California state and local government agencies looking for more revenue have long been looking at real estate sales to increase their tax take. Last month, the California Court of Appeal for the Second Appellate District provided a huge boost. In 926 North Ardmore Avenue, LLC v. County of Los Angeles (Cal. Ct. App. 2d Dist No. B248536, Sept. 22, 2014), the Court held that the Los Angeles County recorder could impose documentary transfer tax ("DTT") on a transfer of an indirect interest in a limited liability company ("LLC") or other legal entity — not just on a transfer of the underlying real estate where a deed is actually recorded — even though the County did not have an ordinance authorizing the recorder to do so. The Court's decision in 926 North Ardmore is troubling because it supports counties now imposing DTT on certain transfers of interests in legal entities, without the need for county board- or voter-approved ordinances. This possibility adds uncertainty not only in the Second Appellate District (which includes Los Angeles, Ventura, Santa Barbara, and San Luis Obispo counties) but in other counties as well, which will certainly view the case as an opportunity to also impose DTT on transfers of interests in ownership entities.
State statute (California Revenue and Taxation Code Section 11925) does permit documentary transfer tax to be imposed – even where a deed is not actually recorded – in narrow circumstances where a partnership or LLC undergoes a technical termination for income tax purposes under Internal Revenue Code ("IRC") section 708. California practitioners long took the position that, absent such a technical termination, transfers of interests in legal entities owning real estate were not subject to DTT because no deed was recorded.
Some California charter cities like San Francisco (which, unlike general law cities, do not need state legislation authorization in order to levy taxes) enacted ordinances expanding the reach of the DTT. Specifically, these ordinances impose DTT on a "change in control" of a legal entity owning real property, with "change in control" defined as a single person or entity acquiring, directly or indirectly, more than 50% of the ownership interests of the legal entity owning the real estate. Some counties (such as Santa Clara) enacted similar ordinances even though counties are not charter cities and such ordinances appeared to go beyond what the state's Transfer Tax Act allowed. Los Angeles County never enacted a similar ordinance, but the County recorder publicly stated that it would follow this same approach
In 926 North Ardmore, the Court of Appeal held in a 33-page decision that Los Angeles Country could impose DTT where a legal entity had undergone a "change in control" without the need for an actual ordinance. The Court's reasoning, essentially, was that there was enough case law and indication of the California legislators' intent to independently support Los Angeles County's position. The Court relied heavily on Proposition 13 and its "change in ownership" rules — under which a "change in control" almost always does constitute a "change in ownership" resulting in property tax reassessment — and concluded that the two California tax schemes should be interpreted and applied consistently.
Although a "change in control" is almost always a "change in ownership" for Proposition 13 purposes, it does not follow that a "change in ownership" for Proposition 13 purposes is necessarily a "change in control." The Los Angeles County position on the DTT, as upheld in 926 North Ardmore, applies only to a change in control which, again, is defined as a single person's or entity's acquiring, directly or indirectly, more than 50% of the ownership interests of the legal entity owning the real estate. For example, if three individuals acquire an LLC 33 1/3% each, then DTT should not apply under 926 North Ardmore because no single individual has acquired a more than 50% interest (even though in certain circumstances that same acquisition may constitute a "change in ownership" under Proposition 13 resulting in full reassessment of the underlying property).
A taxpayer that closes any real estate transaction involving a direct or indirect "change in control" of a partnership, LLC or corporation owning real estate — even if no deed is to be recorded — should, first, be sure that the purchase agreement specifies which side pays the DTT (normally the seller does so) and, second, reserve an amount for the DTT if the taxpayer is the responsible party. (The DTT is generally $1.10 per each $1,000 of consideration, though rates in chartered cities may be as high as $5.60 per each $1,000 of consideration.) If a legal entity undergoes a "change in control," it is already required by law to file a form with the California State Board of Equalization (Form BOE-100-B) so that the Board may alert the applicable county assessor that a Proposition 13 change in ownership has occurred triggering reassessment. We can anticipate that the recorder's office in the same county will use the Form BOE-100-B to issue a notice to the entity demanding the DTT.
If a county does issue a notice demanding DTT, the better course of action for the taxpayer is probably to pay the amount demanded in order to stop interest from running and prevent possible collection by the county; immediately file a claim for refund so as to preserve the taxpayer's rights; and then wait to see if the issue wends its way through other Appellate Districts and, perhaps, to the California Supreme Court.