The final proposed rewrite of NH’s Real Estate Transfer Tax rules released last week includes at least one and possibly more regulations that appear at odds with the statutes that they are meant to interpret. Among them is a rule stating that only an entity meeting the definition of a business organization under Business Profits Tax law can qualify as a real estate holding company, which means that a transfer of interest in a non-profit organization cannot be subject to RETT while a direct transfer involving the same entity would be.
Another regulation proposed by the Department of Revenue Administration provides that an assignment of a real estate ground lease with a term of at least 30 years is taxable even though a related rule provides that a new lease of real estate is only taxable if it runs for 99 years or longer. A third regulation exempts changes in certain “carried interests” in a real estate holding company from tax while an acquisition of a stake in the same entity by more conventional means would be taxable.
A final proposal would make transfers pursuant to the statutory conversion of a corporation into an LLC subject to only the $40 minimum amount of tax, despite the fact that the legislative history of the underlying statute appears to require that tax be paid on the fair market value of the entity’s real estate. For a detailed analysis of that rule, see Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum.
Rev. 801.09 – Only Business Organizations can be Real Estate Holding Companies
Unless specifically exempted, RETT is payable on each direct transfer of real estate (RSA 78-B:1, I(a)). There is no blanket exemption for transfers involving non-profit entities. Transfers of an interest in a real estate holding company are also subject to RETT to the extent of the entity’s NH real estate (RSA 78-B:1-a, V).
Proposed Rev. 801.09 is intended to provide guidance on the statutory definition of the term ‘real estate holding company’. The proposed rule states, among other things, that only an entity that qualifies as a business organization under Business Profits Tax law can be considered a real estate holding company for RETT purposes. Not-for-profit entities falling under the criteria set out in IRC § 501(c) are excluded from the BPT definition of a business organization. While the proposed regulation is consistent with the existing rule, Rev. 801.07, for some reason that rule had never been revised to reflect a 2009 amendment to RSA 78-B:1-a, VI dropping the business organization requirement from the statutory definition of a real estate holding company.
That statutory change was presumably made because an exemption for a transfer of an interest in an entity that wasn’t subject to BPT would probably represent an unconstitutional classification of taxpayers since RETT would be owed on a transfer of interests in a similarly situated business that is subject to BPT. An example would be a transfer of an interest in a Sec. 501(c)(2) entity, which is a common vehicle for the ownership of real estate by non-profits and is not considered a business organization under BPT law. If the taxability of a direct transfer of real estate made by any entity does not depend on whether it qualifies as a business organization under BPT law, then it would almost certainly be unconstitutional to only subject transfers of interests in the same entity to RETT if it is considered a business organization while exempting similar transfers if it is a non-profit.
Rev. 802.01(j) – Transfer of Leases with 30- and 99-Year Terms
Proposed Rev. 802.01(j) states that the transfer of a lessee interest in a ground lease (including related improvements) with a term of at least 30 years (including renewal options) is subject to RETT. There is no similar provision under the current rules. However, existing rule Rev. 802.01(f), which remains unchanged under the proposed rewrite, states that leases of 99 years or more (including renewal rights) are subject to tax.
RSA 78-B:4 provides that transfers of real estate “or any interest in real estate” are subject to tax. A lease is an interest in real estate. The fact that a newly signed lease is only subject to RETT if it is for 99 years or more while the assignment of a lease is taxable if it has a term of only 30 years appears inconsistent and illogical. In addition, the new rule subjecting transfers of leases with terms of 30 or more years to RETT represents a benefit to the State and a cost to taxpayers. The fiscal impact statement for the revenue rule, however, claims that there would be none.
Rev. 803.06 – Taxability of Carried Interests
Proposed Rev. 803.06 would, if adopted, exempt from tax any changes in the profit-sharing percentages of a partnership or LLC owning NH real estate. There is currently nothing in the RETT statutes or rules stating specifically that such changes in carried interests are, or are not, subject to tax. Even if adopted, however, it’s not clear that the rule would settle the issue for good, especially with respect to changes in the ownership of capital percentages that frequently occur concurrently, but not necessarily in lockstep, with those of the profit-sharing interests in the entity.
Ownership of an interest in a partnership or an LLC involves a bundle of rights. While one of those rights entitles the owner to share in the allocation of the entity’s profits (and losses), another establishes the share of any distributions of capital the owner will receive upon dissolution. They are two different rights, and are not necessarily represented by the same percentage interests. Those percentages are established under the terms of the entity’s operating agreement and sometimes vary from one another to a considerable extent. Even if they happen to be the same, they are still independent of one another.
The operating agreement of an entity taxed federally as a partnership (which includes most LLCs) might provide that one or more parties contribute the capital to fund the enterprise while another party (or parties) provides most of the services deemed necessary for its operation. Such agreements sometimes state that the “services partner(s)” will be allocated a given percentage of the entity’s profits and losses, with an incentive increase in the profit sharing percentage after certain conditions in the operating agreement are met (such as the repayment of the original capital contributions.)
The possible RETT ramifications of such an arrangement become more apparent when the entity – for purposes of this analysis, a partnership – is required to make distributions returning the capital “contributed” by its partners. The operating agreement might provide that the “services” (or “sweat equity”) partner also be granted a right to share in the distribution of the assets of the partnership in proportion to his or her capital account in the entity (which will have increased due to the services performed) upon dissolution of the entity. If the partnership is a real estate holding company, the question becomes whether such “transfers” of ownership interest are subject to RETT.
Carried Interests – Does a Sweat Equity Partner “Buy” an Interest in the Entity?
Per RSA 78-B:1, I(a), each transfer or real estate or “interest in real estate” is presumed taxable unless specifically exempted by law. The right to receive a distribution of the real property of a real estate holding company is an interest in real estate. Transfers of interests in real estate holding companies are taxable to the extent of the fair market value of the entity’s underlying real estate (RSA 78-B:1-a, V). The definition of the term “price or consideration” at RSA 78-B:1-a, IV states that consideration is “…the amount of money, or other property and services, or property or services valued in money which is given in exchange for real estate, and measured at a time immediately after the transfer of the real estate”. Taken together, the above could support the position that the transfer of a carried interest in a partnership (that qualifies as a real estate holding company) in exchange for services provided by a sweat equity partner is subject to RETT, with the taxable consideration equal to the fair market value of the entity’s assets at the time the transfer takes place. The following example is intended to illustrate why such transfers might be considered taxable.
One individual contributes a building worth $1M to the partnership while another contributes nothing, but agrees to do all the partnership’s work. Each partner gets a one-half interest in the entity. The partnership agreement states that the partner contributing the real estate will receive guaranteed payments for the total value of the building contributed whenever funds become available, plus 10% annual interest on that value before distribution of any partnership profits or assets. But on the day following the formation of the partnership, the partners decide that they don’t want to go through with the endeavor. The partnership immediately disposes of its property for the same $1M it had been valued at the day before. The partner who contributed the building gets paid $1M. The other partner gets nothing.
But if the partnership instead continues in existence, the “sweat equity” partner is effectively buying additional interests in the partnership as he or she contributes services. And since the principal asset of the partnership is real estate, the sweat equity partner effectively purchases a 50% interest in that asset once the investing partner has been paid the $1M that the interest was worth on the date of contribution. That would appear to make the “purchase” a transfer of a 50% interest in a real estate holding company.
Another way to look at it is to assume a situation where the entity is a newly created partnership, the only asset of which only asset is a $1M building. But instead of taking on a “sweat equity” partner, the entity hires an individual as its manager to do all of its work in return for a total salary of $500K over, say four years. Assume that after four years, during which time the value of the building remained unchanged, the manager takes the $500K of salary he or she had earned and buys a half interest in the partnership. In those circumstances, the manager would clearly have purchased a taxable interest in a real estate holding company.
In either scenario above, the individual performing all the services ends up with a 50% interest in the real estate holding company. In one situation, tax is obviously owed. In the other, the answer is not so evident. The issue, therefore, is not merely a question of whether the proposed rule should also specifically exempt changes in ownership interest in addition to the profit sharing percentages it currently focuses on. A more detailed review of whether the acquisition of ownership interests in a real estate holding company by a sweat equity partner is subject to RETT is probably needed. Whether such a determination should be made by rule, or be left up to the Legislature, is also an open issue.
Carried Interests – Ongoing Variations in Capital Accounts
One practical problem with implementing any rule stating that carried interests are taxable arises if the ownership of capital percentages on a partnership’s Schedule K-1 vary, as they sometimes do, because of relatively minor changes due to small withdrawals and/or contributions (perhaps because of payments made by a partner on behalf of the entity). It would appear burdensome, if not impractical, to treat each one of those percentage variations as a taxable transfer in a real estate holding company. (In fact, many of them might be so small that, if they were considered taxable, they would require payment of the $40 minimum transfer tax.) Proposed Rev. 802.05(d), however, would appear to exempt such de minimis transfers from tax.
Carried Interests – Rule Doesn’t Apply to Corporations
The fact that the proposed rule on carried interests applies only to partnerships and LLCs brings up the question of whether it violates the NH Constitution’s prohibition of taxpayer classification, which effectively states that similarly situated parties must be treated equally unless there is a compelling public interest for distinguishing between them.
Corporations sometimes issue shares to employees as compensation for services provided. Ownership of those shares includes the right to share in any distributions of the entity’s profits (through dividends) as well as to any distributions of its capital upon dissolution. Since the issuance of those shares serves to dilute the percentage ownership interests of existing shareholders, an argument could be made that it is subject to RETT (assuming that the corporation is a real estate holding company) because the employee effectively “purchased” the stock by way of providing his or her services to the entity. The proposed RETT rule, which only exempts partnerships and LLCs from tax, would effectively discriminate against similar transfers of interests involving a corporation.
Rev. 805.02 – Percentage Requirements for Real Estate Holding Companies
The title to proposed Rev. 805.02 describes the rule as “Determination of Fair Market Value for Purposes of Real Estate Holding Company Status.” Except for minor changes in references to a related rule, Rev. 805.02 is the same as the existing rule. Both the current and the proposed rule require the use of specific formulas and/or appraisals for determining the fair market value of a real estate holding company’s assets.
The current rule was put into place to provide guidance on a previous statutory definition, which stated (among other things) that an organization would meet the definition of a real estate holding company if more than 50% of its gross receipts were derived from the ownership or disposition of real estate or if the fair market value of its real estate made up more than 50% of its total assets. The Legislature presumably dropped those specific percentage requirements from the statute in 2006 because such bright-line percentage thresholds are frequently ruled to be per se violations of NH’s constitutional ban on the classification of taxpayers. Even though existing Rev. 805.02 was never revised to reflect that amendment, there appears to be no reason to retain guidelines for a standard that has been stricken from the statute.
Legislative Hearing on June 20th
The DRA submitted its final proposal for the rewrite of the RETT rules to the Joint Legislative Committee on Administrative Rules, which will review them at its session scheduled for June 20th.
By law, NH Rules have to be readopted no less frequently than every ten years (RSA 541-A:17, I).