TAM 1027045: Retail store sale-leasebacks produced ordinary results, while tenant allowances were reimbursements

Plain-English summary

This Technical Advice Memorandum addresses a specialty retailer that constructed stores and either sold them to investors with a leaseback or built them on leased land. The IRS treated the Ground Owned transfers as sales under section 1001, rather than financing transactions. It treated the tenant improvement allowances in the Ground Leased transactions as reimbursements for landlord-owned improvements, not as purchase payments for a sale, so the taxpayer could depreciate its unreimbursed costs. The retailer held the Ground Owned stores primarily for sale to customers in its ordinary business, making the resulting gains and losses ordinary rather than capital under section 1221(a)(1). The conclusions depend on the facts and transaction structures described in the memorandum.

Ruling snapshot

• Question: How should the retailer's Ground Owned and Ground Leased store transactions be treated for sales, depreciation, and capital-gain purposes?
• Outcome: mixed
• Key authorities: IRC §§ 1001, 110, 1221, 165, 167, and 168; Frank Lyon Co. v. United States; Grodt & McKay Realty, Inc. v. Commissioner; In re: Elder-Beerman Stores, Corp.

Full text (IRS public release)

                        INTERNAL REVENUE SERVICE
              NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                            March 15, 2010

                                                  Third Party Communication: None
                                                  Date of Communication: Not Applicable

Number: 201027045
Release Date: 7/9/2010
Index (UIL) No.: 1221.00-00, 1001.00-00
CASE-MIS No.: TAM-127287-09

Director

     Taxpayer's Name:                            ------------------------------------------------------
     Taxpayer's Address:                         ----------------------------
                                                 ----------------------------------
     Taxpayer's Identification No                ----------------
     Year(s) Involved:                           ---------------------------------------
     Date of Conference:                         --------------------------

LEGEND:

Taxpayer ------------------------------------------------------
A ----
B ----

ISSUE(S):

1. Whether the Taxpayer’s transfers of retail buildings in Ground Owned
   transactions and in Ground Leased transactions qualify as sales under § 1001 of
   the Internal Revenue Code so that Taxpayer recognizes gain or loss.

2. Whether the Taxpayer held certain retail buildings primarily for sale to customers
   in the ordinary course of its trade or business under § 1221(a)(1) so that sale of
   the retail buildings resulted in ordinary, not capital, gain or loss.

CONCLUSION(S):

1. The Taxpayer’s transfers of retail buildings in Ground Owned transactions qualify
   as sales under § 1001 and result in gain or loss. The Taxpayer’s transfers of

TAM-127287-09 2

  retail buildings in Ground Leased transactions do not qualify as sales. Instead,
  the tenant improvement allowances received by Taxpayer from landlords in these
  transactions represent reimbursements for costs incurred by Taxpayer for
  leasehold improvements to be owned by the landlords. To the extent Taxpayer
  has incurred costs that exceed the tenant improvement allowance received from
  a landlord for a particular retail building, Taxpayer has a depreciable interest in
  the retail building.

2. Taxpayer held the retail buildings sold in Ground Owned transactions primarily
  for sale to customers in the ordinary course of its trade or business under
  § 1221(a)(1), and the sale of these retail buildings resulted in ordinary, not
  capital, gain or loss.

FACTS:

Taxpayer is a specialty retailer of consumer electronics, home office products,
entertainment software and related services. Taxpayer operates retail stores
throughout the United States. The majority of Taxpayer's retail stores are self-
constructed in either a “Ground Owned” or “Ground Leased” transaction. Four
representative transactions were submitted to the national office for review. Three
transactions are Ground Leased transactions and one is a Ground Owned transaction.

Ground Owned Transactions

In a Ground Owned transaction, Taxpayer owns the land upon which it constructs a
building. Following construction and an appraisal, Taxpayer transfers title to the land
and the building to an institutional investor for cash consideration. Taxpayer then
leases back the property, generally for a term of 22 years, with two ten-year renewal
periods at Taxpayer’s option. Rent for the renewal terms is pre-determined and
substantial.

Ground Leased Transactions

In a Ground Leased transaction, Taxpayer leases land from a landlord (typically a
shopping center developer) and constructs a building to be used by Taxpayer as a retail
store (“the leasehold improvement” or “retail building”). Upon completion of the
leasehold improvement, the landlord is obligated to pay Taxpayer a “Tenant
Improvement Allowance” ("TIA"). Following construction of the leasehold
improvements, the landlord leases the land and leasehold improvements to Taxpayer
for a term substantially similar to those common under the Ground Owned scenario.

The amount of the TIA is negotiated by Taxpayer and the landlord prior to construction
of the leasehold improvement. While the amounts paid Taxpayer in Ground Owned
transactions were based on independent third-party appraisals, no appraisals were
TAM-127287-09 3

performed as part of the Ground Leased transactions. Rather, the amount of the TIA in
these transactions reflected the relative bargaining strengths of Taxpayer and its
landlord, with the projected cost of leasehold improvements providing a starting point for
negotiation.

The TIA generally is paid to Taxpayer after the leasehold improvements are
constructed, title to the improvements is transferred to the landlord, and the Taxpayer
provides proof that all contractors have been paid. If a landlord fails to pay any portion
of the TIA, the lease agreement permits Taxpayer to withhold or reduce rent until the full
amount of the TIA is paid. Generally, the amount of the TIA in Ground Leased
transactions is less than the amount expended by Taxpayer to construct the leasehold
improvements.

LAW AND ANALYSIS:

Issue One

Whether the Taxpayer’s transfers of retail buildings in Ground Owned transactions and
in Ground Leased transactions qualify as sales under § 1001 so that Taxpayer
recognizes gain or loss.

Ground Owned Transactions

In the case of Ground Owned transactions, Examination’s position is that the sale-
leaseback transactions are in substance financings, not sales, because the term of the
leaseback to Taxpayer exceeds the useful life of the property.

In applying the doctrine of substance over form, courts look to the objective economic
realities of a transaction rather than to the particular form the parties may have
employed. Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978). Within the field
of taxation, the courts are concerned with "substance and realities, and formal written
documents are not rigidly binding.” Helvering v. Lazarus & Co., 308 U.S. 252, 255
(1939).

A lease agreement that transfers all of the benefits of ownership of personal property to
the lessee for substantially the entire useful life of the property is considered a sale (i.e.,
the transfer of equitable ownership). See, e.g., Rev. Rul. 55-540, 1955-2 C.B. 39; Rev.
Rul. 55-541, 1955-2 C.B. 19. Where the transaction involves a sale-leaseback, support
exists for recharacterizing the transaction as a financing. See, e.g., Rev. Rul. 72-543,
1972-2 C.B. 87 (transfer of title to a vessel followed by 21-year charter back to seller for
rent sufficient to repay acquisition and reconstruction costs plus accrued interest
recharacterized as a financing arrangement.)
TAM-127287-09 4

Where real property is subject to a sale and leaseback, courts have sometimes recast
the transaction as a financing arrangement. However, in such cases, a comparison of
the length of the lease term to the estimated useful life of the real property is only one of
a number of factors considered in making the determination of whether or not to respect
the form of the transaction. See, e.g., Helvering v. Lazarus, supra (Court
recharacterized purported transfer of ownership and 99-year leaseback as a mortgage
and noted that lease obligations of taxpayer were structured to repay amount advanced
to taxpayer.).

In the case of Ground Owned transactions, the facts do not support Examination’s
position that the leaseback term exceeds the useful life of the leasehold improvements.
The sale-leaseback transactions here entail both land and leasehold improvements.
Land, however, does not have finite useful life. Further, the lease agreements generally
provide for two ten-year renewal terms following an initial 22-year term. Rents for the
renewal terms are predetermined but substantial. If Taxpayer does not exercise its
renewal rights, the leasehold improvements revert to the landlord, who has certain
remarketing rights. These facts evidence that the useful life of the property extends
beyond the initial lease term. We are not aware of any other facts that would support
treating the Ground Owned transactions as financing arrangements. Accordingly, we
conclude that the Ground Owned transactions are sales for Federal income tax
purposes.

Ground Leased Transactions

In the Ground Leased transactions, Examination’s position is that Taxpayer may
depreciate its unreimbursed leasehold improvement costs over the specified recovery
period of the improvements. Taxpayer’s position is that it may deduct these costs in full
under § 165 in the year the improvements are transferred to a landlord. Taxpayer’s
theory is that it sold the leasehold improvements to developers in exchange for the
TIAs, and that the leasehold improvements had a basis equal to the total cost of the
improvements (including both costs reimbursed through the TIA and Taxpayer’s
unreimbursed costs). Taxpayer concludes that it realizes gain (or loss) to the extent a
TIA is more (or less) than the total cost of the improvements.

   General rules regarding depreciation of leasehold improvement costs

Section 167(a) provides that there shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear, and obsolescence of property
used in the taxpayer's trade or business. Section 1.167(a)-4 of the Income Tax
Regulations provides that capital expenditures made by a lessee for the erection of
buildings or the construction of other permanent improvements on leased property are
recoverable through allowances for depreciation or amortization.
TAM-127287-09 5

The depreciation deduction for tangible property placed in service after 1986 generally
is determined under § 168. Section 168(i)(8)(A) provides that buildings erected (or
improvements made) on leased property are determined under the provisions of § 168.
A commercial building generally is classified as nonresidential real property under
§ 168(e)(2) and is depreciated using the straight-line method of depreciation, mid-month
convention and a 39-year recovery period under § 168(b).

Case law both supports this general principal that a lessee depreciates leasehold
improvements and clarifies that the party entitled to depreciate property is not
necessarily the party with title to the property but rather the party who has invested in
the property and thereby acquired a depreciable interest. See Gladding Dry Goods Co.
v. Commissioner, 2 B.T.A. 336, 338 (1925) (the right to take a depreciation deduction
for leasehold improvements is based on the capital investment in the property and not
on legal title); Hopkins Partners v. Commissioner, T.C. Memo. 2009-107 (legal title and
the right of possession are not determinative).

If a lessor makes improvements at the lessor’s own expense, the lessor is entitled to
depreciation deductions even though the lessee has the use of the improvements.
Gladding Dry Goods, 2 B.T.A. at 338-339.

    Leasehold improvement costs and tenant improvement allowances

Case law addresses how the foregoing rules regarding recovery of leasehold
improvement costs apply when a lessor pays a lessee a tenant improvement allowance.
In re: Elder-Beerman Stores, Corp., 207 B.R. 548 (S.D. Ohio 1997), is a bankruptcy
court decision involving transactions similar to those at issue here. Taxpayer, a retailer,
had agreed to contract for the construction of leasehold improvements, and a shopping
center developer, as lessor, had agreed to pay a tenant improvement allowance.
Taxpayer and the developer had “mutual rights of approval” over construction plans.
The amount of the tenant improvement allowance was the result of negotiation, but the
taxpayer based its negotiations on the construction budget. “[P]ayment of each tenant
allowance was tied to the completion of the entire store or to the completion of different
stages of the construction process.” Id. at 553. Prior to payment, developers wanted
“clean” title and required “lien waivers” from contractors.

The court held that the tenant improvement allowances were reimbursements by the
developers for improvements the developers would own as lessors: “[T]he transactions
will be respected as structured by the parties. Elder-Beerman and the developers
unambiguously entered into lease agreements in which Elder-Beerman constructed the
stores for the developers. The tenant allowances were basically reimbursements of
those construction costs.” Id. at 557.1 The court further noted that to the extent the
1
The Elder-Beerman court noted that its conclusion is consistent with the position taken by the Service in
a Coordinated Issue Paper on Tenant Allowances to Retail Store Operators (issued October 8, 1996 (the
"ISP Paper") and reprinted at Daily Tax Reporter No. 196 (BNA)). The ISP paper addresses the tax
TAM-127287-09 6

retailer was not fully reimbursed, it had a depreciable interest: “To the extent the tenant
allowances did not provide a complete store, Elder-Beerman had to invest its own
capital in the stores. Regardless of which party might be considered to legally own such
additional property, Elder-Beerman is deemed to own the property, for tax purposes.”
Id. at 557. “When Elder-Beerman did commit its capital to the store, it rightfully
depreciated those amounts representing the consumption of that capital. See Treas.
Reg. § 1.167(a)-4.” Id. at 556.

Congress also has addressed the proper tax treatment of tenant improvement
allowances. The Taxpayer Relief Act of 1997 (the Act) added a safe harbor in § 110 of
the Code whereby it is assumed that a construction allowance is used to construct or
improve lessor property (and is properly excludable by the lessee) when long-lived
property is constructed or improved and used pursuant to a short-term lease. The Act
provides a reporting requirement to ensure that the lessee and the lessor consistently
treat the property funded with the construction allowance as nonresidential real property
owned by the lessor. H.R. Rep. No. 148, 105th Cong., 1st Sess. 423, 424 (1997)
(House Report); S. Rep. No. 33, 105th Cong., 1st Sess. 232-33 (1997) (Senate Report).

The legislative history of the Act states that no inference is intended as to the treatment
of amounts that are not subject to the safe harbor provision. In such cases, the
provisions of the ISP paper and present law (including case law) will continue to apply.
H.R. Conf. Rep. No. 220, 105th Cong.,1st Sess. 658-59 (1997). The legislative history
also contains the following statement:

    The [Senate] committee [on finance] understands that it is common
    industry practice for a lessor to custom improve retail space for the use by
    a lessee pursuant to a lease. Such leasehold improvements may be
    provided by the lessor directly constructing the improvements to the
    lessee's specifications. Alternatively, the lessee may receive a

consequences to an anchor store upon its receipt of a cash tenant allowance from a shopping center
developer in conjunction with entering into a lease. The ISP Paper concludes that if the anchor store can
be found to own the leasehold improvements funded with the tenant allowances under the ownership test
set forth in Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981), then the anchor store has
an accession to wealth and the cash received from the developer is includible in its gross income. The
ISP paper recognizes that any amounts received from the landlord and expended by the tenant on assets
owned by the landlord cannot be characterized as income to the tenant.

See also John B. White, Inc. v. Commissioner, 55 T.C. 729, 735 (T.C. 1971):

White's contention that the incentive payment is not income rests upon an analogy which it has attempted
to draw between the facts of this case and situations where a lessee has been reimbursed or has a right
of reimbursement against a lessor for expenses which the lessee has incurred for improvements made
upon the leased property. In such cases, it has been held that since the lessor is ultimately liable for the
expenditures in question, the expenditures are not deductible or depreciable by the lessee. See, e.g.,
Levy v. Commissioner, 212 F. 2d 552 (C.A. 5), affirming a Memorandum Opinion of this Court; 379
Madison Ave., Inc., 23 B.T.A. 29, 41-42, rev’d on other grounds, 60 F. 2d 68 (C.A. 2).
TAM-127287-09 7

  construction allowance from the lessor pursuant to the lease in order for
  the lessee to build or improve the property. The [Senate] committee [on
  finance] believes that the tax treatment of lessors and lessees in either
  case should be the same.

S. Rep. No. 33 at 232. The “tax treatment” that Congress sought to preserve in the
case of tenant improvement allowances is for the lessor to depreciate its investment
(whether made directly or in the form of a tenant improvement allowance) and for the
lessee to depreciate its unreimbursed costs.

  The Ground Leased Transactions are not Sales

Taxpayer’s proposed recast of the Ground Leased transactions frustrates the purpose
of § 168(i)(8)(A) and § 1.167(a)-4, implies a tax treatment inconsistent with
Congressional intent underlying § 110, and conflicts with applicable case law (including
Elder-Beerman). These authorities contemplate that a lessee recovers its
unreimbursed leasehold improvement costs through depreciation deductions, not as a
loss under the theory that improvements have been “sold” immediately upon completion
for less than their cost.

While we are not prepared to conclude that there could never be a case in which the
law would respect a purported sale of leasehold improvements, in this case neither in
form nor in substance did Taxpayer sell leasehold improvements. The operative
documents refer to the TIAs as “reimbursements,” and in at least some cases amounts
were paid as Taxpayer obtained lien waivers from its contractors by paying construction
costs. This is consistent with characterizing the TIAs as reimbursements to Taxpayer
for the costs of landlord-owned property.

Furthermore, the lease provisions governing early terminations by the landlord and
condemnations of the leased property provide for payment to Taxpayer of the
“unamortized cost of leasehold improvements.” This indicates that Taxpayer had a
continuing investment in the leasehold improvements. These provisions, which require
that Taxpayer be compensated for the cost of leasehold improvements upon the
occurrence of specified events, are impossible to reconcile with Taxpayer’s theory that it
sold the improvements to its lessors and is entitled to loss deductions for its
unreimbursed costs.

The Taxpayer cites the factors from Grodt & McKay Realty as support for its view that
tax ownership of the leasehold improvements transferred from Taxpayer to the landlord
in return for its payment of the TIA. However, as the court in Elder-Beerman pointed
out, in the context of tenant improvement allowances, these factors are used for
determining which party owns the leasehold improvements, not for whether a “sale” of
the leasehold improvements has taken place.
TAM-127287-09 8

We conclude that the Ground Leased transactions are not sales. Rather, Taxpayer and
Taxpayer’s landlords, pursuant to § 168(i)(8)(A), must depreciate their respective
investments in the leasehold improvements. Where the landlord paid Taxpayer a TIA
that partially reimbursed Taxpayer for its leasehold improvement costs, Taxpayer has a
depreciable interest in the leasehold improvements in an amount equal to the difference
between Taxpayer’s costs and the amount of the TIA. Landlord has a depreciable
interest in the leasehold improvements in an amount equal to the TIA paid to Taxpayer.

Issue Two

The second issue is whether Taxpayer held certain retail buildings primarily for sale to
customers in the ordinary course of its trade or business under § 1221(a)(1) so that the
character of any gain or loss on their disposition is ordinary rather than capital.
Because we have concluded that the Ground Leased transactions are not sales, the
following discussion applies only to the Ground Owned transactions, which we have
found to be sale-leasebacks.

Section 1221(a) provides that the term “capital asset” means property held by the
taxpayer (whether or not connected with his trade or business) except in eight specified
situations. The specified exception at issue is:

   (1) Stock in trade of the taxpayer . . . or property held by the taxpayer primarily
       for sale to customers in the ordinary course of his trade or business.

Whether the Ground Owned stores were held by Taxpayer primarily for sale to
customers in the ordinary course of its business is primarily a question of fact. The
determination must depend upon a consideration of all the factors and circumstances
surrounding the relevant transaction in relation to the conduct of Taxpayer’s business.
See Lawyers Title Company of Missouri v. Commissioner, 14 T.C. 1221 (1950), acq.,
1950-2 C.B. 3.

Congress intended that capital asset treatment be an exception to the normal
requirements of the Internal Revenue Code and that the profits generated by everyday
business operations be ordinary income. The Supreme Court in Arkansas Best
Corporation v. Commissioner, 485 U.S. 212 (1988), held that the general definition of
the term “capital asset” encompasses all property not within the exclusions of
§§ 1221(1)-(5). Further, the courts have given the statutory exceptions to capital asset
treatment a broad interpretation and narrowed the capital asset classification. Guardian
Industries Corp. v. Commissioner, 97 T.C. 308, 315-16 (1991), aff’d, 73 A.F.T.R.2d
(RIA) 1903 (6th Cir. 1994).

The controlling factor in determining the character of the gain or loss from the Ground
Owned transactions is the purpose for which the stores were held, determined as of the
time of sale. This determination is based on the Taxpayer’s method of operation and
TAM-127287-09 9

the standards customary in its line of business. Guardian Industries, supra at 316. In
order for a sale of property to be classified as ordinary, sale to customers in the ordinary
course of business must be of first importance or the principal reason that property is
held. Malat v. Riddell, 383 U.S. 569, 572 (1966)

Taxpayer represents that its primary business was the sale of electronics. The
construction details of Taxpayer’s stores (and the locations of those stores) were critical
to its retail electronics business. In its business judgment, Taxpayer needed a store
that was configured in a certain fashion and that had certain features designed to
facilitate the sale of electronics. To meet these needs, Taxpayer adopted the following
business model: select a location, construct the store, find a purchaser for the store,
and sell the store with a lease back. It constructed and sold with a lease-back
approximately A stores per year. While these stores were sold for their appraised
value, Taxpayer sold approximately B% of the stores at a loss. The stores were sold at
a loss because of increased costs due to rapidly constructing the stores, store features
that were of value to Taxpayer but not necessarily to other retailers, and the rapid sale
and lease back of the stores. In Taxpayer’s judgment, this business model kept capital
free to continue to select locations and build stores, rather than having capital tied up in
existing stores.

Based on all the facts and circumstances, we conclude that the sale-leaseback of
Ground-Owned stores was a necessary incident to the conduct of Taxpayer’s business
and that the stores were held primarily for sale to customers in the ordinary course of
Taxpayer’s business. Accordingly, the resulting gains and losses are ordinary, not
capital.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.