Watch Out for State Taxes

Published on: 08:30AM Jun 14, 2012

In my home state of Washington, we have an excise tax for any real estate sales that take place during the year. This tax is usually close to a 2% rate on the gross sales price. For a sale of $1 million of real estate, your excise tax liability is about $20,000.

Many taxpayers had created partnerships to own real estate, and this got even more common when limited liability companies came into existence about 30 years ago. Many of these partnerships and LLCs had 50/50 partners. After a few years of ownership, it was very common for one partner to buy out the other partner. Most taxpayers would feel that this should not trigger an excise tax, but the State of Washington has a rule that says if a controlling interest in an LLC or partnership is transferred in any one-year period, the excise tax is triggered based upon the fair market value of all of the underlying assets.

The state's definition of a controlling interest is a sale of 50% or more. When I look in a dictionary, I do not find 50% considered to be controlling, but for the State of Washington, it is.  This can lead to unexpected, costly consequences for our taxpayers.

Let's consider a 50/50 LLC with one piece of real estate with a gross value of $2 million and debt owed of $1,950,000. One member buys the other member out for $25,000 and reports this on his tax return. He does not file any excise tax return with the state. Suddenly, he gets a nice letter from the Department of Revenue telling him the LLC owes excise tax of about $36,000 plus interest and penalties.

The bottom line is that when you consider structuring transactions for federal and state income tax purposes, you always need to watch out for other state excise, sales or property tax issues.  Many times, these taxes can be substantially higher than income taxes.