California imposes a transfer tax on transfers of interests in real property at a rate of 55 cents for each $500 of net value. The tax must be paid whenever a deed is recorded. For the first time, in a closely watched case, the California Supreme Court has held that this transfer tax can apply in some circumstances to the transfer of an interest in a legal entity that owns real property, even if the transfer does not involve any deeds with respect to the real property.

In 926 North Ardmore Avenue, LLC. v. County of Los Angeles(6/29/17), Beryl and Gloria Averbook owned the property located at 926 North Ardmore Avenue through their revocable living trust. Following the death of Beryl, the property was transferred to a single member limited liability company (“LLC”). The interests in the LLC were transferred to a limited partnership called BA Realty. The 99% limited partnership interests in BA Realty were transferred to four trusts for the benefit of Gloria. The 1% general partnership interest was held by the administrative trust through another single member limited liability company. Upon the completion of these steps, the four trusts and the administration trust owned the interests in BA Realty, a limited partnership. BA Realty owned 100% of the membership interests in LLC and LLC owned the Ardmore Avenue property.

In 2009, three of the four trusts sold their interests in BA Realty (aggregating just under 90%) to two trusts created for the sons of Beryl and Gloria. The trusts paid for the interests with promissory notes and the price was based on an appraisal of the property. It was this sale of interests in BA Realty that gave rise to the issues in the case.

The Los Angeles County Assessor re-assessed the property for property tax purposes based upon there having been a change in ownership. The transfer to the trusts for the sons was a change in ownership because, following the transfer of the property to the LLC and BA Realty, which was exempt under the original co-owners exception, there had been a transfer of more than 50% of the interests in BA Realty. This triggered an ownership change and re-assessment of the property under Revenue & Taxation Code Section 64(d).

Beginning in 2010, the Los Angeles County Recorder began demanding payment of the documentary transfer tax whenever it became aware of a change in ownership re-assessment caused by the transfer of interests in a legal entity. In accordance with that practice, the Recorder demanded payment of the transfer tax. The tax was paid and a claim for refund was made. The claim was denied and the case ultimately ended up before the California Supreme Court.

The taxpayer’s main argument was that tax applied only to deeds submitted for recording and could not be applied to transfers of interests in legal entities that own real property. The County argued that the tax applies whenever an interest in real property is sold, whether directly by deed or indirectly through the sale of interests in a legal entity that owns real property.

The Court determined that the tax could apply to certain transfers of interests in legal entities due to Revenue & Taxation Code Section 11925(a), which provides that a transfer of an interest in a partnership does not give rise to the transfer tax if the partnership is continuing. However, if the partnership terminates, the entity is treated as having conveyed the real property and that deemed conveyance is subject to the tax. Therefore, the court determined that under some circumstances a transfer of a legal entity could trigger application of the transfer tax.

The Court concluded that the key to determining application of the transfer tax was to determine whether a change in the beneficial ownership of the property had occurred. The Court reviewed a variety of federal cases interpreting the old deed stamp tax, upon which the California documentary transfer tax is based. The Court determined that the Recorder’s practice of imposing the tax when the transfer of interests in a legal entity constituted a property tax change in ownership was consistent with the notion of the transfer of a beneficial interest.

Justice Kruger wrote a strong dissenting opinion in which he pointed out that when the legislature enacted the documentary transfer tax in 1967, it could not have considered basing its application of the property tax entity change in ownership rules because those provisions were not enacted until 1979, following the passage of Proposition 13. He believed that the argument of the taxpayer was correct and the tax can be applied only to actual conveyances by deeds.

It is interesting that the Court did not take what may have been a more direct route to the imposition of the tax found on the face of the statute. Revenue & Taxation Code Section 11925(b) provides that:

“If there is a termination of any partnership or other entity treated as a partnership for federal income tax purposes, within the meaning of Section 708 of the Internal Revenue Code of 1986, for purposes of this part, 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.”

This Section provides that if a transfer of an interest in a partnership causes the partnership to terminate pursuant to IRC Section 708, then the partnership is treated as having executed a deed to the property and the tax applies. IRC Section 708(b) provides that if within a 12-month period, a 50% or greater interest in a partnership is sold or exchanged, the partnership is treated as terminating. In this case, an interest of just under 90% was sold so the partnership terminated under IRC Section 708(b) and it seems that the tax became payable under Section 11925(b) of the Revenue & Taxation Code. The Los Angeles County Ordinance enacted to impose the tax mirrors this provision in its Section 4.60.080. The Court noted the termination rule of IRC 708 in a footnote to its opinion but did not make it the basis of its holding. Instead, the Court premised that application of the transfer tax on an entity change in ownership under the property tax rules.

It may be that the Supreme Court did not rely on Section 11925(b) because when the case was before the Court of Appeals the taxpayer had argued that Section 11925(b) did not apply because the partnership, BA Realty, did not actually own any real property. It owned an interest in LLC, which owned the real property. The Court of Appeals accepted the taxpayer’s argument on this point and held that the tax applied whenever the transfer of an interest in an entity caused a property tax change in ownership.