Duncan P. Ogilvie has to tell his clients about their unusual quandary: You owe a tax dating back to 2007, but there's no way to pay it.
Ogilvie, of Miller Canfield's Ann Arbor office, is advising his clients to sit tight until the Michigan Department of Treasury issues guidance on a newly enacted tax law.
The law, Public Act 473 of 2008, was intended to close a loophole in the state's transfer tax on real estate.
But for now, it is leaving Ogilvie and other lawyers stymied. It is worded so vaguely that lawyers can't figure out how it will be paid, or who needs to pay it.
What is clear is that the Department of Treasury intends to collect the tax, and it intends to impose the tax retroactively to Jan. 1, 2007.
The law is meant to focus on commercial property transactions. (See "Lawyers: Treasury botched closing of loophole," page 24.) Before the law's passage, a loophole allowed sellers of commercial properties to avoid paying the $3.75 per $500, or $7,500 per $1 million, state tax on the sale price of real estate, said Jay A. Kennedy, senior counsel at Warner Norcross & Judd LLP's Southfield office.
"What companies were doing to avoid this tax is to set up an entity, like an LLC, where the property may be the only asset," Kennedy said. Then, he said, the limited liability company would transfer to the buyer. Because the real estate belonged to the LLC, there would be no transfer of deed.
In an ordinary sale of real estate, the transaction is recorded with the county register of deeds. That recording of the sale makes the seller responsible for paying the state transfer tax.
But because there is no deed in the sale of a limited liability company or other similar entity, Kennedy said, the transaction didn't require payment of the tax.
The new law is supposed to change that, said the bill's sponsor, former state Rep. Steven Bieda, D-Warren.
The law says that when a person, company, partnership or other legal entity has an 80 percent ownership interest in such an entity, and 90 percent of the limited liability company's value is made up of real estate, the sale of that LLC "shall be recorded."
"But how?" asks C. Leslie Banas of Honigman, Miller, Schwartz & Cohn LLP, in Bloomfield Hills. Banas also chairs the real property law section of the State Bar of Michigan.
"Transferring ownership of your garden variety LLC, there is no obligation to publicly disclose the terms of that agreement," she said. "It's just like a stock sale agreement. There may be a document or share certificate that's transferred, but the underlying agreement is not subject to public disclosure."
Glenn White, administrator of the tax policy division for the Michigan Department of Treasury, said that the state has prepared guidance on how the department will administer the tax. He expects it to be released soon.
"We haven't made a formal position on this except what the statute is requiring," he said.
But when asked what the statute requires, in terms of what documents need to be recorded when an entity changes ownership, he took a long pause before saying, "If you want to be prudent, record the contract. The statute requires recording of the deed or the contract."
Ogilvie said the register of deeds probably will not want to record contracts, as they are long, sometimes hundreds of pages.
And, Ogilvie said, when someone unfamiliar with an LLC ownership-transfer contract reads it, he or she may not understand exactly what was paid and to whom it was paid.
"It's very clear that the tax is imposed when the instrument, or deed, is recorded," Ogilvie said. "If there are no documents to record, then the tax can't be imposed. I'm not sure if this tax will be enforced at all. It will be curious as to whether anyone voluntarily pays this tax."
They won't, said Jess Bahs of Royal Oak-based Howard & Howard Attorneys; Bahs chairs the taxation section of the State Bar of Michigan.
The language about the event that triggers the levying of the tax is too ambiguous, he said.
"There is a reasonable argument that unrecorded contracts do not trigger the tax," he said. "Until this is litigated or further addressed, I believe some attorneys will simply advise their clients against paying the tax. In light of the language in the current bill, it will be difficult for Treasury to impose negligence or late filing and payment penalties against contracting parties."
When the issue is litigated, Bahs said, there is a reasonable argument that the tax violates due process.
"The tax unforeseeably affected prior contractual arrangements and voluntary acts," Bahs said.
In other words, added Banas, "This tax is treating one class of taxpayer differently than it ever did. That violates due process."
Kennedy said his clients not only will bristle over paying the tax; they also will be upset that their business transactions are going to be made public record when they submit their contracts for recording.
"They're closely held businesses where the parties don't want the public to know all the terms of the transaction," he said.
What concerns Kennedy are the other assets that could be part of the LLC.
"Those terms should not be made public," Kennedy said. "And those are not recordable, but they're in the LLC, so if there is an amendment which requires the LLC transfer to be recorded, everything would be public."
Kennedy said he hopes the Legislature will amend the act and clarify some of the language.
But clients are reporting that they're hoping the Department of Treasury is in charge of clarifying the details of the law, Bahs said.
"There's a fairly sizable group who feels like this is payback," Bahs said. "The sin that real estate developers committed was they made too much money. And now the state is going after them."
So when the Single Business Tax was replaced last year by the Michigan Business Tax, real estate was one of the industries which was hit hard by a tax increase, and some feel that they were singled out to bear the burden of the state budget shortfalls.
"I've heard some say they would rather deal with this through the treasury than through technical amendments. The process in dealing with the Legislature is too slow, or the transfer tax could wind up getting increased," Bahs said.
Bahs is also not telling his clients to pay the tax, or at least he's not telling them to do it yet.
"I would tell them to wait, particularly with the enforceability issues and the vague language," Bahs said. "We'll get out some information, but I'm not telling them they owe the tax."
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Lawyers: Treasury botched closing of loophole
When the Michigan Department of Treasury proposed a law to close a tax loophole on real estate transfer taxes, the result left lawyers wondering: How did the Treasury get it so wrong?
"I understand wanting to close the loophole. The Treasury didn't like this so-called loophole from day one," said Jay Kennedy, of Warner, Norcross & Judd's Southfield office. "But it has to be done the right way. I'm not sure if anyone even who wanted this statute changed even talked to real estate attorneys."
The loophole-closing law is too vague and unfairly taxes some real estate sellers by reaching back two years for a retroactive tax, he said.
The Department of Treasury has made clear that the state wants to collect transfer taxes on commercial real estate sales, despite a law that allowed some sellers to avoid paying them.
The loophole, under the previous law, worked this way: Sellers of commercial real estate would establish a limited liability company with real estate as its sole asset.
Then, the LLC could be sold, but the deed for the real estate would not change ownership because it belonged to the LLC.
Therefore, the LLC ownership transfer would not be recorded with the county register of deeds.
The recording is what triggers the state's transfer tax of $3.75 per $500 of the sale price, or $7,500 per $1 million. As a result, LLC sales avoided the tax.
The bill proposed by the Department of Treasury, House Bill 6122, attempted to close the loophole by imposing the transfer tax on the seller of a limited liability company or similar entity that has one person or group with an 80 percent ownership interest, if 90 percent of the LLC's assets are real estate.
But lawyers say the bill and the subsequent law, Public Act 473, have some big problems.
The first, Kennedy said, is that the law is retroactive to Jan. 1, 2007. The nature of LLCs may make it impossible to know who owes the taxes.
"Those entities are often dissolved immediately after the sale of the asset," he said.
Second, said Duncan Ogilvie, of Miller, Canfield, Paddock & Stone's Ann Arbor office, the tax isn't so much a transfer tax as it is a recording tax.
That, in turn, poses two problems for commercial real estate held in an LLC. One problem is that the deed to the real estate isn't transferred, so there is nothing to record with the register of deeds. Such recording normally triggers the seller's responsibility to pay the tax.
The other problem is that no law requires anyone to transfer a deed and record it.
"Most people do, of course, to protect themselves. But you could buy a house and never record the deed, and you'd never pay the tax," Ogilvie said.
The bill was tied to a package of 13 "rammed through" the House and Senate on the last day of the 2008 legislative session, said Kim Rhead of Lansing lobbying firm Karoub Associates, which, on behalf of the State Bar of Michigan's real property section, worked against changing the law.
Most of 13 bills included changes to the Michigan Business Tax.
"What we were hearing," Rhead said, "is that the only way any of those 13 bills were going to get passed is if all of them got passed."
Lawmakers didn't have the time to identify all problems with the bill before the end of the December 2008 session, and even the bills's sponsor, former state Rep. Steven Bieda, D-Warren, acknowledged that some of the language in the bill is too vague.
For example, Bieda said he hadn't considered that there is no recording instrument, such as a deed, to file when an LLC changes ownership. The bill stated that when the instrument is recorded, the tax must be paid within 15 days.
"There may be a necessity to look at the bill again to clarify some of the definitions," he said, adding that the state's term-limit law prevented him from seeking re-election.
One thing he was aware of was the retroactive date, which he said was a compromise with Treasury, which wanted the effective date to reach back four years.
The other problems with how LLC transactions are to be recorded will be sorted out, and Treasury will issue guidance soon, said Glenn White, administrator of the tax policy division.
He stressed that the state will require the transactions to be recorded. And for now, he said, "If you want to be prudent, record the contract with the register of deeds," which he acknowledged has never been required in the history of Michigan tax law.
The law change was proposed by the Department of Treasury. Officials with the department met with representatives from Michigan Association of Realtors to determine the bill's language, said Scott Schrager, Michigan Department of Treasury director of legislative affairs.
"The bill came about because we were seeing a lot of advertisements on the Internet by attorneys who were marketing a tax-avoidance strategy," Schrager said.
The strategy advertised was to use the LLC to sell real estate.
While Schrager was noticing the advertising, Bieda was working on getting some reductions to the Michigan Business Tax, and in particular was trying to reduce the amount of the Michigan Business Tax paid by real estate brokers.
Bieda said officials in the Department of Treasury approached him about ending the practice of the last-minute drop-down of real estate into a limited liability company prior to sale.
"They talked to me because they saw this as an emerging problem," Bieda said. "They wanted to close the loophole before too many people had a chance to go through it."
Bieda said he was focusing on bigger issues with the Michigan Business Tax while details on the transfer tax bill were being hammered out, so he let Treasury take the lead in meetings with the Realtors.
Schrager said there were three such meetings as well as two public hearings at the time the bill was introduced.
But he acknowledged that the department did not specifically ask other groups to propose the bill's language.
Other groups, such as tax attorneys and real property attorneys are "free to interject themselves in the process at any time," he said. "We met with who we were asked to meet with. It's not our party to invite people to. I will tell you there is frequently legislation that is adopted and groups aren't invited to provide input."
But the partnership between the Department of Treasury and the Realtors has some wondering if the Realtors threw commercial property sellers to wolves to get a tax break for themselves.
"This bill is a revenue-raiser to offset the Michigan Business Tax cuts Bieda was working on," Kennedy said. The cuts, Bieda said, were a reduction in the tax real estate brokers pay.
Bieda said that some people in the real estate and development community in Michigan think they've been unfairly targeted by the state's taxation changes. That wasn't the intent of his bill.
"We weren't trying to go after deep pockets," Bieda said. "What we were going after were the people who were avoiding paying the same tax as everyone else."
To view the bill online, go to www.legislature.mi.gov/documents/2007-2008/publicact/htm/
Source: Michigan Lawyers Weekly