary, then (a) the exception in R&T Code section 11925(a) to continuing partnerships likewise should not apply, and (b) the "exception to the exception" for Section 708 terminations in R&T Code section 11925(b) also should not apply. For instance, if R&T Code section 11925 does not apply to property held in a subsidiary of a tax partnership, then (a) a transfer of interests in the tax partnership that does not trigger a Section 708 termination but that does result in a change in ownership for property tax purposes would trigger DTT on property held by the subsidiary, but (b) a transfer of interests in the tax partnership that does trigger a Section 708 termination but that does not result in a change in ownership for property tax purposes would not trigger DTT on property held by the subsidiary.[21]
Interestingly, some cities and counties never amended their DTT provisions to reflect the application of Section 708 to entities that are not partnerships for state law purposes but are classified as partnerships for federal income tax purposes. In theory, those cities and counties could claim that the exception for continuing partnerships does not apply to property that is held directly by another form of tax partnership, such as a limited liability company that is classified as a partnership for federal income tax purposes.
As noted in Justice Kruger’s dissenting opinion, questions remain in determining how Ardmore will apply to future transactions, including the manner in which the tax is computed. The majority opinion did not address the computational issues that arise when a less-than-100% transfer occurs. The statute addresses this issue in situations where the property is owned by an partnership that terminates under Section 708.[22] However, there is no comparable provision applicable to other entity interest transfers that now trigger a DTT. The dissenting opinion uses as an example the possible transfer of the 10% remaining interest in the Partnership to one of the trusts that previously acquired 45%. This transfer would result in another property tax change in ownership under R&T Code section 64(c)(1), and Justice Kruger questions whether that change in ownership would trigger yet another DTT on 100% of the value of the property.
Please contact any Gibson Dunn tax lawyer for updates on this issue.
[1] 926 Ardmore Ave., LLC, v. County of Los Angeles, S222329 (Cal. June 29, 2017).
[2] Cal. Rev. & Tax. Code (R&T Code) § 11901 et seq.
[3] California Constitution, Article XIIIA, Section 2(a).
[5] Interests are determined by reference to voting stock in the case of a corporation, and profits and capital in the case of a partnership or limited liability company. R&T Code section 64(c)(1); Rule 462.180 of Title 18, Division 1, Chapter 4, of the California Code of Regulations.
[6] R&T Code section 64(c)(1).
[7] These generally are transfers where the proportional interests of the transferors and transferees in the property remain the same after the transfer.
[11] R&T Code section 11911 authorizes California counties to levy a tax on "each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers . . . ."
[13] United States v. Seattle Bank, 321 U.S. 583 (1944).
[15] Slip opn. at 19-20 (noting that "the change in ownership rules are designed to identify precisely the types of indirect real property transfers that the [DTTA] is designed to tax").
[16] See discussion above under "California Property Tax/Change in Ownership."
[18] While Section 708 does not use the phrase "continuing partnership," this phrase fairly clearly should be read to refer to a tax partnership that does not terminate under Section 708.
[19] For example, assume tax partnership P that owns real property and is owned equally by three partners, A, B and C. If A purchases the entire interest of B (and assuming no other relevant sales or exchanges occurred within 12 months), there would be a change in ownership for property tax purposes under R&T Code section 64(c)(1), but no termination of P under Section 708. Therefore, absent other adverse facts, the transaction would not give rise to DTT.
[20] According to the Court, Ardmore conceded at trial that R&T Code section 11925 did not apply. Slip opn. at 6, fn 7. The opinion of the lower court (unpublished), however, stated that R&T Code section 11925 did not apply to the transaction, meaning whether a Section 708 termination occurred was immaterial to the lower court.
[21] For example, using the same facts as in footnote 19, if the property were held in a subsidiary of P and R&T Code section 11925 does not apply to property held in a subsidiary, then the purchase by B from A would give rise to DTT. On the other hand, if A sold its entire interest in P to D and B concurrently sold its entire interest in P to E, while the transactions would result in a Section 708 termination, no property tax change in ownership would occur (again, assuming no other adverse facts) and therefore the DTT should not apply.
[22] R&T Code section 11925(b) provides that "the partnership or other entity shall be treated as having executed an instrument whereby there was conveyed, for fair market value (exclusive of the value of any lien or encumbrance remaining thereon), all realty held by the partnership or other entity at the time of the termination."
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these and other tax-related developments. If you have any questions, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or any of the following:
Los Angeles
Hatef Behnia (+1 213-229-7534, [email protected])
Paul S. Issler (+1 213-229-7763, [email protected])
Dora Arash (+1 213-229-7134, [email protected])
Orange County
Scott Knutson (+1 949-451-3961, [email protected])
© 2017 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.