California Supreme Court’s Ardmore decision allows for documentary transfer tax on real estate held by entities undergoing a Proposition 13 change in ownership.
In 926 North Ardmore Avenue LLC v. County of Los Angeles,1 the California Supreme Court concluded that, subject to certain limitations, California’s Documentary Transfer Tax Act (the California DTTA), applicable to direct sales of real estate, is also applicable to transfers of entity interests in entities holding real estate if those transfers result in a Proposition 13 “change in ownership” under Revenue and Taxation Code (R&TC) sections 64(c) or (d). In its 6-1 decision, the California Supreme Court reasoned that Proposition 13’s property tax “change in ownership rules are designed to identify precisely the types of indirect real property transfers that the Transfer Tax Act [(California DTTA)] is designed to tax.”2
The Ardmore case involved the transfer of roughly 90 percent of the partnership interests in BA Realty LLLP (BA Realty) to two trusts (45 percent each). This transfer caused a Proposition 13 change in ownership (R&TC section 64(d)) of the apartment building owned by 926 North Ardmore Avenue LLC—an entity indirectly owned by BA Realty.3 The Los Angeles County Registrar-Recorder imposed a documentary transfer tax under the California DTTA. While the California DTTA applies to “realty sold” in return for consideration, Los Angeles County claimed the transfer of entity interests triggering a Proposition 13 change in ownership was sufficient evidence of “realty sold” to subject the entity’s real estate to the transfer tax.
The taxpayer argued that the California DTTA was only applicable to direct sales of real estate and that it was not applicable to transfers of interests in entities that hold real estate. The taxpayer explained that the California DTTA was based on the Federal Stamp Act, which had two separate components—one imposed a tax on written instruments conveying “lands, tenements, or other realty sold” for consideration (Federal Realty Transfer Tax) and the other imposed a tax on the transfer of corporate stock (Federal Entity Transfer Tax). Since the California Legislature adopted a California DTTA that included only the Federal Realty Transfer Tax (but not the Federal Entity Transfer Tax), the taxpayer argued that the California DTTA does not extend to transfers of entity interests. 4 In further support of the claim that the California DTTA does not extend to entity transfers, the taxpayer cited United States v. Seattle Bank, 321 U.S. 583 (1944). There, the U.S. Supreme Court confirmed that the Federal Realty Transfer Tax did not apply to the real estate of a state bank that was merged into a federal bank, because the real estate transfer was effected by a merger rather than a “deed conveyance or other instrument.”5
The California Supreme Court disagreed with the taxpayer.
The Court did not address the fact that the California Legislature only adopted the Federal Realty Transfer Tax (but not the Federal Entity Transfer Tax). Instead, the Court reasoned that the California DTTA must extend to entity transfers because it includes a provision (R&TC section 11925) that applies the transfer tax to real estate owned by a partnership when the partnership undergoes a termination under Internal Revenue Code section 708 due to certain transfers of interest in the partnership. Even though this section is only applicable to realty owned by statutorily terminated partnerships, the existence of R&TC section 11925 led the Court to conclude that the transfer tax could be triggered by the transfer of interests in a legal entity and was not limited to the direct transfer of realty.
The Court further stated that a closer reading of case law on the Federal Realty Transfer Tax shows that transfer tax is applied whenever there is a “change in the beneficial ownership of real property.” In support of its conclusion, the Court cited the 1935 First Circuit case of Carpenter v. White (80 F.2d 145) where two separate companies sold their real estate to a third company in exchange for stock in the buyer rather than cash. The Court indicated that application of the transfer tax to a direct sale of realty in return for stock consideration justified extending the California DTTA to entity transfers.
Ultimately, the majority concluded that it was justified in incorporating the 1978 Proposition 13 change in ownership rules for entity transfers into the 1968 California DTTA on realty transfers, because Proposition 13 was “designed to identify precisely the types of indirect real property transfers the Transfer Tax Act [(California DTTA)] is designed to tax.”6 The Court explained,
The [Proposition 13] change in ownership provisions, including section 64, subdivisions (c) and (d), provide rules for distinguishing “ ‘true’ changes in ownership” from “ ‘paper’ ones,” and they identify a subset of beneficial interest transfers that are significant enough to approximate new ownership, and thus to warrant property reappraisal. . . .[¶] Section 11911 permits the imposition of documentary transfer tax whenever a transfer of an interest in a legal entity results in a change in ownership of real property within the meaning of section 64, subdivision (c) or (d), so long as there is a written instrument reflecting a sale of the property for consideration.7
In dissent, Justice Kruger noted the absence of any precedent to justify application of the California DTTA to “run-of-the-mill transfers of interests in legal entities that happen to own real estate.”8 Justice Kruger concluded that the existing California DTTA requires a direct transfer of real estate to trigger the transfer tax. A direct transfer of real estate was the distinguishing factor between the U.S. Supreme Court’s Seattle Bank holding that no transfer tax applied to a merger of two regulated banks and the 1935 First Circuit Carpenter case cited by the majority where a transfer tax was imposed on the transfer of real estate from one corporation to another in exchange for newly issued stock.
While the dissent recognized there may be a superficial appeal to applying the California DTTA and property tax laws in a uniform manner, the dissent rejected this extension of the transfer tax because “it finds no support in either the language of the [California] DTTA . . . or in the over-150-year history of the documentary transfer tax.”9 Similarly, Justice Kruger noted that there was no evidence that the California Legislature had taken any action to incorporate the 1978 statutory provisions of Proposition 13 into the California DTTA:
[t]he two statutes were enacted at different times and for different purposes. . . . These statutory schemes also relate to distinct types of taxes: Whereas the documentary transfer tax is an excise tax on the privilege of selling real property interests—and is imposed only when that right is exercised—real property taxes are imposed on the property itself, and on a recurring basis.
The [California] DTTA does not purport to incorporate the later-enacted property tax laws, nor do the property tax laws purport to amend the [California] DTTA. And differences between the two statutory schemes make clear that the rules applicable in one context cannot be imported wholesale into the other.10
Justice Kruger concluded that it is the job of the California Legislature, not the courts, to decide whether the California DTTA should be expanded to transfers of entity interests.
The majority’s expansion of the [California] DTTA may or may not be a good idea, but it ventures well beyond the statute’s language and historical practice. I would leave it to the Legislature to determine the circumstances under which an entity interest transfer should result in a deemed sale of the entity’s real estate, and how to calculate the tax due in those circumstances.11
The California Supreme Court’s decision will no doubt be the source of future litigation. While counties and cities will likely seek transfer taxes on Proposition 13 changes in ownership under either R&TC sections 64(c) or (d), it remains unclear just what new transfer taxes will be due because of these Proposition 13 entity changes in ownership . Will the transfer tax be assessed to the buyers and sellers of the transferred entity interests, or will it be imposed on the entity itself as the ongoing owner of the realty? When a Proposition 13 event is triggered by a transfer of only a portion of an entity (e.g., a 45 percent owner increasing his interest to a “controlling” 55 percent), will the transfer tax be applied to the full value of the entity-owned realty, or just the realty attributable to the transferred entity interests? Given that the Court relied on a California DTTA provision limited to partnership interests (R&TC section 11925), does the decision extend to transfers of corporate stock? Given the Court’s conclusion that the corporate merger in Seattle Bank was not substantively a realty sale subject to transfer tax, will transfer tax be due on corporate acquisitions involving only limited real estate?
The Pillsbury attorneys identified above are happy to discuss any questions you may have including various defenses and limitations that should be considered in a specific transaction.
1 California Supreme Court No. S222329 filed June 29, 2017.
2 Ardmore Slip Op. at 20.
3 Under R&TC section 64(d), if there have been cumulatively more than 50 percent of the interests in an entity transferred by any of the ‘original co-owners’ of the entity, there is a re-assessable change in ownership of the entity’s property that was previously excluded from reassessment under R&TC section 62(a)(2) (Original Co‑Owner Rule). BA Realty’s partnership interests were subject to R&TC section 64(d)’s Original Co-Owner Rule because the holders of the 926 North Ardmore Avenue, LLC interests had previously contributed those interests to BA Realty in a proportional interest transfer that was excluded from reassessment under R&TC section 62(a)(2).
4 Unlike Los Angeles, which adopted the California DTTA verbatim (including only the Federal Realty Transfer Tax), several other California counties and cities amended their transfer tax ordinances in recent years in an apparent effort to impose a transfer tax when there has been a transfer of entity interests that cause a Proposition 13 change in ownership (e.g., Santa Clara County Documentary Transfer Tax Ordinance §§ A30-32 and A30-44 (effective 2007), City and County of San Francisco Real Property Transfer Tax Ordinance § 1114(b) (effective 2008), the City of Oakland Real Property Transfer Tax Ordinance § 4.20.030 (effective 2009), Documentary Transfer Tax Chapter of the County of Napa § 3.24.020 (effective 2011), Documentary Transfer Tax of the County of Monterey § 5.32.020 (effective 2012)).
5 The taxpayer also explained that the statutory structure for Proposition 13 changes in ownership was adopted in 1978 and could not possibly provide guidance to the California DTTA, which was adopted ten years earlier in 1968.
6 Ardmore Slip Op. at 20.
7 Id. (citations omitted).
8 Ardmore Slip Op. Dissent at 2.
9 Id. at 1-2.
10 Id. at 9-10 (citations omitted).
11 Id. at 13.