Avoid Transfer Taxes? Maybe Not

A second provision of the New York State transfer tax regulations supports the conclusions that Willa's transfer of her interest in the Company to Henry and his transfer of his interest in the Townhouse to her are subject to transfer tax. Section 575.11(a)(10) of the regulations issued by the New York State Department of Taxation and Finance provides that:

A conveyance from one spouse to the other pursuant to the terms of a divorce or separation agreement is subject to tax. (There is a rebuttable presumption in such case, that the consideration for the conveyance, which includes the relinquishment of marital rights, is equal to the fair market value of the interest in the real property conveyed.)

Again, the Town of East Hampton and New York City have adopted similar regulations. (Note that the instructions included on Schedule E of the New York City Real Property Transfer Tax Return provide that a transfer or property pursuant to a “marital settlement agreement” is also subject to transfer tax.)

The Step Transaction Doctrine

Because Willa and Henry had not executed a “separation agreement” (as such term is used in Section 170 of the New York Domestic Relations Law) and obviously they had not obtained a decree of divorce, if Willa now transferred her interest in the Company to Henry and he transferred his interest in the Townhouse to her, couldn't they take the position that, literally, the transfers were not “pursuant to the terms of a divorce or separation agreement” within the meaning of Section 575.11(a)(10) of the regulations?

Inasmuch as the transfers would be “in contemplation of” the execution of a separation agreement and would be integral to the subsequent closing of such an agreement, under the “step transaction” doctrine, as described below, the transfers should be treated as made “pursuant to” the terms of a separation agreement within the meaning of the regulation and thus subject to tax.

The step transaction doctrine has been frequently invoked by the Internal Revenue Service and the federal courts to ensure proper income tax treatment of a series of transactions. Commissioner v. Court Holding Co., 324 U.S. 331 (1945). In True v. U.S., 190 F.3d 1165 (10th Cir. 1999), the Tenth Circuit observed that:

Deciding “whether to accord the separate steps of a complex transaction independent significance, or treat them as related steps in a unified transaction, is a recurring problem in the field of tax law.” King Enters., Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969). In search of an answer to this problem, courts utilize a variety of approaches, including a particular incarnation of the basic substance over form principle known as the step transaction doctrine. Simply stated, the step transaction doctrine provides that “interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction.” Commissioner v. Clark, 489 U.S. 726, 738 (1989) '

The New York State and New York City tax authorities have similarly applied the “step transaction” doctrine in transfer tax cases. Matter of Kevin Kelly, DTA No. 819863 (State of New York ' Division of Tax Appeals, Dec. 8, 2005); See also Matter of Exchange Plaza Partners v. City of New York, 159 A.D.2d 333 (1st Dep't 1990), appeal denied, 76 N.Y.2d 702 (1990); Matter of The Fleetwood Realty Company, TAT (H) 93-294 (RP), TAT (H) 95-12 (RP) (New York City Tax Appeals Tribunal ' Administrative Law Judge Division) (Feb. 28, 1995); Matter of Seven West 34th Street Development Corporation, FHD-92-436 (RPT) (New York City Department of Finance, March 31, 1992); New York City Department of Finances, Statement of Audit Procedure RPTT 2008-1 (2/29/08).

For example, in Fleetwood Realty , supra , the taxpayer partnership held a leasehold interest in rental real property located at East 65th Street in Manhattan. The fee interest in the property was owned by Peter S. Kalikow (Kalikow), who beneficially owned all the interests in the taxpayer. The leasehold and fee were both subject to a $38 million mortgage debt held by Travelers Insurance Company (Travelers).

Kalikow wanted to convert the property to cooperative or condominium ownership. Under the terms of the mortgage, Travelers' consent was required for such a conversion. Furthermore, New York law prohibited a so-called leasehold condominium. So the taxpayer and Kalikow requested that Travelers release the mortgage lien on the taxpayer's leasehold estate and permit a merger of the leasehold and fee.

On Oct. 4, 1989, Travelers and Kalikow executed a release agreement pursuant to which Travelers released its mortgage lien on the taxpayer's leasehold estate and confirmed that the taxpayer's liability to pay the debt was terminated. The following day, the taxpayer assigned its leasehold estate to Kalikow, thereby merging the leasehold into the fee.

For purposes of computing the New York State and New York City transfer taxes on the transfer of rental or other commercial property, consideration ordinarily includes the amount of mortgage debt assumed in connection with such transfer and the amount of mortgage debt to which the property is subject. In Fleetwood Realty, the taxpayer took the position that, since its leasehold was released from the Travelers' debt before the leasehold was assigned to Kalikow, it received no consideration in the form of any relief from indebtedness. However, the New York City Department of Finance disagreed and the New York City Tax Appeals Tribunal upheld the department's position.

In the view of the administrative law judge, inasmuch as the taxpayer's indebtedness to Travelers was discharged on the day prior to the day of the taxpayer's assignment of the leasehold, the taxpayer was seeking to elevate form over substance. The judge rejected this approach, concluding that since the assignment was clearly contemplated by all the parties at the time the taxpayer's debt to Travelers was released, the two steps should be analyzed as an “integrated transaction.” Accordingly, the judge held that the taxpayer received taxable consideration for its assignment of its leasehold in the form of a release from its indebtedness.

The tax authorities have applied the step transaction doctrine to combine a series of transactions separated by much more than one day. For example, in Seven West 34th Street Development Corp., supra, an issuance of the taxpayer's stock was determined to be an element of a single transaction with the subsequent transfer of real property to the taxpayer nearly one year later.

In any event, as the transfers by our hypothetical couple, Willa and Henry, were contemplated as a condition of their execution of any separation agreement, such transfers should be treated as made pursuant to such agreement. Thus, they are subject to transfer tax.

Transfer of an Interest in a Company

New York's real estate transfer tax (RETT) is imposed on ” ' each conveyance of real property or interest therein when the consideration exceeds five hundred dollars '” New York Tax Law ' 1402(a). The term “ conveyance” is defined, in relevant part, as “the transfer or transfers of any interest in real property ' including ' [a] transfer or acquisition of a controlling interest in any entity with an interest in real property.” New York Tax Law ' 1401(e). In turn, a “controlling interest” means, in the case of a partnership, association, trust or other entity (other than a corporation) ” ' fifty percent or more of the capital, profits or beneficial interest in such partnership, association, trust or other entity.” New York Tax Law ' 1401(b). In other words, the RETT is payable in the case of a transfer of 50% or more of the capital or profits in a partnership or limited liability company that owns real estate located in New York.

In Willa and Henry's case, the Operating Agreement of the Company, dated as of Jan. 9, 2004, provides that each owns a 50% membership interest in the Company. Under this agreement, they are each entitled to 50% of the profits and losses of the Company, as well as 50% of the distributions made by the Company. Accordingly, for purposes of the RETT, each owns a controlling interest in the Company. Therefore, Willa's transfer of her interest in the Company to Henry will be treated for purposes of the RETT in a manner similar to her transfer of an interest in real property to him.

Similarly, the Mansion Tax applies to ” ' each conveyance of residential real property or interest therein when the consideration for the entire conveyance is one million dollars or more.” New York Tax Law ' 1402-a(a). Since the term “ conveyance” includes the transfer of a controlling interest in an entity owning real property, the Mansion Tax is also imposed on the transfer of a controlling interest in an entity owning residential real property. See New York State Department of Taxation and Finance Publication 577, FAQS Regarding the Additional Tax on Transfers of Residential Real Property for $1 Million or More. Accordingly, Willa's transfer of her interest in the Company to Henry will be subject to the Mansion Tax if the transfer is subject to the RETT.

Finally, the transfer tax statute enacted by the Town of East Hampton follows the RETT. Therefore, Willa's transfer of her interest in the Company to Henry will also be subject to the town's transfer tax if the transfer is subject to the RETT.

Conclusion

Willa and Henry's agreements represent transfers for value rather than bona fide gifts. That is, Henry's transfer of his interest in the Townhouse to Willa is the quid pro quo for her transfer of her interest in the Company to him (and vice versa). Accordingly, as each party is receiving consideration for the property he or she is transferring, each party will be subject to New York State transfer tax (including the Mansion tax) as well as the applicable local transfer tax.

Furthermore, there is an alternative ground for imposing transfer tax in this case. New York State, New York City, and the Town of East Hampton (within which the Bridgehampton house is located) each impose a transfer tax on a transfer made pursuant to a separation agreement. Here, while the parties proposed to make the transfers prior to their execution of a separation agreement, the transfers are in fact a step in an overall plan to divide their property under their separation agreement. Accordingly, under the so-called “step transaction” doctrine, the transfers will be treated as made pursuant to their separation agreement, and thus subject to transfer tax.

And, finally, the fact that Willa will transfer to Henry a 50% membership interest in the Company, rather than a tenancy-in-common interest in the Bridgehampton residence, will not result in an avoidance of the New York State or Peconic Bay Region transfer taxes. All such taxes (including the Mansion tax) are imposed on transfers of a controlling interest in an entity that owns real property located in the applicable jurisdiction.

Elias M. Zuckerman is a partner with Katsky Korins, LLP, where has headed the firm's tax department since 1988.

Last month, we began discussion of a hypothetical couple's transfers of assets to one another. The married parties, Henry and Willa, own a townhouse in Manhattan (the Townhouse) and each owns a 50% membership interest in 17 House, LLC (the Company), which owns a residence in Bridgehampton, NY. There are no mortgages on either property. We wanted to know the tax consequences to the couple of their proposed agreement that Henry transfer his interest in the Townhouse to Willa prior to their execution of a separation agreement, and that Willa transfer her membership interest in the Company to Henry prior to execution of such agreement.

We continue our analysis of the tax consequences of their proposed agreement herein.

Transfer Pursuant to a Separation Agreement

A second provision of the New York State transfer tax regulations supports the conclusions that Willa's transfer of her interest in the Company to Henry and his transfer of his interest in the Townhouse to her are subject to transfer tax. Section 575.11(a)(10) of the regulations issued by the New York State Department of Taxation and Finance provides that:

A conveyance from one spouse to the other pursuant to the terms of a divorce or separation agreement is subject to tax. (There is a rebuttable presumption in such case, that the consideration for the conveyance, which includes the relinquishment of marital rights, is equal to the fair market value of the interest in the real property conveyed.)

Again, the Town of East Hampton and New York City have adopted similar regulations. (Note that the instructions included on Schedule E of the New York City Real Property Transfer Tax Return provide that a transfer or property pursuant to a “marital settlement agreement” is also subject to transfer tax.)

The Step Transaction Doctrine

Because Willa and Henry had not executed a “separation agreement” (as such term is used in Section 170 of the New York Domestic Relations Law) and obviously they had not obtained a decree of divorce, if Willa now transferred her interest in the Company to Henry and he transferred his interest in the Townhouse to her, couldn't they take the position that, literally, the transfers were not “pursuant to the terms of a divorce or separation agreement” within the meaning of Section 575.11(a)(10) of the regulations?

Inasmuch as the transfers would be “in contemplation of” the execution of a separation agreement and would be integral to the subsequent closing of such an agreement, under the “step transaction” doctrine, as described below, the transfers should be treated as made “pursuant to” the terms of a separation agreement within the meaning of the regulation and thus subject to tax.

The step transaction doctrine has been frequently invoked by the Internal Revenue Service and the federal courts to ensure proper income tax treatment of a series of transactions. Commissioner v. Court Holding Co. , 324 U.S. 331 (1945). In True v. U.S., 190 F.3d 1165 (10th Cir. 1999), the Tenth Circuit observed that:

Deciding “whether to accord the separate steps of a complex transaction independent significance, or treat them as related steps in a unified transaction, is a recurring problem in the field of tax law.” King Enters., Inc. v. United States , 418 F.2d 511, 516 (Ct. Cl. 1969). In search of an answer to this problem, courts utilize a variety of approaches, including a particular incarnation of the basic substance over form principle known as the step transaction doctrine. Simply stated, the step transaction doctrine provides that “interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction.” Commissioner v. Clark , 489 U.S. 726, 738 (1989) '

The New York State and New York City tax authorities have similarly applied the “step transaction” doctrine in transfer tax cases. Matter of Kevin Kelly, DTA No. 819863 (State of New York ' Division of Tax Appeals, Dec. 8, 2005); See also Matter of Exchange Plaza Partners v. City of New York , 159 A.D.2d 333 (1st Dep't 1990), appeal denied, 76 N.Y.2d 702 (1990); Matter of The Fleetwood Realty Company, TAT (H) 93-294 (RP), TAT (H) 95-12 (RP) (New York City Tax Appeals Tribunal ' Administrative Law Judge Division) (Feb. 28, 1995); Matter of Seven West 34th Street Development Corporation, FHD-92-436 (RPT) (New York City Department of Finance, March 31, 1992); New York City Department of Finances, Statement of Audit Procedure RPTT 2008-1 (2/29/08).

For example, in Fleetwood Realty , supra , the taxpayer partnership held a leasehold interest in rental real property located at East 65th Street in Manhattan. The fee interest in the property was owned by Peter S. Kalikow (Kalikow), who beneficially owned all the interests in the taxpayer. The leasehold and fee were both subject to a $38 million mortgage debt held by Travelers Insurance Company (Travelers).

Kalikow wanted to convert the property to cooperative or condominium ownership. Under the terms of the mortgage, Travelers' consent was required for such a conversion. Furthermore, New York law prohibited a so-called leasehold condominium. So the taxpayer and Kalikow requested that Travelers release the mortgage lien on the taxpayer's leasehold estate and permit a merger of the leasehold and fee.

On Oct. 4, 1989, Travelers and Kalikow executed a release agreement pursuant to which Travelers released its mortgage lien on the taxpayer's leasehold estate and confirmed that the taxpayer's liability to pay the debt was terminated. The following day, the taxpayer assigned its leasehold estate to Kalikow, thereby merging the leasehold into the fee.

For purposes of computing the New York State and New York City transfer taxes on the transfer of rental or other commercial property, consideration ordinarily includes the amount of mortgage debt assumed in connection with such transfer and the amount of mortgage debt to which the property is subject. In Fleetwood Realty, the taxpayer took the position that, since its leasehold was released from the Travelers' debt before the leasehold was assigned to Kalikow, it received no consideration in the form of any relief from indebtedness. However, the New York City Department of Finance disagreed and the New York City Tax Appeals Tribunal upheld the department's position.

In the view of the administrative law judge, inasmuch as the taxpayer's indebtedness to Travelers was discharged on the day prior to the day of the taxpayer's assignment of the leasehold, the taxpayer was seeking to elevate form over substance. The judge rejected this approach, concluding that since the assignment was clearly contemplated by all the parties at the time the taxpayer's debt to Travelers was released, the two steps should be analyzed as an “integrated transaction.” Accordingly, the judge held that the taxpayer received taxable consideration for its assignment of its leasehold in the form of a release from its indebtedness.

The tax authorities have applied the step transaction doctrine to combine a series of transactions separated by much more than one day. For example, in Seven West 34th Street Development Corp., supra, an issuance of the taxpayer's stock was determined to be an element of a single transaction with the subsequent transfer of real property to the taxpayer nearly one year later.

In any event, as the transfers by our hypothetical couple, Willa and Henry, were contemplated as a condition of their execution of any separation agreement, such transfers should be treated as made pursuant to such agreement. Thus, they are subject to transfer tax.

Transfer of an Interest in a Company

New York's real estate transfer tax (RETT) is imposed on ” ' each conveyance of real property or interest therein when the consideration exceeds five hundred dollars '” New York Tax Law ' 1402(a). The term “ conveyance” is defined, in relevant part, as “the transfer or transfers of any interest in real property ' including ' [a] transfer or acquisition of a controlling interest in any entity with an interest in real property.” New York Tax Law ' 1401(e). In turn, a “controlling interest” means, in the case of a partnership, association, trust or other entity (other than a corporation) ” ' fifty percent or more of the capital, profits or beneficial interest in such partnership, association, trust or other entity.” New York Tax Law ' 1401(b). In other words, the RETT is payable in the case of a transfer of 50% or more of the capital or profits in a partnership or limited liability company that owns real estate located in New York.

In Willa and Henry's case, the Operating Agreement of the Company, dated as of Jan. 9, 2004, provides that each owns a 50% membership interest in the Company. Under this agreement, they are each entitled to 50% of the profits and losses of the Company, as well as 50% of the distributions made by the Company. Accordingly, for purposes of the RETT, each owns a controlling interest in the Company. Therefore, Willa's transfer of her interest in the Company to Henry will be treated for purposes of the RETT in a manner similar to her transfer of an interest in real property to him.

Similarly, the Mansion Tax applies to ” ' each conveyance of residential real property or interest therein when the consideration for the entire conveyance is one million dollars or more.” New York Tax Law ' 1402-a(a). Since the term “ conveyance” includes the transfer of a controlling interest in an entity owning real property, the Mansion Tax is also imposed on the transfer of a controlling interest in an entity owning residential real property. See New York State Department of Taxation and Finance Publication 577, FAQS Regarding the Additional Tax on Transfers of Residential Real Property for $1 Million or More. Accordingly, Willa's transfer of her interest in the Company to Henry will be subject to the Mansion Tax if the transfer is subject to the RETT.

Finally, the transfer tax statute enacted by the Town of East Hampton follows the RETT. Therefore, Willa's transfer of her interest in the Company to Henry will also be subject to the town's transfer tax if the transfer is subject to the RETT.

Conclusion

Willa and Henry's agreements represent transfers for value rather than bona fide gifts. That is, Henry's transfer of his interest in the Townhouse to Willa is the quid pro quo for her transfer of her interest in the Company to him (and vice versa). Accordingly, as each party is receiving consideration for the property he or she is transferring, each party will be subject to New York State transfer tax (including the Mansion tax) as well as the applicable local transfer tax.

Furthermore, there is an alternative ground for imposing transfer tax in this case. New York State, New York City, and the Town of East Hampton (within which the Bridgehampton house is located) each impose a transfer tax on a transfer made pursuant to a separation agreement. Here, while the parties proposed to make the transfers prior to their execution of a separation agreement, the transfers are in fact a step in an overall plan to divide their property under their separation agreement. Accordingly, under the so-called “step transaction” doctrine, the transfers will be treated as made pursuant to their separation agreement, and thus subject to transfer tax.

And, finally, the fact that Willa will transfer to Henry a 50% membership interest in the Company, rather than a tenancy-in-common interest in the Bridgehampton residence, will not result in an avoidance of the New York State or Peconic Bay Region transfer taxes. All such taxes (including the Mansion tax) are imposed on transfers of a controlling interest in an entity that owns real property located in the applicable jurisdiction.

Elias M. Zuckerman is a partner with Katsky Korins, LLP, where has headed the firm's tax department since 1988.