Flip Tax Fracas

Two attorneys contacted me a couple of months ago. Toward the beginning of August 2008, their clients had both sold their cooperative apartments (technically, of course, their stock in the cooperative and the appurtenant proprietary leases) at a Brooklyn building and were required to pay the corporation at closing, respectively, $10,350 and $8,850 in flip taxes, or transfer fees. Their attorneys were notified of this requirement late – in one case, only a day before closing. These sums represented three percent of the sales prices.

The annual shareholders meeting of the corporation had been held the month before these closings, immediately followed by a meeting of the new board of directors. At that gathering according to minutes distributed later by the managing agent, the board resolved that, “Effective immediately, a flip tax of three percent of gross sales price will be levied on all apartment resales. Said flip tax to be collected at closing.” The clients were already in contract at the time of the board resolution and had been previously told, in writing, during the period of their attorney’s due diligence, that there was no flip tax.

The clients’ attorneys contacted the corporation immediately following the closings and requested proof that the transfer fees were validly implemented. (The issue of the clients having already been in contract at the time of the resolution was never raised, although it certainly could have been prior to any settlement.) Toward the end of August, the corporation’s attorney responded with a copy of those July minutes and noted, “There is nothing in the bylaws or the proprietary lease prohibiting the imposition of a flip tax. The board has amended the bylaws to provide for a flip tax.” It has never been specified, however when the board amended the bylaws and no proof has ever been received that the bylaws were, in fact, ever so amended.

But would it have made a difference? Doesn’t every cooperative attorney know that a valid transfer fee requires an amendment of the proprietary lease – requiring a shareholder vote – unless otherwise provided in the offering plan or a pre-conversion amendment thereto?

On May 2, 2008, Judge Cynthia Kern of the New York County Civil Court rendered her decision in Andrew Weigel vs. 30 West 15th Street Owners Corp. In that case, Judge Kern concluded that “the cooperative…was allowed to impose the transfer tax by properly amending its bylaws as there was nothing in the proprietary lease or offering plan which prohibited the imposition of a transfer tax or was inconsistent with the imposition of a transfer tax.”

Judge Kern’s conclusion – that a transfer tax (or “flip tax”) commonly charged by a cooperative to a selling shareholder as a means of raising revenue can legally be put into effect merely by amending the bylaws – came as a surprise. This is particularly so not only because it flies in the face of general understanding of the cooperative legal community of the meaning of the New York State Business Corporation Law (BCL) but also, as an equitable matter, because most bylaws can be amended merely by the board of directors alone (in some cases, by as few as two or three individuals). And transfer taxes are usually hefty financial impositions, often unlike maintenance charges or assessments that are usually calculated on a per share basis.

Controversy over how a valid transfer fee could be enacted took shape with the seminal December 19, 1985 Court of Appeals case FeBland vs. Two Trees Management Co., et al. and its companion case, 330 West End Apartment Corporation vs. Kelly. This case is still the highest authority in this state on transfer fees (also called flip taxes).

These boards had imposed transfer fees based on a percentage of profit. First, the court looked to the corporate documents for specific authority for such an imposition. It looked at language that is extremely common in cooperative bylaws and leases authorizing the collection of “a reasonable fee to cover actual expenses and attorneys’ fees of the Corporation, a service fee of the Corporation and such other conditions as it may determine” in the case of a transfer, as well as “cash requirements” of the cooperative generally. The court determined that the standard general language of these (and most) bylaws and proprietary leases do not provide authority for a transfer fee so easily (they usually require more). And even if the lease provision authorizing collection of a shareholder’s pro rata portion of the cooperative’s “cash requirements” had been such authority, the transfer fees imposed here were not “proportional to the number of shares held by that shareholder in relation to the total number of issued shares, as required by the provision.

Secondly, in FeBland, the court determined that the format of the flip tax as passed, which varied based on whether the selling shareholder was an original purchaser or not, created more than one class of cooperative shares. It noted that, under the Internal Revenue Code, a corporation is entitled to tax benefits as an eligible “cooperative” only, among other requirements, if it has but one class of shares. Further, these cooperatives were authorized by their certificates of incorporation to have only one class of shares. And BCL 501(c) applied, which (then as now) requires each share to be equal to every other share of the same class. The court felt that when the flip tax was not proportional to the number of shares owned by the shareholder, BCL 501(c) was violated (and the cooperative would be disqualified from the significant tax benefits provided by Internal Revenue Code qualification).

Significantly, the court of appeals concluded, “that although under proper circumstances a flip tax which conforms to the requirements of the Business Corporation Law Section 501(c) and of the proprietary lease may be adopted, in the present case (1) neither the bylaws nor the proprietary lease authorizes the imposition by the board of directors of a flip tax …; (2) neither corporation’s resolution can be justified by the cash requirements provisions of its proprietary lease; and (3) although the…board of directors [in FeBland] was authorized by its certificate of incorporation to amend its bylaws, the resolution adopted…whether deemed to have amended an existing bylaw or to have enacted a new bylaw, was invalid because in violation of Business Corporation Section 501(c).”

It appears that the decision meant that (A) a transfer fee had to either be imposed on a per share basis or the law (the BCL) needed to be amended to authorize a transfer fee which was not calculated on a per share basis and (B) the bylaws or proprietary lease had to contain specific authority for the imposition of a flip tax. At the time, however, it is not unfair to say that the real estate bar saw the sole problem in creating a legal flip tax to be the need to amend the BCL to allow a transfer fee on other than a per share calculation.

So, legislation was passed in 1986 amending BCL 501(c) to add, “With respect to corporations owning or leasing residential premises and operating the same on a cooperative basis, however, provided that maintenance charges, general assessments pursuant to a proprietary lease, and voting, liquidation or other distribution rights are substantially equal per share, shares of the same class shall not be considered unequal because of variations in fees or charges payable to the corporation upon sale or transfer of shares and appurtenant proprietary leases that are provided for in proprietary leases, occupancy agreements or offering plans or properly approved amendments to the foregoing instruments.” (The law was further amended in 1996 to apply as well to corporations whose voting rights and calculations of maintenance, etc. are other than a per share basis (e.g., on a per apartment basis).

This seemed pretty clear: where a flip tax was provided for in the proprietary lease or offering plan or plan amendment or an occupancy agreement, transfer fees calculated on other than a per share basis or made inapplicable to a sponsor would no longer violate the equality-of-shares-within-a-class requirement of BCL 501(c). Most everyone in the field then assumed – or took the safe path – and advised their clients that any valid flip tax should be specifically authorized in the proprietary lease or occupancy agreement (requiring shareholder approval) or offering plan or plan amendment.

No one paid too much attention to that part of the court of appeals’ determination that proportional transfer fees, i.e., those calculated on a per share basis, are not required to be contained only in the BCL-enumerated documents (meaning bylaws could be a source of such authority (house rules still seem to be excepted for the moment). But even if this is still true and non-proportional transfer fees could be authorized in proprietary leases, occupancy agreements, offering plans, or properly approved amendments, we would still be hard pressed to understand those subsequent cases that permitted non-proportional transfer fees to be authorized initially and solely by bylaws.

In fact, beginning with the appellate division’s ruling in Quirin vs 123 Apartments Corp., the court of appeals search for authorization in corporate documents for the power of a cooperative to enact a transfer fee was turned on its head. Quirin, for example, concluded, “In the instant matter, the proprietary lease does not specifically exclude the collection of a flip tax, nor does the certificate of incorporation.”

Wait a moment. A normal person understands that if something needs to be authorized, and it isn’t, it is excluded. But to say that if something isn’t specifically excluded, it is authorized is, at the least, a stretch. (This same argument consumed the Federalists and the Anti-Federalists during the drafting of the U.S. Constitution.) As Yogi Berra would have said, include me out.

On January 12, 1988, the same appellate division decided Mogulescu, et al. vs 255 West 98th Street Owners Corp. Like Quirin, the offering plan provided for bylaws containing a transfer fee, here calculated on a declining percentage of profit based on time of sale (that is, it was a disproportional flip tax).

The plaintiffs clearly had read the court of appeals’ decisions carefully and first argued that the transfer fees charged them were invalid under FeBland and 330 West End because of the “absence of specific authority for a transfer fee in the[ir] proprietary lease.” The court redrafted the plaintiffs’ argument against them by writing: “Notwithstanding the fact that the proprietary lease does not exclude the imposition of a transfer fee and, indeed, expressly provides that ‘[t]his lease incorporates by reference, as if the same were set forth herein at length, all the terms of Lessor’s Plan to Convert to Cooperative Owner…as amended prior to the date of this lease.’”

Adherence to the terms of the offering plan is a pretty good argument for upholding this transfer fee. The 1986 BCL amendment after all permits disproportional flip taxes which are contained in offering plans-and this one was, even though it was contained in the bylaws portion of the offering plan.

But the Mogulescu court actually wrote, “The statute [BCL 501(c)(3)], consequently, permits the imposition of a transfer fee which has been validly adopted pursuant to the terms of the offering plan, proprietary lease and bylaws, considered in conjunction with one another, despite the fact that the charges assessed may not be equal per share or that the holders of unsold shares retain certain benefits not available to the other shareholders.”

The statute has never said anything about a flip tax being valid if contained in bylaws. The flip tax here may have been in the bylaws but only because it first originated in the offering plan. Where and how did the court come up with the conclusion that, contrary to the plain language of the statute, a flip tax originating in bylaws was valid?

In the years since FeBland, the cases have been all over the map. But too many have run with the concepts of looking for exclusions of flip tax imposition authority in the corporate documents instead of authorizations.

And many have continued to quote Mogulescu’s unique interpretation of BCL 501(c) to the effect that nonproportional transfer fees may validly appear in bylaws (and why not in-house rules?) despite the clear contrary language of the BCL. The appellate division followed Mogulescu and in 2005 overturned a perfectly reasoned decision of the Westchester Supreme Court in Zilberfein vs Palmer Terrace Co-op Inc.

The New York County Supreme Court grappled with the issue in a March 31, 2008, decision in Pello vs 425 E. 50 Owners Corp. Pello brought suit to void a flip tax imposed by the cooperative’s board of directors in 2005, increased by the board in 2006 (calculated as a percentage of the sales price) and applied to her attempted sale at the end of 2006. The court, immediately misquoting FeBland, stated, “As noted by the Court of Appeals, the imposition of a flip tax is not per se unreasonable or illegal provided that it is neither prohibited by a corporation’s bylaws or proprietary lease, and does not violate the proportionality requirements as mandated by …501(c).” It continued, “…501(c) which generally bars unequal treatment of shares, was specifically amended in 1986 to ‘permit the imposition of a transfer fee which has been validly adopted pursuant to the terms of the offering plan, proprietary lease and bylaws considered in conjunction with one another….” BCL 501(c) says nothing about bylaws.

Pello continued: “Furthermore, a transfer fee such as the one at bar, which is ‘proportional to the profit earned by the assigning shareholder’ will not be held violative of BCL Section 501(c) as long as it is again, authorized by either the corporation’s bylaws or by the proprietary lease ….” Pello holds, in effect, that a transfer fee that is a percentage of profit is actually a proportional transfer fee (contrary to the court of appeals and citing what should have been an irrelevant case dealing with a sublet fee). So very few transfer fee calculations would be non-proportional to this court.

Pello also found that the transfer fee represented a “change to the terms of the proprietary lease…effected indirectly through an amendment to the bylaws.” While this remains difficult to understand, the bottom line is that the Pello court struck down the transfer fee. Happily it had a problem because the alleged bylaw amendment(s) imposing or changing the flip tax had been accomplished through board action. Pello found a conflict where the lease could only be amended by shareholder action. The reasoning is too long and complicated for this article and perhaps illogical but I do like the result.

But I still counsel my clients (as do my partners) to do what the Council of New York Cooperatives & Condominiums expressed in a 2002 article, “Understanding Flip Taxes”: “Thus it has been clear since 1986 that if a flip tax is not part of your cooperative’s organizing documents, the only legal way to enact a flip tax is to amend the proprietary lease.” This, of course, requires shareholder approval. And while I might buy the argument that a dollar per share transfer fee could properly be imposed by a proper amendment of the bylaws alone, I have a problem with a board amendment of bylaws for this purpose (again, then why not use house rules?) and with a percentage of profit calculation being deemed a proportional transfer fee. Now if only all the courts would get together and clearly agree.

My case was settled. The cooperative did the right thing. The case was certainly a losing proposition for them had the bylaws never been amended. And had the bylaws been amended, the cooperative would probably have lost anyway based on how far the sale process had proceeded before such imposition and based on those courts that still understand that FeBland and the BCL require disproportional transfer fees (and include those based on a percentage of sales price as disproportional) to appear in the enumerated documents – and the bylaws are not one of those documents. It is an area of the law which is still developing.

Stay tuned. H

ADDENDUM. There is a June 2008 First Department Appellate Division decision on a board-imposed-flip tax protest which, read alone, is incomprehensible. The 25-page lower court decision (J.H.O. Gammerman) highlights the discrepancy between first and second Department holdings (first department: a nonproportional flip tax may not appear only in the bylaws; second department: it may). While the June 2008 appellate division decision upheld that part of Gammerman’s decision finding the board-imposed flip tax illegal, the reasoning only makes the status of the law even murkier. While the board in this case had the authority to change the transfer fee (provided in the bylaws by an offering plan amendment), the court felt that: (a) any change had to be in an actual bylaw amendment and not just via board resolution and (b) only the fee change applicable to the non-sponsor shareholders was so provided: the fee was also altered with respect to the sponsor but through a settlement agreement. Apparently, this invalidated the entire transfer fee.