While not a tax issue per se, the problem discussed here often arises as a result of transfers of real property that were made for income or estate tax planning purposes. People frequently transfer real property to living trusts or to family-owned entities such as partnerships or limited liability companies. In Kee Kwok v. Transnation Title Insurance Company (2009), the California Court of Appeals held that where a husband and wife purchased property in the name of a limited liability company (“LLC”) in which they were the sole members, obtained a title insurance policy in the name of the LLC, and then transferred title to the property to themselves in their capacities as trustees of a family trust, they were no longer insureds under the policy and, therefore, were not entitled to coverage. The case has significant implications in the family income and estate tax planning arenas. It emphasizes the point that where parties transfer title to trusts for estate planning purposes, they must be careful to change their insurance policies to reflect the changes in ownership or risk losing their insurance coverage.
In this case, the Kwoks formed Mary Bell, LLC (the “LLC”) which purchased real property. The plaintiffs were the only members of the LLC. At the time of purchase, they purchased a CLTA policy that insured title to the property and to an easement over a neighboring property. The LLC was the only named insured under the policy. The policy defined insured as: “the insured named in Schedule A, and, subject to any rights or defenses the Company would have against the named insured, those who succeed to the interest of the named insured by operation of law as distinguished from purchase including, but not limited to, heirs, distributees, devisees, survivors, personal representatives, next of kin, or corporate or fiduciary successors.” The policy provided that it would continue in force in favor of an insured only so long as “the insured retains an estate or interest in the land or holds an indebtedness secured by a purchase money mortgage given by a purchaser from the insured, or only so long as the insured shall have liability by reason of covenants of warranty made by the insured or any transfer or conveyance of the estate or interest.”
The Kwoks commenced construction of a residence on the property. The neighbors refused to provide access to the easement asserting that the easement was invalid. When construction was delayed, the Kwoks moved into the residence that was already on the property. Subsequently, Mr. Kwok signed a grant deed, transferring the property from the LLC to himself and his wife “as trustees of the Patrick Man Kee Kwok and Maria Oi Yee Kwok Revocable Trust.” No documentary transfer tax was paid. They then filed a certificate of cancellation of the LLC.
When they could not resolve the easement dispute, they filed a lawsuit to enforce their rights and tendered a claim to the title insurer, which denied coverage on the grounds that the transfer of the property by the LLC to the Kwoks, as trustees of the trust, did not arise by operation of law and, therefore terminated coverage. The Court agreed. It found that the only insured was the LLC and that coverage did not devolve to the Kwoks as members of the LLC on dissolution of the LLC. Rather, title was transferred by deed from the named insured to the Kwoks as trustees of their family trust, a totally separate entity.
The Kwoks argued that there was no change in the beneficial ownership of the property. The Court held that the issue is “not whether there was a change in the beneficial ownership of the property, but whether appellants, as trustees of their family trust, succeeded as insureds under the terms of the policy.” The Court noted that there was nothing in the policy definition of “insured” that identifies “beneficial owners” as insureds. Rather, under the definition, they could only become insureds by operation of law and “the transfer of property by an insured into a family trust is a voluntary act and not one that arises by operation of law.”
The policy also provided that insureds included “those who succeed to the interest of the named insured by operation of law as distinguished from purchase, including, but not limited to, . . . distributees.” The Kwoks argued that they received the property by operation of law as distributees. They noted that no money changed hands and the grant deed shows that no transfer tax was paid. The Court found that under Corporations Code section 17001(j), a “distribution” is “the transfer of money or property by a limited liability company to its members without consideration.” Here, however, the Court noted that title passed to the Kwoks in their capacities as trustees of the trust, and that they were not members of the LLC as trustees. Therefore, they were not distributees under the policy.
The bottom line is that if title to property is transferred from individuals to those individuals as trustees of a trust for estate planning purposes, or to other entities such as partnerships or limited liability companies, the new owner may not be entitled to coverage under existing policies, and may need to obtain either endorsements adding them as insureds or new policies. Some newer policies may cover transfers to trusts but not to other entities. When any such transfer is made, the policy must be reviewed and if the transfer is not covered, the original title insurer must be contacted to obtain an endorsement covering the new owner. In California, most of the common transfers to and from family trusts and other entities can be covered under CLTA Endorsement 107.9 which is not expensive, but you must go to your title insurer and ask for it.
Note that this same problem exists with regard to other forms of insurance such as general liability coverage. If the individuals have general liability coverage in their own names and then transfer title to themselves in their capacities as trustees of a trust, depending on the language of their policies, they may not be entitled to coverage in their new capacities under their existing policies. Thus, any time a property transfer occurs, the transferees must carefully review their policies to determine whether they are entitled to coverage under their existing policies and, if not, take appropriate steps to insure that they do have coverage by either obtaining endorsements adding them as insureds or obtaining new policies.