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AMBRECHT & BRITTAIN, LLPProperty Tax Alert: Current Position of State Board of Equalization on Application of Step Transaction Doctrine to Transfers Involving Legal EntitiesBy Frayda L. Bruton, Esq.
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Proposition 58, passed by the voters in 1986 and codified in Revenue and Taxation Code § 63.1 in 1987, allows an exclusion for transfers between parents and children of the family residence and the first $1 million of full cash value of "all other real property." In 1996, the voters extended this provision to transfers between grandparents and grandchildren if all the parents are deceased. The Legislature intended, but this intent was never codified, that the step transaction doctrine was not to apply to transfers of real property interests into and out of legal entities. Note 2 following Section 63.1 provides in part: [I]t is the intent of the Legislature that the provisions of Section 63.1 of the Revenue and Taxation Code shall be liberally construed in order to carry out the intent of Proposition 58 ... to exclude from change in ownership purchases or transfers between parents and their children described therein. Specifically, transfers of real property from a corporation, partnership, trust, or other legal entity to an eligible transferor or transferors where the latter are the sole owner or owners of the entity or are the sole beneficial owner or owners of the property, shall be fully recognized and shall not be ignored or given less than full recognition under a substance -over- form or step transaction doctrine, where the sole purpose of the transfer is to permit an immediate retransfer from an eligible transferor or transferors to an eligible transferee or transferees which qualifies for the exclusion from change in ownership provided by Section 63.1. Thus, assume that W, who owns 100% of Blackacre, transfers fractional interests in Blackacre to Cl, C2 and C3; W then files a Claim for Reassessment Exclusion Between Parents and Children (PT 58) under Section 63.1, excluding the transfers from reassessment; and W, Cl, C2 and C3 subsequently contribute their respective interests in Blackacre to Blackacre LLC, taking back proportionate interests in the entity. Result: the step transaction doctrine does not apply, and no change in ownership occurs under Section 62(a)(2). W, C1, C2 and C3 become "original co-owners." W can continue making gifts to Cl, C2 and C3 as long as she does not reduce her interest below 50%. See, Section 64(d). However, Note 2 will not prevent 100% reassessment of Blackacre if W transfers her 100% ownership to an entity consisting of W, C 1, C2 and C3. Penner v. County of Santa Barbara, 37 Cal.App. 4th 1672 (1995). Since the codification of Proposition 58, questions have arisen as to variations on the example that appeared in Note 2. Suppose that H and W establish HW Enterprises, a family limited partnership; they then transfer Greenacre to HW Enterprises, taking back a 1% general partnership interest and 99% limited partnership interests. Result: no change in ownership. H and W become original co-owners under Section 62(a)(2). H and W immediately begin to make a series of gifts of interests in HW Enterprises to C1, C2, GC I and GC2 (whose parent C3 has died and whose other parent has remarried). [A different result might obtain if the parents of GC1 and GC2 were alive.] Does the step transaction doctrine apply to these transfers? No, according to the legal staff at the State Board of Equalization. As long as H and W do not cumulatively transfer more than 50% of the capital and profits of HW Enterprises, there will be no change in ownership. Taking the last example a step further, suppose that H and W have cumulatively transferred 49% of the limited partnership interests to C1 C2, GC1 and GC2; the partners then agree to dissolve the partnership and retransfer the real property to each of H, W, C I, C2, GC I and GC2 in proportion to their relative interests in HW Enterprises. Result: no change in ownership under Section 62(a)(2). H and W then transfer to C1, C2, GC1 and GC2 undivided interests in Greenacre, properly reporting these transfers under Section 63.1. Immediately following the transfers of Greenacre, H, W, Cl, C2, GCI and GC2 transfer their interests to HW Enterprises No. 2 in exchange for proportionate limited and general partnership interests. Should the step transaction doctrine be applied to collapse the subsequent. transfers? The current thinking of the Legal Division of the State Board of Equalization is that Note 2 applies to the entire series of transactions: the formation of HW Enterprises, its subsequent dissolution followed by the transfers of fractional interests in Greenacre to the children and grandchildren (by their parents) and the retransfer of the interests into HW Enterprises No. 2. Originally, the Legal Division construed the application of Note 2 to be limited to the facts of the example, that is, the step transaction doctrine would not apply only to gifts by parents (eligible transferors) of real property to children (eligible transferees) followed by contribution by the children and parent(s) to an entity where each would take back a pro rata interest in the entity. The current thinking is that the legislative intent is not to be construed as limiting the application of Section 63.1 to one example. The example was meant to be illustrative, not defining. Further examples need to be proposed that illustrate permissible transfers to which the step transaction doctrine would not apply under the safe harbor of Note 2. A formal proposal should be made to the Property Tax Committee of the State Board of Equalization recommending new examples that would fall within the safe harbor. If you have proposed examples, please fax them to Frayda L. Bruton at (916) 444-2684 or e-mail them to flbruton@ncal.net. Reprinted with thanks to the author, California Trusts and Estates Quarterly, Vol. 3, No. 4, Winter, 1997, and to the Estate Planning, Trust and Probate Law Section of the California State Bar, which Section publishes the Quarterly.
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