Tax Implications of Board Actions - Miller & Miller

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Joel E. Miller, Partner, Miller & Miller. Should an apartment corporation enter into a major financial transaction without considering the tax consequences?

BACKSTORY A smallish New York city housing co-op received a too-good-to-refuse (it seemed) offer from a developer that wanted to buy its building, and it decided to sell. It then did the following, in this order: (1) it demanded a somewhat higher price from the buyer; (2) when the buyer agreed, it hired a real estate lawyer, for an extremely modest fee, making it clear that his role was to be solely to write up the deal; (3) it entered into the straightforward contract that he prepared; and (4) it told its accountant what it had done. The accountant got very upset. Did they not realize, he asked, that a truly enormous income tax would be incurred if the deal went through as written? There would be two levels of tax. First, the corporation itself would be taxed on the gain on the sale, and in view of the corporation’s very low tax basis in the building, the gain would amount to almost all of the selling price. And, there being no special capital gains rate for corporations, the combined federal, state, and city net rate would be very close to 50 percent.

Then there would be a second tax to be paid by the shareholders when the corporation gave out whatever it had left. The rate at which the shareholders would have to pay would be relatively low, it is true, but that would be of small comfort to them if almost half of the selling price had already been dissipated. The accountant then suggested that the co-op go back to the developer and ask if it would be willing to buy all of the corporation’s outstanding shares from the shareholders instead of buying the building from the corporation. If that could be done, there would be only one level of tax, i.e., on the shareholders at the relatively low rate. The savings would be huge.

The co-op did go to the developer, but the developer, being aware of the tax burden that would fall on it (when it took the property out of the corporation), was unwilling to make the change. It already had a binding contract. The co-op then sought to escape by simply refusing to deed the property over, but the developer went to court, and the co-op was ordered to honor the agreement that it had signed. It finally did so, thereby incurring the income tax burden that its accountant had warned about. At that point, the co-op sued the real estate lawyer, who, in turn, called in his malpractice insurance company. That is where I came in. The insurance company’s lawyers retained me to advise them about the income tax aspects of the deal that was done as well as what the tax results likely would have been under other structures that might have been adopted.

It turned out that my expertise was not needed. The real estate attorney had - wisely - insisted on a retainer agreement that spelled out what he was being engaged to do, and that agreement said very plainly that he was not giving any tax advice. That did not matter, said the co-op. It was malpractice, the co-op said, for its lawyer to allow it to sign a contract without having first received competent tax advice (a proposition that, if accepted, would be rather beneficial for people in my line of work). However, the court, quite understandably, did not see it that way, and threw out the co-op’s suit.

COMMENT The moral of the story is that it is just plain foolish for a co-op – or anyone else, for that matter – to commit to a dollar-significant transaction without first looking into the potential consequences, tax and otherwise. Perhaps the contemplated deal should be left undone. Perhaps a better way might be found. As it happens, a provision added to the Internal Revenue Code in 1988 especially for qualified “cooperative housing corporations” might have been utilized by the co-op in our story to achieve the desired result at a fraction of the income tax cost, and at little additional expense to itself and none to the purchaser.

It is a shame that the co-op chose to proceed on its own, with unfortunate consequences for all concerned. Income tax rules can be tricky, and the above is a good example of that. In this case, the following three things came into play, which, for whatever reason, real estate lawyers generally seem to be unaware of: (a) the high income tax rate applicable to corporations, (b) the existence of the rule that a corporation that distributes property to its shareholders thereby incurs an income tax just the same as if it had sold the property at its fair market value, and (c) the existence of the above-mentioned special code provision for cooperative housing corporations. As with any technical subject, there is no substitute for obtaining guidance from someone well versed in the area.

From the Desk of JEM:

4+

Number of years I have been negotiating a (still unfinished) dispute over building control.

17: Number of aquariums full of fish that I have acquired over the years.