In an issue of first impression under the New York State real estate transfer tax, a New York State Administrative Law Judge has held that the transfer tax cannot be imposed on a member’s sale to its comember of a 45% membership interest in a limited liability company (“LLC”) owning real property in New York State, where both members previously owned the real property as tenants-in-common. Matter of GKK 2 Herald LLC, DTA No. 826402 (N.Y.S. Div. of Tax App., May 26, 2016). At issue was the scope of the Department of Taxation and Finance’s authority to aggregate acquisitions of minority economic interests in real property.

Facts. The facts in the case were undisputed. In 2007, GKK 2 Herald LLC (“GKK”) and an unrelated party (“Co-Owner”) acquired an office building located in Herald Square (the “Office Building”). Upon acquisition, GKK and Co-Owner held undivided 45% and 55% tenantin-common fee interests respectively in the Office Building. New York State real estate transfer tax (“RETT”) was paid on that acquisition.

On December 22, 2010, GKK contributed its 45% fee interest to Owner LLC, a newly formed Delaware LLC, and Co-Owner contributed its 55% fee interest to Owner LLC. In exchange, GKK received a corresponding 45% membership interest and Co-Owner received a corresponding 55% membership interest in Owner LLC. GKK and Co-Owner filed RETT returns, reporting the contribution of their fee interests in exchange for membership interests in Owner LLC as exempt “mere changes of identity or form of ownership” under Tax Law § 1405(b)(6).

On the same day, GKK then sold its 45% membership interest to CoOwner. GKK and Co-Owner timely filed an RETT return, reporting Co-Owner’s purchase of GKK’s 45% membership interest in Owner LLC as a non-taxable transfer of less than a controlling interest in an entity that owns real property. As a result, Owner LLC became sole owner and operator of the real property, with Co-Owner as its sole member. 

The Department claimed that the transaction was a transfer of a 100% controlling economic interest in real property, 55% of which was a nontaxable “mere change in form” of ownership, and 45% of which was a taxable change in beneficial ownership, and assessed RETT on that basis. 

Applicable RETT law and positions of the parties. RETT is “imposed on each conveyance of real property or interest therein” located in New York State. Tax Law § 1402(a). A “conveyance” is defined to include the transfer or acquisition of a “controlling interest” in an entity that owns real property. Tax Law § 1401(e). In the case of a non-corporate entity, a “controlling interest” is defined as “fifty percent or more of the capital, profits or beneficial interest in such partnership, association, trust or other entity.” Tax Law § 1401(b)(ii). The regulations further provide that, “where there is a transfer or acquisition of a controlling interest in an entity . . . and the real estate transfer tax is paid on that transfer or acquisition and there is a subsequent transfer or acquisition of an additional interest in the same entity,” the transfers or acquisitions may be aggregated if they occur less than three years apart. 20 NYCRR § 575.6(d). RETT does not apply to “[c]onveyances to effectuate a mere change of identity or form of ownership or organization where there is no change in beneficial ownership.” Tax Law § 1405(b)(6).

The Department did not contest that the contributions by GKK and Co-Owner of their respective 45% and 55% fee interests in the Office Building, in exchange for corresponding membership interests in Owner LLC, were exempt from the RETT as “mere change[s] of identity or form of ownership.” The Department instead argued that the regulations permitting aggregation of certain acquisitions allowed it to aggregate Co-Owner’s purchase of GKK’s 45% interest in Owner LLC with Co-Owner’s 55% membership interest in Owner LLC, which it acquired in the preceding “mere change in form” transaction. GKK maintained that the sale of its 45% membership interest was a nontaxable transfer of a less-thancontrolling interest in real property and that the Department could not aggregate exempt transfers with non-exempt transfers to reach a taxable result. 

ALJ Decision. The ALJ held in favor of GKK that CoOwner’s purchase of GKK’s 45% interest in Owner LLC was not an acquisition of a “controlling interest” in real property, and no transfer tax was due. She rejected the Department’s claim that an acquisition of a 55% interest in an entity that qualified for the “mere change in form” exemption could be aggregated with the acquirer’s subsequent purchase of a 45% interest in the same entity. 

The ALJ held that the RETT regulation authorizing aggregation does not permit the aggregation of a nontaxable mere change in form transaction with a transfer of a minority interest. She found that the plain language of the regulation (20 NYCRR § 575.6(d)) permitting the aggregation of less than a controlling interest only applied to interests on which RETT was paid on the initial transaction. Therefore, the ALJ concluded that where, as here, no transfer tax was paid on the initial “mere change in form” transaction, the aggregation regulation did not apply. The ALJ also noted that it was not clear that the RETT statute authorized the regulation permitting aggregation of successive transfers at all but found it unnecessary to address that issue, because the regulation did not apply to the transaction at issue. 

Although the Department argued that the ALJ should defer to its interpretation, the ALJ held that where, as here, the Department’s interpretation is inconsistent with the plain language of the statute and regulations, that interpretation is not entitled to any deference. The ALJ also rejected the Department’s reliance on precedent under the former real property transfer gains tax, noting that the gains tax statute was broader in scope than the RETT law with respect to aggregation. As we went to press, the Department requested an extension of time to appeal the ALJ decision.

GKK was represented by Irwin M. Slomka, Thomas P. McGovern, and Kara M. Kraman of Morrison & Foerster LLP.

Additional Insights

The ALJ decision calls into question an earlier 2015 New York City ALJ decision that involved the same transaction. In Matter of GKK 2 Herald LLC, TAT(H) 13-25 (RP) (N.Y.C. Tax App. Trib., Admin. Law Judge Div., Apr. 1, 2015), a New York City ALJ reached the opposite result, upholding the City’s imposition of real property transfer tax (“RPTT”) on the transaction. The City ALJ upheld application of the federal income tax “step transaction doctrine” to, in effect, treat the transaction as if GKK sold its 45% fee interest directly to Co-Owner, even though Owner LLC, and not CoOwner, thereafter owned the fee interest. An appeal of the City ALJ decision is currently pending before the City Tax Appeals Tribunal.