At this year’s International Council of Shopping Centers (ICSC) Retail Development & Law Symposium held in Columbus, Ohio last month, I led a roundtable discussion on a commonly utilized transactional structure referred to as a membership interest “drop-and-swap,” which is also referred to as the “LLC loophole.”
After reviewing how LLC membership interest sale transactions are structured and why real estate professionals elect to utilize the structure, our group then considered the implications of two recent developments: (1) House Bill 449, which is currently being reviewed by the House Ways and Means Committee and is a form of “controlling interest” transfer tax statute; and (2) the Ohio Supreme Court opinion issued on February 6, which affirmed a decision by the Ohio Board of Tax Appeals and determined that, for real property tax purposes, the consideration paid for the membership interests of a limited liability company is the best evidence of the true value of the real property held by that limited liability company.
I have included an abbreviated outline of my ICSC group discussion below. If you have any questions or would like to discuss this topic in further detail, please contact me directly by e-mail at firstname.lastname@example.org.
1. Overview of the LLC Membership Interest Sale Structure
The LLC membership interest structure is a popular strategy for conveying real estate because, if successfully carried out, then under Ohio law the transacting parties can avoid the payment of transfer tax payable in connection with a conventional transfer of real estate, typically paid by the seller, and the purchaser may defer property tax reassessment for a period of time after closing, resulting in potentially significant annual property tax savings depending on the delta between the county’s appraised value and the sales price. Aside from tax strategy, transacting parties may also maintain anonymity by not publicly disclosing the consideration paid. Anonymity is especially important in multi-parcel developments, where publicly disclosing the identity of the buyer or the purchase price for one parcel can derail the acquisition of the balance of the planned development.
Consider the following example:
Party A owns real estate currently appraised by the county at $500,000, with annual property taxes of $16,881. Party B offers to purchase the property for $2,000,000. Under a conventional deed conveyance of the property, Party A would typically be responsible for transfer taxes equal to $8,000, based on at a rate of $4 per $1,000. Upon closing, Party B can expect the county to reassess the value of the property to reflect the purchase price of $2,000,000, which is publicly disclosed by Party B via the real property conveyance fee statement of value filed with the county at closing. Accordingly, Party B’s annual property tax liability would increase from $16,891 to $67,526.
If the parties instead elect to utilize the membership interest structure, Party A would enjoy the benefit of $8,000 in closing cost savings and Party B would potentially defer $50,635 per year in annual property taxes.
2. Recent Ohio Law Developments
A. House Bill 449 (currently in House Ways and Means Committee, transferred 1/28/20)
House Bill 449 is a form of a “controlling interest” transfer tax statute intended to capture transfer tax on the sale of a controlling interest (defined as more than 50%) in a pass-through entity that, directly or indirectly, owns real property, whether accomplished in one transaction or a series of transactions (within one year of each other). The current form of House Bill 449 has the potential to overreach beyond just closing the LLC loophole by adding new, unintended transaction costs to any transaction in which a controlling interest is transferred and the underlying entity or its subsidiaries own real estate.
Several other states have similar versions of controlling interest transfer statutes in effect, though each state’s version may define a qualifying transfer slightly differently. By way of example, Michigan’s version of a controlling interest transfer tax statute imposes a transfer tax on the sale of a controlling interest (80% or more) in any entity only if the real property owned by that entity comprises 90% or more of the fair market value of the assets held by the entity. While Michigan’s version seems to have less overbreadth than House Bill 449, Michigan’s statute is potentially too narrow by only applying to a direct membership interest transfer of the real estate holding entity, and not capturing ownership transfers in a shell parent entity with a wholly-owned subsidiary holding real estate (essentially a multi-layered drop-and-swap membership interest structure).
However, even with the passage of House Bill 449 in its current form or a similar iteration, without proper enforcement mechanisms in place and/or an appropriately tailored statute, it may still be difficult in practice to obtain accurate public disclosures to sufficiently address the LLC loophole. For example, over reliance on the discretion of the transacting parties filing the transfer disclosure or creating an opportunity for alternative loopholes, such as in Michigan, may undermine the effectiveness of the controlling interest transfer tax statute.
B. Columbus City Schools Bd. Of Edn. v. Franklin Cty. Bd. Of Revision
On February 6, the Ohio Supreme Court affirmed a decision of the Ohio Board of Tax Appeals, determining that, for real property tax purposes, the consideration paid for the membership interests of a limited liability company is the best evidence of the true value of the real property held by that limited liability company.
The underlying facts of the case involved a “drop and swap” membership interest sale of a 264-unit apartment complex in New Albany, which was valued at $16,000,000. The School Board for Columbus City Schools filed for reassessment, inferring a sales price of $34,000,000 by applying a loan-to-value ratio based on the recorded mortgage securing a loan for $25,536,000. The actual purchase price was $35,250,000, which was obtained by the School Board from the purchase contract during discovery. Notably, as it relates to structuring the transaction, the Ohio Supreme Court found that a distinguishing factor in this case was that the purchase contract identified itself as a purchase and sale agreement for real property, and not LLC membership interests.
After Columbus City Schools Bd. Of Edn. v. Franklin Cty. Bd. Of Revision, purchasers should anticipate that increasingly vigilant school boards will file for property value reassessments by tracking membership interest transfer sales via exempt conveyance form filings and/or mortgage release filings. Accordingly, purchasers should factor this risk into their deal underwriting process. Though increased vigilance by school boards probably won’t close the LLC loophole completely, it may create a chilling effect on the real estate market generally by increasing the underwritten transaction costs.
There are compelling public policy reasons for why legislators and local public officials want to close the LLC loophole – counties are losing out on transfer taxes and public schools are losing out on critical funding from artificially low property taxes. For those who may be deterred from engaging in transactions as a result, there are also strong counter arguments, for example, the desire to maintain privacy in commercial dealings, commercial property taxation based on a sale price often does not reflect true fair market value (as distinguished from residential property), and it will become cost prohibitive in many circumstances to activate underutilized property because of the ensuing property reassessment increase based on the sale. However, with continued momentum toward closing the LLC loophole in Ohio, it seems inevitable that the transfer of real estate through the sale of membership interests will be short-lived (at least, unless/until a new, innovative transaction structure is created in response).
 See statement released by Hamilton County Auditor on October 16, 2019: https://www.hamiltoncountyauditor.org/pdf/news_LLCLoophole.pdf
 See Columbus City Schools Bd. Of Edn. v. Franklin Cty. Bd. Of Revision, Slip Opinion No. 2020-Ohio-353.
 See paragraphs 37-38, stating, “…one fact stands out as having overriding significance. In Salem Med. Arts and Gahanna-Jefferson, the purchase contracts provided for sales of corporate shares or partnership interests without explicit reference to an intent to sell and buy the real estate itself… In stark contrast, the BTA in this case confronted a document labeled by the parties as “Sale of Palmer House on the Boulevard 4121 Palmer Park Circle East New Albany, Ohio” and “Purchase and Sale Agreement.” That is, the contract identifies itself as a purchase agreement for the real estate at issue.”
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