A Rare Taxpayer Win in California Step Transaction Case
You won't find the "step transaction" doctrine in federal or California tax statutes, but it is a fundamental tax principle. The step transaction doctrine says that if you would get an unwanted tax result by proceeding from point "A" to "C," you cannot avoid that result by the roundabout way of first going from "A" to "B" (step one) and then from "B" to "C" (step two), even though steps one and two each by themselves do not produce the unwanted result.
The U.S. Supreme Court sanctioned the step transaction doctrine during the Great Depression, and the California Court of Appeal (Second District) held six decades later (Shuwa Investment Corp. v. County of Los Angeles, 1 Cal.App.4th 1635 (1991)) that step transaction also applied under Proposition 13 in determining whether property undergoes a "change in ownership" and gets reassessed for property tax purposes.
This January, the California Court of Appeal (Fourth District) applied step transaction in Dyanlyn Two v. County of Orange (____ Cal. App. 4th ___, No. G049269 (4th Dist. Jan. 30, 2015) but that taxpayer (unlike the one in Shuwa and almost every decision since then) won, convincing the court that Orange County could not combine the taxpayer's step one (resulting in no reassessment) and step two (again no reassessment) into a single transaction (which would have resulted in reassessment). Dyanlyn Two shows how a taxpayer with good facts and documentation can beat a creative county assessor.
Step Transaction and Shuwa
The taxpayers in Shuwa used three steps (none of which standing alone would have resulted in 100 percent reassessment) to achieve a sale of property that, if done directly, would clearly have been a 100 percent change in ownership. The property was the former ARCO Plaza in downtown Los Angeles and Shuwa wanted to buy it from the two partners. First, one partner sold Shuwa its 50 percent partnership interest (no reassessment because under California Revenue and Taxation Code (R&TC) section 64(c) there is no change in ownership if one person does not acquire more than 50 percent of the entity owning the property); second, the partnership liquidated (no reassessment because under R&TC section 62(a)(2) there is no change in ownership if the entity's owners own the same direct percentage interests in the property as they had owned indirectly through the entity); and third, Shuwa purchased the remaining partner's 50 percent interest in the property (a reassessment, but only as to that 50 percent piece).
The Los Angeles County assessor argued that, first, the step transaction doctrine (up to then solely a federal income tax concept) applied for Proposition 13 purposes as well; and second, under these facts the assessor could combine the three steps into one transaction — a "straight" sale by the former partners to Shuwa of the property — and reassess 100 percent of the property. The court agreed with the county on both scores. In particular, the court held that the assessor could combine the steps under any of the three tests that federal courts in the income tax context used to determine whether the IRS could combine separate steps: the "end result" test (Shuwa and the sellers embarked on the steps knowing that they would reach the end result by which Shuwa owned the entire property); the "interdependence" test (none of the steps undertaken by Shuwa and the sellers would have made sense by themselves because Shuwa would not have acquired the entire property); and the "binding commitment" test (Shuwa and the sellers had entered into legally binding commitments to proceed from one step to the next, and could not have "halted" after the first or second steps). As Shuwa demonstrates, whether an assessor can combine several steps into one transaction and reassess a property is highly fact-specific and depends on the nature of the transaction, the parties' intent (not always obvious), and the "four corners" of their agreements and other documentation.
Step Transaction Revisited in Dyanlyn Two
Dyanyln Two involves the intersection of step transaction with another curiosity of Proposition 13: entering into a 35 year lease is a change in ownership resulting in reassessment, both under statutes applying Proposition 13 and the California State Board of Equalization's (BOE's) administrative property tax rules.
The facts were as follows: Golden Westminster Specialty Center was a general partnership composed of an individual (John P. Sullivan) and another general partnership named Dyanlyn Development Company (Dyanlyn One) composed of two individuals. In 1977 Golden Westminster entered into a 60-year ground lease (to 2037) with the property owner, which lease gave Golden Westminster an option to purchase the property outright which Golden Westminster could exercise in 2002 or 2007. Golden Westminster built a shopping center on the property and operated it for 30 years. As the 2007 option deadline approached Golden Westminster realized that it could not afford to exercise the option, but it did not want to lose the property given how heavily it had invested in it. To make the project more attractive to "new money" investors, Golden Westminster in early December 2006 (when the remaining term of the lease was 31 years) entered into an extension of the lease with the owner for another 15 years (to 2052). Later than same month — Dec. 28 to be exact — the owner sold the property to (as tenants in common) Sullivan's trust (25 percent); Dyanlyn Two, composed of the same owners as those in Dyanyln One (50 percent); and Sechelt Associates LP, the hard-sought new money investor (25 percent).
The court of appeal devoted half its opinion to discussing the property tax consequences of creating, extending and transferring property subject to leases of 35 years or more given the fundamental purposes of Proposition 13 when voters passed it in 1978 and California statutes interpreting it since then. The court devoted the other half to discussing the step transaction doctrine.
Here, step one was the extension of the lease in early December 2006 for another 15 years (no reassessment because under BOE guidance extending a lease with an original term of more than 35 years that through the passage of time had "run down" to less than 35 years was not a change in ownership even if the extension was for an additional 35 years or more); and step two was the sale in late December 2006 (no reassessment under R&TC section 62(g) which provides that a sale of the lessor's interest in property subject to a lease with a remaining term of 35 years or more is not a change in ownership). The Orange County assessor argued that it could combine steps one and two into one transaction and that the lessor had in essence sold the property subject to a lease of less than 35 years to the new owners, the theory being that the lessee had extended the lease in early December 2006 (when the remaining term was only 31 years) in order to "shoehorn" the Dec. 28 sale into R&TC section 62(g). The assessor's treatment would have resulted in full reassessment because under BOE Rule 462.100(a)(2)(A) a sale of the lessor's interest in property subject to a lease with a remaining term of less than 35 years was a change in ownership.
The court of appeal, however, agreed with the taxpayers that the assessor could not combine the steps under the step transaction doctrine and Shuwa. The assessor could not combine the steps under the "end result" test because there was no evidence that all the parties — Sechelt, the new money investor, included — knew that the Dec. 28 sale would take place when Sullivan and the Dyanlyn owners (but not Sechelt) entered into the lease extension earlier that month. For similar reasons, the "interdependence" test did not apply because it made business sense for Sullivan and the Dyanlyn owners to extend the lease in early December and protect their investment not yet knowing that they would get a money investor (Sechelt) later that month. (The assessor and trial court did not use the "binding commitment" test and so the court of appeal barely addressed it.)
The court went even further, however, and cast doubt on the validity of BOE Rule 462.100(a)(2)(A) as the assessor tried to apply it to the facts before it. Both statute and Rule 462.100(a)(2)(A) provide that a change in ownership includes transfer of a lessor's interest in property subject to a lease with a remaining term of less than 35 years. The court, however, said that the assessor improperly applied this rule where, as here, the lease's original term was for more than 35 years; the term through the passage of time had "run down" to less than 35 years; and the lessor sold the property to what was essentially the same parties as those that constituted the original lessee (as opposed to an unrelated third party buyer). The court's theory was that the lessee always had beneficial use of the property and therefore the lessor's sale did not transfer beneficial use of the property for Proposition 13 purposes. The court suggested that the BOE amend Rule 462.100(a)(2)(A) to clarify that a change in ownership did not include a sale of the property subject to a lease with a remaining term of less than 35 years if that sale is to the lessee.
Dyanlyn Two shows that the step transaction doctrine is alive and well in California and that assessors and courts will apply it whenever a buyer is trying to avoid reassessment based on two separate steps that, considered independently, are not changes in ownership. Dyanlyn Two also demonstrates, however, that the facts of each case are unique and that the assessor does not have unbridled discretion under step transaction to combine steps into a single transaction resulting in full reassessment. With good facts and persuasive evidence, the Dyanlyn Two taxpayers were able to convince the court of appeal that the lease extension was independent of the sale, even though the steps occurred in the same month and there was significant overlap — in fact more than 50 percent overlap — between the owners extending the lease (Sullivan and the Dyanlyn One owners) and the purchasers (Sullivan, the Dyanlyn Two owners, and Sechelt). It is true that the taxpayers were unsuccessful at three steps below — before the assessor, before the Orange County Assessment Appeals Board, and before the trial court — but they eventually prevailed.
Regarding the court's disapproval of BOE 462.100(a)(2)(A), taxpayers should tread carefully for three reasons. First, Dyanlyn Two is binding precedent only in the Fourth Appellate District (which incudes Orange and San Diego counties and the Inland Empire). Second, the court did not need to address the validity of BOE 462.100(a)(2)(A), because it had held for the taxpayers under the step transaction doctrine anyway, and so the court's disapproval of BOE 462.100(a)(2)(A) should be viewed as dictum. Third, to the extent the court disapproved of Rule 462.100(a)(2)(A) it did so in the context of the facts before it: that is, the lease's original term was for more than 35 years; the term through the passage of time had "run down" to less than 35 years; and the lessor sold the property to what was for all intents and purposes the original lessee as opposed to an unrelated third party buyer. Under similar facts, parties who want to rely on Dyanlyn Two (that is, take the position that there is no reassessment upon the transfer of the property from the lessor to the lessee) will need to carefully negotiate and document the property tax provisions in their purchase and sale contracts to address the event that the assessor refuses to follow Dyanlyn Two (that is, reassess in full under BOE 462.100(a)(2)(A)) or another court disagrees with the Dyanlyn Two court's disapproval of the BOE rule.