PLR 1041034: A TRS structure supports qualifying REIT rental income

Plain-English summary

The IRS ruled on a public real estate investment trust’s proposed restructuring of a commercial facility lease after the existing lessee defaulted and entered bankruptcy. The ruling concludes that the new taxable REIT subsidiary would not be treated as operating or managing the facility because an eligible independent contractor would perform those functions. Rent paid by the new taxable REIT subsidiary to the REIT’s disregarded subsidiary would qualify under the REIT gross-income tests. The ruling also concludes that leases to related operating subsidiaries would not prevent the manager from qualifying as an eligible independent contractor because the lessees were separate entities and the leases were represented to be arm’s length. The IRS expressed no opinion on whether the taxpayer otherwise qualified as a REIT or on other federal income tax consequences.

Ruling snapshot

• Question: Would the proposed taxable REIT subsidiary and independent-contractor arrangement produce qualifying REIT rental income?
• Outcome: Approved
• Key authorities: IRC §§ 856, 856(c), 856(d), 856(e), and 856(l); IRC § 6110(k)(3); Treas. Reg. §§ 1.856-3 and 1.856-4

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201041034
Release Date: 10/15/2010
Index Number: 856.01-00
Person To Contact:
--------------------------------- ------------------------, ID No. ------------
--------------------------------- Telephone Number:
--------------------------------------- ---------------------
------------------------------------------------ Refer Reply To:
-------------------------------------- CC:FIP:B02
PLR-152446-09
Date:
June 17, 2010

              :

Legend:

Taxpayer = -----------------------------------------

Year 1 = -------

Business = --------------

Properties = ------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Year 2 = -------

OP = --------------------------------------------

GP = ----------------------------------------

TRS = -------------------------------------------

LLC 1 = -------------------------------

Facility = ---------------------------------------------------------

Lessee = ------------------------------------------------

Year 3 = -------
PLR-152446-09 2

Date 1 = ------------------

LLC 2 = ---------------------------------

Date 2 = -----------------------------

Date 3 = --------------------------

New TRS = -------------------------------------

a = ---

b = ---

c = -------------

LLC 3 = --------------------------------------------------------

LLC 4 = ---------------------------

d = ---

e = ---

Agreement = ----------------------------------------------------

LLC 5 = ------------------------------------------------

LLC 6 = ------------------------------------

LLC 7 = -----------------------------

LLC 8 = ------------------------------

LLC 9 = ---------------------------------

Dear ---------------:

      This is in reply to a letter dated November 25, 2009, and subsequent

submissions, requesting rulings on behalf of Taxpayer. The requested rulings concern
the operation and management of Taxpayer’s Business Properties for purposes of
sections 856(c)(2) and (c)(3) of the Internal Revenue Code.
PLR-152446-09 3

Facts:

   Taxpayer is a domestic corporation that was formed in Year 1 to invest in, own,

and lease commercial real estate. Taxpayer’s primary business is to acquire and
develop real property and improvements primarily for long-term lease to providers of
Business services such as those provided at the Properties. Taxpayer also makes
mortgage loans to Business operators that are secured by their real estate assets.
Taxpayer elected to be taxed as a real estate investment trust (REIT) on its Year 2
federal income tax return. Taxpayer is a public REIT and to its knowledge no person
owns more than 5 percent of its outstanding stock.

 Taxpayer conducts all of its real estate operations through a limited partnership,

OP. The sole general partner of OP is GP, which is wholly-owned by Taxpayer.
Taxpayer directly owns substantially all of the limited partnership interests in OP.

   Taxpayer owns all of the issued and outstanding stock of TRS. Taxpayer and

TRS have jointly elected to have TRS treated as a taxable REIT subsidiary under
section 856(l). TRS has made loans secured by non-real estate assets to tenants of
Taxpayer’s properties for operating or working capital purposes.

    OP is the sole owner of LLC 1, which is treated as a disregarded entity for federal

income tax purposes. LLC 1 owns certain real estate including the Facility, a Business
property. LLC 1 leased the Facility to Lessee in Year 3. However, due to defaults and
the inability of Lessee to meet its obligations to LLC 1 and other creditors, LLC 1
terminated the lease on Date 1. Lessee then filed for bankruptcy protection and
submitted a Plan of Reorganization (Plan) to the Bankruptcy Court. On Date 2, LLC 1,
Lessee, and LLC 2, an entity that was formed to become the new operator of the
Facility entered into a Term Sheet that contemplated an amendment to the Plan.
Subsequently, on Date 3 the parties submitted the Second Amended Plan of
Reorganization (Amended Plan) to the Bankruptcy Court.

     Upon approval of the Amended Plan the following steps will be taken:

1.       Taxpayer will create a new wholly-owned subsidiary, New TRS, with which it
        will jointly elect to have treated as a TRS of Taxpayer under section 856(l).
2.       LLC 1 will lease the Facility to New TRS under terms similar to those used for
        unrelated lessees.
3.       New TRS will sublease the Facility to LLC 2 on terms similar to the terms of
        the New TRS lease with LLC 1.
4.       In consideration of (i) the costs, expenses, and damages incurred by LLC 1
        as a result of the default by Lessee and the reletting of the Facility, (ii)

PLR-152446-09 4

      Taxpayer’s services in locating a replacement operator, and (iii) the financing
      that Taxpayer or its affiliate is willing to provide to LLC 2, New TRS will
      receive an a percent membership interest in LLC 2. New TRS’s membership
      interest in LLC 2 does not grant New TRS any authority to direct the
      operations or management of the Facility. New TRS’s governance rights in
      LLC 2 only arise in extraordinary circumstances set forth in an operating
      agreement between the members of LLC 2 (Operating Agreement). New
      TRS’s a percent interest in the profits, losses, and distributions of LLC 2 will
      be reduced to a b percent interest in those items if and when New TRS
      receives after-tax distributions of c million dollars from LLC 2.
5.     The remaining d percent equity interest in LLC 2 will be owned by LLC 3,
      which will be owned by LLC 4 and certain other owners. When New TRS’s
      interest in LLC 2 is reduced, LLC 3’s interest in LLC 2 will increase to e
      percent.
6.     LLC 2 will assume Lessee’s Agreement for the Facility and will employ the
      persons providing services at the Facility.
7.     New TRS will provide LLC 2 a working capital loan to be secured by, among
      other things, a first priority security interest in LLC 2’s accounts receivable.
8.     A wholly-owned subsidiary of LLC 4, LLC 5, will manage the Facility pursuant
      to a management services agreement between LLC 2 and LLC 5 for a
      percentage of net revenues. This fee will be subordinated to the rent and loan
      obligations to New TRS. Taxpayer represents that LLC 5 and affiliated
      entities are engaged in the active conduct of the trade or business of
      managing Business facilities and have managed or are managing the
      operation of Business facilities for entities unrelated to Taxpayer or New TRS.
9.     LLC 4 and LLC 5 are owned by persons unrelated to Taxpayer for purposes
      of section 856(d)(8) and section 52(a) and (b). Under the Operating
      Agreement and the management services agreement, all decisions regarding
      the operations and management of the Facility are made by either LLC 5 or
      LLC 3.
10.    Under the Operating Agreement, New TRS, or another person designated by
      New TRS is given the authority to take certain “extraordinary actions”
      following either the delivery to LLC 2 of notice of the occurrence of certain
      material events of default or notice to LLC 2 from Taxpayer of termination of
      the sublease. The “extraordinary actions” include the right to terminate the
      management agreement; the right to remove and replace the general
      manager; and the right to dissolve LLC 2. The “extraordinary actions” do not
      confer on New TRS a right to operate or manage the Facility.

   LLC 4 is owned equally by LLC 6 and LLC 7, who are both in the business of

operating Business facilities. LLC 6 is owned by an individual who also owns a
controlling majority interest in and is the chief executive officer of LLC 8. The owners of
LLC 6 and LLC 7 also own LLC 9. LLC 8 and LLC 9 are privately-held companies that
manage multiple Business facilities in several states through subsidiaries. Through its
PLR-152446-09 5

subsidiaries or OP, Taxpayer currently leases Business facilities to subsidiaries of both
LLC 6 and LLC 7. Taxpayer represents that all transactions between its affiliates and
either LLC 8 or LLC 9 have been negotiated on an arm’s length basis. To Taxpayer’s
knowledge, no owner or affiliate of LLC 8 or LLC 9 owns any Taxpayer stock.

   When LLC 8 or LLC 9 acquire or develop a Business facility, it does so through a

new LLC or subsidiary. These subsidiary entities have their own assets, employees,
suppliers and vendors. Taxpayer represents that the subsidiary entities are separate,
independent operating entities as set forth in their organizational documents. In
addition, Taxpayer represents that all of its existing leases with subsidiaries of LLC 8
and LLC 9 require those entities to form separately organized single purpose
subsidiaries to lease Business facilities from a Taxpayer subsidiary.

Law and Analysis:

  Section 856(c)(2) provides that at least 95 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

  Section 856(c)(3) provides that at least 75 percent of a REIT's gross income

must be derived from, among other sources, rents from real property.

    Section 856(d)(1) provides that rents from real property include (subject to

exclusions provided in section 856(d)(2)): (A) rents from interests in real property; (B)
charges for services customarily furnished or rendered in connection with the rental of
real property, whether or not such charges are separately stated; and (C) rent
attributable to personal property leased under, or in connection with, a lease of real
property, but only if the rent attributable to the personal property for the taxable year
does not exceed 15 percent of the total rent for the tax year attributable to both the real
and personal property leased under, or in connection with, the lease.

   Section 856(d)(2)(C) provides that any impermissible tenant service income is

excluded from the definition of rents from real property. Section 856(d)(7)(A) defines
impermissible tenant service income to mean, with respect to any real or personal
property, any amount received or accrued directly or indirectly by the REIT for services
furnished or rendered by the REIT to tenants at the property, or for managing or
operating the property.

   Section 856(d)(7)(C) provides certain exclusions from impermissible tenant

service income. Section 856(d)(7)(C) provides that for purposes of section
856(d)(7)(A), services furnished or rendered, or management or operation provided,
through an independent contractor from whom the REIT does not derive or receive any
income shall not be treated as furnished, rendered, or provided by the REIT, and there
shall not be taken into account any amount which would be excluded from unrelated
PLR-152446-09 6

business taxable income under section 512(b)(3) if received by an organization
described in section 511(a)(2).

   Section 856(d)(8)(B) provides that amounts paid to a REIT by a TRS shall not be

excluded from rents from real property by reason of section 856(d)(2)(B) when a REIT
leases a qualified lodging facility or qualified health care facility to a TRS, and the facility
or property is operated on behalf of the TRS by a person who is an eligible independent
contractor.

    Section 856(d)(3) defines an independent contractor as any person who does not

own, directly or indirectly, more than 35 percent of the REIT’s shares and, if such
person is a corporation, not more than 35 percent of the total combined voting power of
whose stock (or 35 percent of the total shares of all classes of whose stock) is owned
directly or indirectly, by one or more persons owning 35 percent or more of the shares
of the REIT.

   Section 856(d)(9)(A) provides that the term eligible independent contractor

means, with respect to any qualified lodging facility or qualified health care property, any
independent contractor if, at the time such contractor enters into a management
agreement or similar service contract with the TRS to operate the facility or property, the
contractor (or any related person) is actively engaged in the trade or business of
operating qualified lodging facilities or qualified health care properties for any person
who is not a related person with respect to the REIT or the TRS. Section 856(d)(9)(F)
provides that for purposes of section 856(d)(8) persons shall be treated as related to
each other if such persons are treated as a single employer under subsections (a) or (b)
of section 52.

    Section 856(l) provides that a REIT and a corporation (other than a REIT) may

jointly elect to treat such corporation as a TRS. To be eligible for treatment as a TRS,
section 856(l)(1) provides that the REIT must directly or indirectly own stock in the
corporation, and the REIT and the corporation must jointly elect such treatment.

    Section 856(l)(2) provides that any corporation in which a TRS owns directly or

indirectly more than 35 percent of the total voting power or value of the outstanding
securities shall be treated as a TRS. Section 856(l)(3)(A) provides that a TRS cannot
directly or indirectly operate or manage a lodging facility or a health care facility. A
“healthcare facility” is defined in section 856(e)(6)(D)(ii) as a hospital, nursing facility,
assisted living facility, congregate care facility, qualified continuing care facility (as
defined in section 7872(g)(4)), or other licensed facility which extends medical or
nursing or ancillary services to patients, and which was operated by a provider of such
services that is eligible for participation in the Medicare program under Title XVIII of the
Social Security Act with respect to the facility.
PLR-152446-09 7

  In Rev. Rul. 75-136, 1975-1 C.B. 195, a corporation acting as an investment

advisor to a REIT formed a wholly-owned subsidiary that entered into a property
management agreement with the REIT. The ruling holds that the subsidiary is not
precluded from qualifying as an independent contractor if the subsidiary operates as a
separate entity with its own officers and employees and keeps separate books and
records that clearly reflect its activities in the management of the property.

   In Rev. Rul. 76-534, 1976-2 C.B. 215, a REIT’s property manager was a wholly-

owned subsidiary of the REIT’s investment advisor. While the management company
was operated as a separate company with separate officers and employees, an
employee of the investment advisor served as a director of both the investment advisor
and the management company. The revenue ruling concludes that the relationship of
the director to both the investment advisor and the management company does not
preclude the property manager from qualifying as an independent contractor.

   Rev. Rul. 77-23, 1977-2 C.B. 197, involves a situation in which an individual was

both a trustee and a salaried employee of a REIT and was also the sole shareholder
and a director of a corporation that served as the REIT’s property manager. The ruling
holds that although the property management company is directly related to the
individual that is a trustee and employee of the REIT, the property manager is not
precluded from qualifying as an independent contractor. The ruling explains that the
proper relationship to be examined to determine independent contractor status is the
relationship between the REIT and the property manager, and not the relationship
between the property manager and the REIT trustee.

   Taxpayer represents that LLC 5 qualifies as an independent contractor under

section 856(d)(3). LLC 5 represents that it and its affiliates are engaged in the active
conduct of the trade or business of managing healthcare facilities and are managing the
operation of healthcare facilities unrelated to those owned by Taxpayer or New TRS.

    Accordingly, we conclude that LLC 5 will be treated as an eligible independent

contractor with respect to the management and operation of the Facility, for purposes of
section 856(d)(9)(A). Also, LLC 5 will be treated as managing and operating the Facility
on behalf of New TRS for purposes of section 856(d)(8)(B) and with respect to the
Facility, New TRS will not be treated as operating or managing a Business facility in
violation of section 856(l)(3)(A). Rent paid by New TRS to LLC 1 is qualifying income
for purposes of the income tests under section 856(c)(2) and (c)(3).

   In this case, Taxpayer, through OP, leases Business facilities to subsidiaries of

either LLC 8 or LLC 9. As stated above, these lessees are in part owned through
certain individuals or entities by the owners of LLC4, which owns LLC 5. The lessees
are separate, independent entities from LLC 4 and LLC 5 and are unrelated to
Taxpayer. It is represented that the leases, and any future leases were or will be
entered into on an arms-length basis. Accordingly, we conclude that the leases to
PLR-152446-09 8

subsidiaries of LLC 8 and LLC9 will not affect whether LLC 5 may be considered an
eligible independent contractor with respect to the Facility under section 856(d)(9)(A).

   Except as specifically ruled upon above, no opinion is expressed concerning any

federal income tax consequences relating to the facts herein under any other provision
of the Code. Specifically, we do not rule whether Taxpayer otherwise qualifies as a
REIT under part II of subchapter M of Chapter 1 of the Code.

  This ruling is directed only to the taxpayer requesting it. Taxpayer should attach

a copy of this ruling to each tax return to which it applies. Section 6110(k)(3) of the
Code provides that this ruling may not be used or cited as precedent.

                                         Sincerely,

                                         Thomas M. Preston_____________
                                         Thomas M. Preston
                                         Senior Counsel, Branch 2
                                         Office of Associate Chief Counsel
                                         (Financial Institutions & Products)