By Alistair M. Nevius
Approximately two-thirds of U.S. states, as well as a number of municipalities, counties and other units of local government, impose a tax on taxpayers when they transfer real property to another party. As a practical matter, a real property transfer tax is typically triggered if a deed is recorded; however, taxpayers often transfer real estate to a new owner without recording a deed, for example, by transferring the ownership interest in an entity that holds title to the property. Given such a loophole, it is small wonder that taxpayers have created entities and engineered transactions in order to avoid this tax.
Beginning with New York in 1986, a number of jurisdictions that impose a real estate transfer tax now require taxpayers who engage in these types of transfers to pay the tax. The imposition of tax occurs when the transfer is deemed to be an indirect transfer of ownership in real property, even if a deed is not recorded. Jurisdictions that have adopted this approach treat transfers of a controlling interest in a legal entity, such as a corporation, as taxable transfers of real property.
A taxpayer is often deemed to have transferred a controlling interest if more than 50% of the ownership interest in the legal entity is transferred to a new owner. The list of legal entities is usually inclusive and includes trusts and single-member limited liability companies. Because there is no reference to federal income tax concepts in these statutes, practitioners who are used to treating entities as disregarded for federal income tax purposes are required to regard them for purposes of applying these concepts.
TWO APPROACHES TO THE CONTROLLING INTEREST CONCEPT
In most cases, the states that have adopted a controlling interest concept take one of two approaches for determining whether a transfer of a controlling interest represents a taxable conveyance of real property:
States that take a broad approach generally tax transfers of a controlling interest in an entity that owns in-state property. Jurisdictions that adopt this approach can and do impose tax in connection with business acquisitions, mergers, stock sales or other changes in a legal entity’s ownership. This type of approach can be a surprise for taxpayers who are more familiar with the traditional transfer tax concepts. States that take a more narrow approach tax a transfer of a controlling interest only in situations where the entity being transferred is primarily in the business of owning real estate. Whether an entity is primarily in the business of owning real estate is determined by measuring the entity’s real estate activity against its total activity, and these states differ significantly in how they determine whether a particular company is subject to the tax.
For a detailed discussion of the issues in this area, see “Controlling Interest Provisions in State and Local Real Estate Transfer Taxes,” by Donald R. Dennis, CPA, and Jonathan M. Cesaretti, J.D., in the September 2011 issue of The Tax Adviser.