December 4, 2007

MARYLAND ENACTS

“CONTROLLING INTEREST” LEGISLATION

Maryland’s real estate transfer taxes apply to the conveyance of real property by deed. Until now, Maryland transfer taxes have not applied to indirect transfers of real property, such as sales of equity interests in entities that own Maryland real property.

For example, Smith owns Goldacre, a parcel of Maryland real estate. If Smith sells Goldacre to Jones and a deed is recorded, then a Maryland transfer tax will be imposed on the sale.

For example, Smith owns 100 percent of the membership interests in Goldacre LLC, a limited liability company that owns Goldacre. If Smith sells all of his Goldacre LLC membership interests to Jones, then, under current law, Maryland transfer taxes will not be imposed on the sale.

The Maryland General Assembly recently passed Governor
Martin O’Malley’s tax plan, changing state law so that Maryland transfer taxes will now be imposed on transfers of “controlling interests” in certain “real property entities.” The new legislation has raised a number of concerns in the Maryland real estate industry. Here are some important questions to consider:

Question #1: What is the effective date? Transfers of “controlling interests” in a “real property entity” that occur after June 30, 2008 will be subject to Maryland transfer taxes.

Observation: The new legislation does not allow any “grandfathering” rules or other transitional relief. A transfer of a controlling interest in a real property entity occurring after June 30, 2008 will be taxed even if the transfer is made pursuant to a binding contract executed before July 1, 2008. This means that there will be an incentive to close deals before July 1, 2008.

Question #2: What is a “controlling interest”? Maryland transfer taxes will be imposed on a transfer of a “controlling interest” in a “real property entity.” In the case of a corporation, a “controlling interest” is more than 80 percent of the value of all outstanding stock. In the case of a partnership or LLC, “controlling interest” means more than 80 percent of the capital and profits.

Question #3: What is a “real property entity”? If Maryland real property comprises at least 80 percent of the value of the assets of an entity and the Maryland real property has a value of at least $1 million (without reduction for any mortgage or other debts secured by the real property), the entity will be a “real property entity.” A “real property entity” does not include an entity with land holdings that are entirely subject to an agricultural use assessment.

Observation: If an entity owns multiple assets that are difficult to value (in addition to Maryland real property), it may be difficult to determine whether the entity is a “real property entity.”

Question #4: How is the tax computed? The Maryland transfer taxes applicable to controlling interest transfers are imposed at the same rates as are applicable to transfers of Maryland real property. By and large, the same exemptions available to certain transfers of Maryland real property will apply (for example, gifts of interests in real property entities). The tax rates vary by county and, in the aggregate, can be as high as 3 percent. The taxes will be based upon the consideration paid for the controlling interests in the real property entity. In this regard, the consideration includes any mortgage on the property or other unsecured debt owed by the real property entity, regardless of whether the mortgage or debt is staying intact or will be repaid as part of the transaction.

For example, Partnership owns Maryland real property having a value of $1,100,000, subject to a mortgage of $700,000. Thus, there is real property equity of $400,000. In addition, Partnership owns tractors and equipment worth $100,000. A partner sells a 90 percent interest in Partnership for $450,000 on August 1, 2008. First, note that the purchase price must be allocated between the Maryland real property and the other assets. The portion of the purchase price allocable to the tractors and equipment must be ignored (thus, the deemed purchase price for 90 percent of the real property is $360,000). The Maryland transfer taxes are imposed on the $360,000 cash (for 90 percent of the real property equity) plus the entire $700,000 mortgage, for a total amount subject to Maryland transfer taxes of $1,060,000.

Observation: In the view of many experts, this was a mistake. The statute should have only taken into account the amount of the mortgage allocable to the percentage interest sold (here, $630,000) and not the entire amount of the mortgage (which is how this works in other jurisdictions, such as Washington, DC, where there is a similar regime).

Question #5: Who pays the taxes and when? The Maryland transfer taxes on controlling interest transfers are due 30 days after the transfer of a controlling interest is complete (i.e., when the last transfer takes the total over 80 percent). The real property entity is responsible for filing a report with the Maryland State Department of Assessments and Taxation (SDAT) within 30 days following the date of the final transfer and is responsible for payment of the resulting Maryland transfer taxes. Neither the seller nor the buyer of the interests is directly responsible for payment of the taxes.

Observation: This is detrimental to equity owners in the real property entity who do not sell their interests. In the example above, the real property entity would owe transfer tax based on $1,060,000 of consideration. The non-selling owners economically bear a portion of the tax, even though they had nothing to do with the sale. From a planning standpoint, agreements among equity owners need to contain provisions obligating partners who transfer their interests and trigger a tax to pay the entire tax, so that the non-transferring owners are not prejudiced. By contractual agreement, the parties should be able to allocate who actually pays the taxes.

Observation: The buyer of an interest in a real property entity needs to be sure that the real property entity has paid all transfer taxes that may have been due as a result of prior equity interest transfers.

Question #6: What is the penalty if the taxes are not paid? If applicable Maryland transfer taxes remain unpaid for 30 days after the date of the final transfer, interest accrues at the rate of 12 percent per annum, plus there is a penalty of 10 percent of the unpaid tax.

Question #7: What if there is a series of transfers of equity interests over a period of 12 months or less? Unless the real property entity can show that the transfers were not part of a “plan,” the Maryland transfer taxes will apply if more than 80 percent of the interests are transferred during that period.

Question #8: What if transfers of equity interests constituting a controlling interest occur over a period of more than 12 months? The Maryland transfer taxes do not apply.

Question #9: If new equity owners are admitted to the real property entity, do the taxes apply? No, so long as the money goes into the real property entity as additional capital, management of the entity does not substantially change, and the new owners are not expected to participate in the day-to-day management.

Question #10: What if the owners of a real property entity transfer their interests to a new entity owned by all of them in the same proportions? The Maryland transfer taxes will not apply.

Additional Considerations

This is only a brief summary of the new law. The new law directs SDAT to promulgate regulations to provide further guidance. In particular, the regulations can be expected to provide exemptions that will mirror exemptions under current law in the case of certain direct deed transactions. SDAT has not yet set a schedule for issuance of the proposed regulations.