SC Lawyer, January 2009, #5. Implications of the South Carolina Real Property Valuation Reform Act on Business and Trust Transactions.

• Author: By Alyson C. Campbell and Scott Y. Barnes

South Carolina Lawyer

2009.

SC Lawyer, January 2009, #5.

Implications of the South Carolina Real Property Valuation Reform Act on Business and Trust Transactions

South Carolina LawyerJanuary 2009Implications of the South Carolina Real Property Valuation Reform Act on Business and Trust TransactionsBy Alyson C. Campbell and Scott Y. BarnesIntroduction

When planning transactions involving business entities or trusts that own real property, attorneys should be aware of the South Carolina Real Property Valuation Reform Act (the "Act"). S.C. Code Ann. §§ 12-37-3110 through 12-37-3170 (Supp. 2007). The Act provides that some transactions, even some not directly involving real property, will trigger a fair market value appraisal of real property owned by the business entity or trust, which will be the basis of ad valorem taxes.

This article will examine how the Act affects transactions by business entities and trusts that own real property and relevant issues with which counsel to such business entities and trusts should be familiar.

Assessable transfer of interest

The first question to consider is "Will the transfer result in an assessable transfer of interest (an "ATI")?" If so, then the transfer will trigger an appraisal of the underlying real property to determine its fair market value and additions and improvements thereto, which will be the basis of the property's value for purposes of determining ad valorem taxes. S.C. Code Ann. § 12-37-3130 (3) and (4). Because ad valorem taxes are normally based on assessments that over time no longer reflect current market values, an appraisal will likely result in higher taxes. Under the Act, the value of the property is its fair market value as of the latest of:

(a) its appraised value for the property tax year 2007; (b) December 31st of the year in which an assessable transfer of interest has occurred; (c) as determined on appeal; or (d) as it may be adjusted as determined in a countywide reassessment program conducted pursuant to Section 12-43-217, but limited to increases limited to 15 percent within a five year period to the otherwise applicable fair market value.

S.C. Code Ann. § 12-37-3140 (A)(1). See also S.C. Code Ann. § 12-37-3140 (C). As a result, after an ATI, the fair market value will generally be used to determine ad valorem taxes for the following tax year. S.C. Code Ann. §§ 12-37-3120 & 12-37-3140.

Transactions considered ATIs range from the intuitive to the not-so-intuitive. The not-so-intuitive examples apply to trusts and business entities. The Act provides the following nonexclusive list of ATIs: (1) a conveyance by deed; (2) a conveyance by land contract; (3) a conveyance to a trust; (4) a conveyance by distribution from a trust; (5) a change in the sole present beneficiary or beneficiaries of a trust; (6) a conveyance by distribution under a will or by intestate succession; (7) a conveyance by lease if the total duration of the lease, including the initial term and all options for renewal, is more than 20 years or the lease grants the lessee a bargain purchase option; (8) a transfer of an ownership interest in a single transaction or as a part of a series of related transactions within a 25-year period in a corporation, partnership, sole proprietorship, limited liability company, limited liability partnership or other legal entity if the ownership interest conveyed is more than 50 percent of the corporation, partnership, sole proprietorship, limited liability company, limited liability partnership or other legal entity; (9) a change of use of agricultural real property that subjects it to the rollback tax; (10) a change of use of real property when classification of property changes as a result of a local zoning ordinance change; or (11) the passage of 20 years since the later of the base year or the last assessable transfer of interest for real property owned by a publicly-held entity whose stock, shares or other ownership interests are traded on a regulated exchange, a pension fund or similar entity. S.C. Code Ann. § 12-37-3150 (A)(1) - (11).

ATIs and trusts

Items 3, 4 and 5 above specifically apply to trusts. Items 3 and 4 implicitly require conveyances of real property. Item 5 does not directly involve real property; therefore, the Act should be considered when there is any change in the sole present beneficiary of a trust that owns real property.

A conveyance to a trust is an ATI. S.C. Code Ann. § 12-37-3150 (3). However, a conveyance to a trust is not an ATI when the property is conveyed by "the settlor or the settlor's spouse, or both à and the sole present beneficiary or beneficiaries of the trust are the settlor or the settlor's spouse, or both." S.C. Code Ann. § 12-37-3150 (A)(3). See also S.C. Code Ann. § 12-37-3150 (B)(8).

A conveyance by distribution from a trust is an ATI, but a distribution from a trust to "the sole present beneficiary or the spouse of the sole present beneficiary, or both" is an excluded transfer. S.C. Code Ann. § 12-37-3150 (A)(4).

The effective date of an ATI consisting of a conveyance is "the date of the transfer and is not affected by the date of recording. Failure to record legal instruments evidencing a transfer of interest gives rise to no inference as to whether or not an assessable transfer of interest has occurred." S.C. Code Ann. § 12-37-3130 (7).

The final ATI specifically relating to trusts does not involve a conveyance. Changing the sole present beneficiary or beneficiaries of a trust is an ATI and will trigger an appraisal to determine fair market value of the trust's real property. S.C. Code Ann. § 12-37-3150 (A)(5). Thus, the death or birth of a beneficiary will be an ATI. However, changing the sole present beneficiary of the trust by adding or substituting the sole present beneficiary's spouse is not considered an ATI. S.C. Code Ann. § 12-37-3150 (A)(5).

ATIs and business entities

The representatives of corporations, partnerships, sole proprietorships, limited liability companies, limited liability partnerships and other legal entities (each, a "legal entity," and collectively, "legal entities") that own real property must be cognizant of the Act when planning transfers of ownership interests, even if real property will not be transferred. S.C. Code Ann. § 12-37-3150 (A)(8). Transactions that will trigger ATIs may include the admission of new shareholders to a corporation or the admission of new members to a limited liability company, the liquidation of a corporation or limited liability company, a capital shift in a limited liability company, limited liability company mergers, or a reallocation or special allocation of profit or loss in a limited liability company or partnership.

In planning a transaction, attorneys should consider whether the contemplated transaction is an ATI, and if so whether an exemption is available. If the transaction is an ATI and does not fall into an exception, the client should be advised of the reporting requirement discussed below.

As noted above, Section 12-37-3150 (A)(8) provides that "a transfer of an ownership interest in a single transaction or as part of a series of related transactions within a twenty-five year period in [a legal entity] if the ownership interest conveyed is more than fifty percent of the [legal entity]" is an ATI.

In considering the application of this section it is important to note that (i) the applicable transfer is of an ownership interest of the Legal Entity, not of real property owned by the legal entity; and (ii) the transfer can occur in a single transaction or in a series of related transactions within a 25-year period.

For example, law firm X is formed in Columbia, South Carolina, on May 1, 2007, by attorneys A and B as a registered limited liability partnership (an "LLP"). A and B intend to grow the law firm and add new partners. A contributes $200,000 to the capital of the LLP, and B contributes $100,000 to the capital of the LLP. They share profits and losses fifty/fifty. In September 2007, the LLP forms a single member limited liability company and purchases an office building for $500,000. (S.C. Code Ann. § 12-2-25(B) provides that "[f]or South Carolina tax purposes, a single-member limited liability company, which is not taxed for South Carolina income tax purposes as a corporation, is not regarded as an entity separate from its owner.") Five years later, law firm X admits three new partners, with each partner entitled to receive 20 percent of profits and losses. Has an ATI occurred? A and B's interest in profits have each been reduced by 30 percent (60 percent total), but is this a "transfer of ownership interest"?

In 2013, A becomes of counsel to the firm and gives up his interest in the LLP's profits and losses and is paid a modest guaranteed payment.

In 2015, A retires, withdraws from the firm and is paid $200,000 for his interest in the firm. At the time of withdrawal, A's capital account is $200,000, B's capital account is $100,000, and the other three partners have a $0.00 capital account. Has an ATI occurred? While the allocation of profits and losses has changed by only 20 percent upon A's retirement, the percentage interest in capital has changed by 66.66 percent. Additionally, if the admission of the three new members in 2012 is a "series of related transactions," then will an ATI occur in 2013 as a result of the 20 percent shift in profits and losses as a result of A's withdrawal (over a three-year period there has been an 80 percent shift in profits and losses)? Again, has a "transfer of ownership interest" occurred?

Unfortunately, the Act provides no guidance as to what constitutes a "series of related transactions" or an "ownership interest." The "step-transaction" doctrine, recognized by federal law, may provide some guidance. Under that doctrine, "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 following three tests have been employed to determine if independent transactions constitute one overall transaction for tax purposes: (1) end result, (2) interdependence and (3) binding commitment. A series of related transactions will be considered a single integrated transaction under the end result test if "it appears that they were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result." Associated Wholesale Grocers, Inc. v. U.S., 927 F.2d 1517, 1523 (10th Cir. 1991) (quoting King Enters., Inc. v. U.S., 418 F.2d 511, 516 (Ct. Cl. 1969)). The interdependence test focuses on "whether on a reasonable interpretation of objective facts the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series." Id. (quoting Paul & Zimet, "Step Transactions," Selected Studies in Federal Taxation 200, 254 (2d Series 1938). Finally, the binding commitment test, which is rarely used, will consider multiple transactions as a single transaction for tax purposes "where the taxpayer is subject to an obligation or binding commitment, at the time the first step is entered into, to pursue the successive steps in a series of transactions." True v. U.S., 190 F.3d 1165, 1175 (10th Cir. 1999).

Only transfers of more than 50 percent of the ownership interest of a legal entity trigger an ATI; transfers of 50 percent or less do not result in an appraisal for ad valorem tax purposes. Under Section 708(b)1(B) of the Internal Revenue Code, a change in ownership in a partnership or limited liability company requires a change in ownership of a partner's (member's) interest in profits and capital. Presumably, the 708(b)1(B) test will be applied by assessors and taxpayers in determining when an ATI exists.

The Act places a new reporting responsibility on a legal entity that conveys an ownership interest that triggers an ATI or change of ownership. The legal entity must "notify the applicable property tax assessor on a form provided by the Department of Revenue not more than forty-five days after a conveyance of an ownership interest that constitutes an assessable transfer of interest or transfer of ownership." S.C. Code Ann. § 12-37-3150 (A)(8) (emphasis added). The Act may require notice whenever the conveyance of an ownership interest constitutes a change in the legal entity's ownership, even if the conveyance is not an ATI. See S.C. Code Ann. § 12-37-3150 (A)(8) ("after a conveyance of an ownership interest that constitutes an assessable transfer of interest or transfer of ownership.").

Exceptions

Certain designated transactions that would otherwise constitute ATIs qualify for exceptions. In addition to the specific exceptions relating to trusts discussed above, the following transactions are not ATIs:

(1) transfers not subject to federal income tax in the following circumstances: a. 1033 (involuntary conversions of property as a result of destruction by fire, hurricane, earthquake, etc.); b. 1041 (transfers of property between spouses incident to divorce); c. 351 (transfers to a corporation controlled by transferor); d. 355 (distributions of stock and securities of a controlled corporation); e. 368 (corporate reorganizations); or f. 721 (non-recognition of gain or loss on a contribution of property to a partnership). Number references in the above subitems are to sections of the Internal Revenue Code of 1986, as defined in Section 12-6-40. * * *

(6) a transfer for security or an assignment or discharge of a security interest. (7) a transfer of real property or other ownership interests among members of an affiliated group. As used in this item, "affiliated group" is as defined in Section 1504 of the Internal Revenue Code as defined in Section 12-6-40. Upon request of the applicable property tax assessor, a corporation shall furnish proof within 45 days that a transfer meets the requirements of this item. A corporation that fails to comply with this requirement is subject to a civil penalty as provided in Section 12-37-3160(B). (8) a transfer of real property or other ownership interests among [legal entities] if the entities involved are commonly controlled. Upon request by the applicable property tax assessor, a [legal entity] shall furnish proof within 45 days that a transfer meets the requirements of this item. A [legal entity] that fails to comply with this request is subject to a civil penalty as provided in Section 12-37-3160(B). S.C. Code Ann. § 12-37-3150 (B).

Under Section 351 of the Internal Revenue Code, a transfer of property to a controlled corporation is generally treated as a tax-free transaction if certain requirements are met. In particular, the transferor(s) must "control" the corporation immediately after the transfer. "Control" is defined as "ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation." Presumably, failure to meet the "control" test will render a transfer of real property to a corporation an ATI.

Section 355 of the Internal Revenue Code relates to the tax-free distribution of stock of a subsidiary corporation to the shareholders of the parent corporation (a "spin off"). The spin off must be of a trade or business that has been actively conducted for the previous five years and not be used as a device for the distribution of earnings and profits of the distributing corporation.

Section 368 of the Internal Revenue Code defines certain corporate reorganizations, including acquisitive reorganizations, recapitalizations, statutory mergers, consolidations and changes in corporate identity, form or place of organization. A reorganization under Section 368 can be tax free, taxable or partially taxable and partially tax free. It is unclear whether a taxable reorganization under Section 368 is an ATI, although the plain language of the Act seems to imply that any corporate reorganization, whether taxable or tax-free, is not an ATI.

Section 721 of the Internal Revenue Code provides that no gain or loss will be recognized to a partnership or a partner upon the contribution of property to a partnership in exchange for an interest in the partnership. If contributed property is subject to a liability, Section 752 of the Internal Revenue Code may render a portion of the transaction taxable. The language of the Act "721 (Non-recognition of Gain or Loss on a Contribution to a Partnership)" implies that only a tax free contribution to a partnership qualifies as an exempt ATI transaction and that a taxable transaction, no matter how small, will be an ATI.

The other exceptions that may apply to business transactions are exceptions (7) and (8) above. Section 707(b) of the Internal Revenue Code defines a "controlled partnership" as "(i) a partnership and a person owning, directly or indirectly, more than 50% of the capital interest, or the profits interest, in such partnership or (ii) two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital interest or profits interest." Neither transfers to members of an affiliated group nor transfers among commonly controlled entities are ATIs.

If either exception (7) or (8) above applies to the transaction, the client should be advised that it may receive a request from the tax assessor for information regarding the transaction. If the client fails to comply with the request, the results may be harsh. The penalty for failure to comply with a request is the same as the penalty discussed below in connection with the annual reporting requirement. S.C. Code Ann. § 12-37-3160 (B)(7) & (8). See also S.C. Code Ann. § 12-37-3160.

Section 12-37-3170 of the Act addresses the impact of the Act on agricultural use values and notes that the Act does not affect "fair market value for agricultural purposes for real property in agricultural purposes." Accordingly, while an ATI will trigger a reassessment of agricultural use property, the resulting value should be the same as the value before the ATI.

Annual reporting requirement

The Act requires county tax assessors to send each real property owner of record a certificate each year, which must be "signed and returned by the property owner or the owner's agent certifying the details of the ownership of the property." S.C. Code Ann. § 12-37-3160 (B)(1). The reporting requirement should be taken seriously, because knowingly falsifying details on the certificates results in a civil penalty, the amount of which must equal more than "twice the taxes lawfully due on the property" and less than "three times the taxes lawfully due on the property." S.C. Code Ann. § 12-37-3160 (B)(1). The Act provides that the penalty "is enforceable and collectable in the same manner as property tax." S.C. Code Ann. § 12-37-3160 (B)(1). Therefore, knowing falsifications could result in a lien on and forced sale of the entity's real property. See S.C. Code Ann. §§ 12-51-40 through 12-51-70.

The penalty raises concerns for purchasers of the assets or ownership interests of a legal entity. If the selling entity has knowingly falsified details on the certificate, then the purchaser may be buying property subject to a lien. It may be prudent for purchaser's counsel to request an affidavit from the seller that it has not knowingly falsified details on the certificate.

Conclusion

When involved in transactions involving entities or trusts that own real property, the Act should be carefully considered, even if the transaction does not directly involve the transfer of real property.