The diverse use of trusts is represented in a recent case from the federal Fifth Circuit Court of Appeals. In Gale v. Carnrite, 559 F.3d 359 (5th Cir. 2009), the dispute involved tax liabilities arising from the sale of membership interests in a Nevada limited liability company. The underlying facts were as follows:
In 1999, Gale expressed interest in purchasing a condominium unit located in San Jose Del Cabo, Baja California Sur, Mexico. The condominium was owned by Villa Rayos Del Sol, LLC, a Nevada limited liability company.
After inquiring about the purchase, the Gales learned that legal restrictions affected the transaction. Specifically, as explained in the decision, “under Article 27 of the Constitution of Mexico, only Mexicans by birth or naturalization or Mexican companies may acquire direct ownership of lands or waters within the zone of 100 kilometers along the frontiers and 50 kilometers along the shores of the country.”
The condominium unit was located within such a restricted area. In order to proceed with the purchase, the Gales were informed that they could not acquire the condominium directly. Per the decision, “Instead, they would be required to purchase the outstanding membership interests in the limited liability company (Villa Rayos), which was the beneficial owner of the leasehold interest in the condominium under a Mexican Bank Trust arrangement known as a “fideicomiso.”
The court explained that “a fideicomiso is a property-ownership arrangement complying with Article 27 of the Mexican Constitution under which a Mexican Bank Trust obtains legal title to a piece of real property within the prohibited zone, and a foreigner, as the beneficiary of the trust, enjoys the beneficial interest in the property, including all the usual rights of ownership.”
The limited liability company’s sole asset was the beneficial interest in the condominium. The only purpose of the limited liability company was to serve as the beneficiary of the fideicomiso.
As to the history of the entity, “Villa Rayos was formed in 1996. Its original members and owners were the Sonenshine Family Trust. [The Sonenshines] previously purchased the beneficial interest in the fideicomiso from the condominium’s developer in 1991 for $715,000, and subsequently transferred the beneficial interest [in the condominium to the limited liability company] in 1996. In February 1999, [defendant] Carnrite purchased all of the outstanding membership interest in [the limited liability company] for $1,725,000.”
In December 1999, the Gales purchased all of the membership interests in the limited liability company from defendant Carnrite. The purchase price was $2,125,000. The seller warranted that at the close of escrow, “the LLC has and will have no liabilities of the any nature, including without limitation tax liabilities due or to become come due.”
The sale closed in January 2000. “Neither [the seller] nor anyone else reported the transaction to the Mexican government; no Mexican income or capital gains taxes were paid on the transfer.”
In September 2005, the Gales sold their interest in the limited liability company to a third party for $2,400,000. According to the case, “a substantial Mexican capital gains tax liability resulted, determined by using the basis of the fideicomiso from 1991.”
The trial court found that the seller breached the warranty made to the Gales in 1999, on the grounds that “at the time of closing, Villa Rayos had a built-in capital gains tax liability equal to the difference between the Gales’ purchase price and the original adjusted basis.” At trial, experts presented evidence regarding interpretation of the Mexican tax code.
The court of appeal reversed the decision, holding in favor of the seller. The court assumed that (i) the 1999 transaction was a taxable event and (ii) “any tax liability initially fell on [defendant] Carnrite.” The question addressed by the court of appeal was “whether, under Mexican law, the LLC was obligated to pay taxes on the 1999 transaction.”
In holding for the defendant, the court held that “the Gales did not show that [the seller’s] failure to pay such taxes resulted in a liability for [the limited liability company].”
The focus of the appellate decision was whether the individual defendant’s “failure to report or pay taxes on the transfer created a tax liability for [the limited liability company].” Explained the court, “both under [the experts’] analysis and the language of the [contract] itself, the individual defendants’ failure to pay resulted in a tax liability for the Gales (the buyer), not [the limited liability company].”
The court further explained that, “the warranty provision covered only the tax or other liabilities of the LLC. [However, limited liability company] was neither the buyer nor the seller in the transaction. The 1999 transaction altered the ownership of the membership interest of Villa Rayos, but there is no factual or legal basis shown by this record that [the limited liability company, i.e.,] Villa Rayos itself became liable for anything or that it would become liable at the default of others.”
The court added that, “by contrast, in 2005 transfer, [the limited liability company] itself sold the beneficial interest in the fideicomiso to [the new purchaser. In the disputed transaction], Villa Rayos was the seller.”
The court concluded that, “the seller provided a warranty that the asset being transferred did not itself have any liabilities. If the act of transferring created liabilities or passed on a pre-existing liability of the seller, that risk was not covered by the warranty.
“A warranty that the buyer was not getting any liabilities of any nature from any source would be a valuable one. We conclude, though, that this war they did not provides comprehensive protection. Because Carnrite’s failure to pay taxes for 2000 is the only breach the Gales allege, Carnrite is entitled to judgment on the breach of contract claim.”
The decision seems to apply a narrow interpretation of contract law. However, it illustrates the thorny tax issues that can arise when trust assets are transferred.