On June 6, 1978 voters in California approved an amendment to the State Constitution to limit reassessments of property for property tax purposes to situations involving a change of ownership. California Revenue & Taxation Code §60 defines a change of ownership as “a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest.” Section 64(a) of the R&T Code provides that transfers of interests in legal entities “shall not be deemed to constitute a transfer of the real property of the legal entity;” however Section 64(c) states that when one person or entity acquires a majority interest in an entity holding real property, it shall be deemed a change in ownership. A recent case in California provides guidance as to a structure for a transfer of 100% of the ownership interests in an entity holding title to property and avoiding a reassessment.
A limited liability company acquired a Hotel in Santa Monica, California in 1999. On July 7, 2006 the company entered into a contract to sell the hotel to another limited liability company. Three months later seller and buyer terminated the contract, and that same day 100% of the ownership interests in the seller were sold. The purchasers, and their respective percentages of the ownership interests were: (1) a separate property trust whose trustee was the wife of Michael Dell (49%); (2) MSD Portfolio, L.P. (42.5%); and (3) Miramar Hotel Investor, LLC (8.5%). MSD Portfolio is owned 99% by Michael Dell and 1% by MSD Capital. Michael Dell holds a 99% interest in MSD Capital. MSD Capital purportedly controlled buyer under the original property sale contract that was terminated on the date the ownership interests were transferred. Hotel Investors is owned by four limited liability companies, two of which each own a 36.5326% interest in Hotel Investors. MSD Capital owns a 33.3% profits interest and a 93.3% capital interest in those two limited liability companies. The Los Angeles County Assessor determined that the transfer constituted a change in ownership and reassessed the Hotel.
The new ownership sued for a refund in taxes paid as a result of the reassessment. The trial court entered a judgment in favor of the refund, and the court of appeal affirmed, holding that if all of the membership interests in an LLC owning property are sold, there is no change of ownership if no one person or entity acquires a 50% interest in capital and profits, relying upon the provisions of R&T Code §64(a) described above.
The court concluded that the County could not establish that Michael Dell acquired a majority interest in the capital and profits of the owner of the Hotel. Using a multiply-through test the court concluded that no one acquired an interest that exceeded 50%, and that Michael Dell had only a 47.82 percent interest. The court then rejected the County’s “substance over form” argument established by the U.S. Supreme Court for federal tax analysis, asserting that federal law is not applicable to a state property tax issue.
It does not appear that the County addressed the issue that Internal Revenue Code §701(b)(1)(B) provides that a sale or exchange of 50% or more of the capital and profits interest in a partnership in any 12 month period constitutes a termination of the partnership under federal tax law. As a result, the transfer of more than 50% of the capital and profits interest in the seller terminated the seller as a partnership. The logical result of the transfer of 100% of the interests is that the owner of the Hotel before the transfer was a different entity than the owner of the Hotel after the transfer, thus there has occurred a change of ownership. Nevertheless, the rules promulgated by the State Board of Equalization, and specifically Rule 462.180(c) and (d) of the California Code Regulations Title 18, include a specific example where a husband and wife acquire, as community property, 100% of an entity which owns real estate. The example provides that since they are treated as each acquiring 50% of the interests, there is “[n]o change in control of [the entity]; no change in ownership of [the property].”
Seems to defy logic, but it appears to be the law, at least for the moment.
This article was written by Alfred M. Clark, III, a partner in the Los Angeles office of Locke Lord LLP. Assistance was provided by Jonathan Koh, an associate in the Los Angeles office of Locke Lord LLP.
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