A recent New York City (“NYC”) determination limited the impact of the step transaction doctrine under the New York City real property transfer tax (“RPTT”). An Administrative Law Judge (“ALJ”) held that the collapsing of a deed to a newly formed entity, followed by a transfer of an economic interest in that entity, resulted in a nontaxable transfer of a less than 50% economic interest in the entity. Matter of 105-02 Forest Hills LLC., et al., TAT (H) 20-18 (RP), et al. (N.Y.C. Tax App. Trib., Adm. Law Judge Div., Sept. 17, 2024).

Facts: On May 2, 2017, Don Rick Associates LLC (“Grantor”) deeded a commercial building located in Queens, New York, to 105-02 Forest Hills LLC (“Grantee”) (“Deed Transfer”). At the time, Grantor’s two members each held a 50 percent membership interest in Grantor, and also indirectly owned, through an intermediate entity, GG Forest Hills, LLC (“GG”), 50% membership interests in Grantee.

Since Grantor’s two members owned 50% beneficial interests in the building both before and after the transactions, the RPTT filed for the Deed Transfer claimed a 100% exemption from the RPTT. Under the RPTT, a deed, instrument or transaction conveying real property or an economic interest in that property that effects a “mere change of identity or form of ownership” (“mere change in form”) is exempt “to the extent the beneficial ownership” in the realty before and after the transaction remains unchanged. NYC Adm. Code § 11-2106.b(8).

On June 28, 2017—approximately two months after the Deed Transfer—another party, SPG Forest Hills LLC (“SPG”), was admitted as a member of Grantee in exchange for a one-dollar capital contribution (“Interest Transfer”). SPG’s admission was anticipated at the time of the Deed Transfer. SPG received a 40% “percentage interest” in Grantee, entitling it to certain unspecified distribution rights relating to that percentage interest. The RPTT also applies to the transfer of a 50% or more ownership interest in “the capital, profits or beneficial interest in a partnership, association, trust or other entity.” N.Y.C. Admin. Code § 11-2101.7 and .8. It does not appear that an RPTT return was filed for the Interest Transfer, presumably because it represented a less than 50% economic interest in Grantee.

NYC Position: The Department of Finance assessed RPTT, invoking the “step transaction” doctrine to collapse the Deed and Interest Transfers into a single deed to SPG of 40% of the realty. The Department relied on a 2016 decision of the NYC Tax Appeals Tribunal, Matter of GKK 2 Herald LLC, which applied the doctrine to treat the respective contributions of 45% and 55% ownership interests in a Manhattan building to a newly formed LLC in exchange for the same percentage interests in the LLC, immediately followed by the sale of the 45% membership interest to the 55% member, as the taxable sale of a 45% interest in the building.

Taxpayer’s Position: The Grantor and Grantee asserted that the Deed Transfer was fully exempt from RPTT as a mere change in form, and that the City was without authority to reduce the exemption on account of the subsequent Interest Transfer. They claimed that the two-month period between the Deed and Interest Transfers distinguished it from GKK 2 Herald, demonstrating that the Deed Transfer had substance and independent significance apart from the Interest Transfer.

Decision: The ALJ ruled in favor of the taxpayers, holding that while the Department was authorized to apply the step transaction doctrine, the substance of the collapsed transaction was the transfer of a less than 50% membership interest in Grantee.

The ALJ noted that, “if viewed in a vacuum,” the Deed Transfer and the Interest Transfer were both non-taxable. In his view, the step transaction doctrine could be applied because, under the “end result” test, both transfers were undertaken to admit a new member in the Grantee. It did not matter whether there was substance and independent significance.

However, the ALJ rejected the Department’s recharacterization of the transaction as a deed made directly to SPG. In doing so, the ALJ found the case distinguishable from GKK 2 Herald, which he viewed as holding that the substance of the collapsed transactions was the sale of the 45% interest in the realty to the 55% LLC member, and not as a transfer of a minority economic interest. The ALJ concluded that no direct sale of realty was made to SPG in substance or in form, quoting federal case law that the step transaction doctrine “cannot generate events which never took place just so an additional tax liability might be asserted.” Actually, in GKK 2 Herald,the NYC Tribunal concluded that there was in substance a taxable 45% deed to the LLC, not to the 55% member, which it held did not qualify as a mere change in form. Here, the ALJ found that the substance of the transactions was the transfer of a minority economic interest in an entity and that even if a 40% membership interest in Grantee was conveyed as the Department asserted, it was still a minority interest transfer and not subject to the RPTT. GKK 2 Herald has led to considerable uncertainty, and this decision provides some needed clarity.