PLR 1333005: IRS allows deduction of certain REIT distribution fees after initial issuance

Plain-English summary

A real estate investment trust asked whether distribution fees and dealer manager fees for continuously offered share classes could be deducted under IRC § 162. The IRS treated the fees as comparable to fees under a Rule 12b-1 plan for an open-end regulated investment company because the REIT continuously offered shares and repurchased some shares. It ruled that the fees were deductible except during the one-year period after the initial issuance of the relevant Class A and Class M shares. Fees incurred during those initial one-year periods had to be capitalized.

Ruling snapshot

• Question: May the REIT deduct distribution and dealer manager fees paid for its continuously offered share classes?
• Outcome: Mixed. The fees were deductible after the applicable initial one-year periods, but fees during those periods had to be capitalized.
• Key authorities: IRC § 162(a); Treas. Reg. §§ 1.263(a)-5(a)(8) and 1.263(a)-5(c)(5); Rev. Ruls. 73-463 and 94-70.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201333005
Release Date: 8/16/2013
Index Number: 162.00-00
Person To Contact:
---------------------- -----------------, ID No. -----------
------------------------------- Telephone Number:
------------------------------------------------------------ ----------------------
------ Refer Reply To:
----------------------------------- CC:ITA:B02
-------------------------------------- PLR-148739-12
Date:
May 02, 2013

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

State = --------------

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

Advisor = -----------------------------------------------------

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

Sponsor = ---------------------------------------------

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

B = ------------------

C = ----

D = ----

E = --

F = --------------

G = --------

H = ----
PLR-148739-12 2

J = ----------------

K = ----

L = ----

M = ----------

N = ------

O = ------

P = ------

Q = --

R = ----

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

  This is in reply to a letter dated November 7, 2012, requesting a ruling on behalf

of Taxpayer that distribution fees and dealer manager fees will be deductible under
§162 of the Internal Revenue Code.

                              FACTS

   Taxpayer is a corporation organized under the laws of State and elected to be

taxed as a real estate investment trust (REIT) for federal income tax purposes for its
taxable year ended Date 1. Taxpayer is externally managed by Advisor.

   Previously, shares of a single class of common stock of Taxpayer were issued to

“accredited investors” in a private offering that was exempt from registration under the
Securities Act of 1933. The first of several closings occurred in Date 2. Through Date
3, Taxpayer raised an aggregate of approximately $B in gross proceeds through the
private offering of shares of its common stock to unaffiliated investors.

   Taxpayer owns and manages a diversified portfolio of retail, office, industrial and

multifamily properties located primarily in the United States. As of Date 3, Taxpayer’s
real estate portfolio was composed of interests in C properties located in D states and E
property in Canada.
PLR-148739-12 3

    In order to raise additional capital to grow Taxpayer’s real estate portfolio, reduce

its leverage and provide liquidity to existing investors, Taxpayer filed a registration
statement on Form S-11 to offer and sell to the public two new classes of shares of
common stock, the Class A shares (“Class A Shares”) and the Class M shares (“Class
M Shares”) (the “Public Offering”).

    As of Date 3, Taxpayer had F shares of common stock outstanding, held by a

total of G stockholders, and no other class of common stock outstanding. Taxpayer will
reclassify its existing outstanding shares of common stock as Class E shares (“Class E
Shares”). Taxpayer will not issue additional Class E Shares.

     Class A Shares will be available to any investor meeting the applicable suitability

standards. Class M Shares will be available for purchase in the offering only (i) through
fee-based programs, also known as wrap accounts, of investment dealers, (ii) through
participating broker-dealers that have alternative fee arrangements with their clients, (iii)
through certain registered investment advisors, (iv) through bank trust departments or
any other organization or person authorized to act in a fiduciary capacity for its clients or
customers, (v) by endowments, foundations, pension funds and other institutional
investors or (iv) by Taxpayer’s executive officers and directors and their immediate
family members, as well as officers and employees of Taxpayer’s advisor or other
affiliates and their immediate family members, and, if approved by the Taxpayer’s board
of directors, joint venture partners, consultants and other service providers.

   Taxpayer intends to continuously offer Class A Shares and Class M Shares in

multiple back-to-back offerings, with no predetermined date on which Taxpayer would
cease offering such shares.

    None of the shares of any class will be listed on a securities exchange. Instead,

Class A Shares and Class M Shares will be offered for sale on a daily basis at the net
asset value (“NAV”) for shares of such class plus, with respect to Class A Shares,
applicable selling commissions and will be repurchased on a daily basis by Taxpayer at
the NAV for such share class. Subject to certain limitations, the share repurchase plan
is intended to allow holders of Class A Shares and Class M Shares to request that
Taxpayer repurchase their shares in an amount up to approximately H% of Taxpayer’s
NAV per year after such shares have been outstanding for at least one year. In addition,
until Taxpayer’s total NAV has first reached $J, repurchases of shares of all classes in
the aggregate may not exceed K% of the gross proceeds Taxpayer receives from the
commencement of the Public Offering through the last day of the prior calendar quarter.

  Class E Shares are not eligible for repurchase but will automatically convert to

Class M Shares one year after escrow release date for the offering. After the Class E
Shares convert to Class M Shares, they will be eligible for repurchase, subject to the
one year waiting period.
PLR-148739-12 4

   Taxpayer will make ongoing payments to the dealer manager of distribution fees

and dealer manager fees with respect to the Class A Shares and of dealer manager
fees with respect to the Class M Shares. Taxpayer will not pay any distribution or
dealer manager fees with respect to Class E Shares.

   The broker-dealers receiving the distribution fees will be purchasing Class A

shares on behalf of their clients. The broker-dealers will receive an up-front selling
commission of L% and ongoing distribution fees. Class A Shares will be allocated
Distribution Fees, which are a daily accrual of M of N% of the NAV of the Class A
Shares for such day.

    The dealer manager fee is paid to the dealer manager in consideration of the

distribution, marketing and stockholder services the dealer manager provides to
Taxpayer in connection with the continuous offerings. A portion of the dealer manager
fee may be reallowed to participating broker-dealers as payment to the participating
broker-dealers based on certain asset thresholds of shares under management, to
compensate the participating broker-dealers for their role in distributing and marketing
Taxpayer’s shares and for providing services to those stockholders who invest through
that particular broker-dealer, thus saving the dealer manager that expense. Class A
Shares and Class M Shares will be allocated dealer manager fees calculated at the
same rate, which are a daily accrual of M of O% of the NAV of the share class for such
day.

   Taxpayer represents that the distribution and dealer manager fees are

comparable to fees paid by open-end regulated investment companies (RICs) pursuant
to Rule 12b-1 (17 C.F.R. §270.12b-1).

                        LAW AND ANALYSIS

   Section 162(a) provides generally that there is allowed as a deduction all the

ordinary and necessary expenses paid or incurred during the taxable year in carrying on
any trade or business.

     In general, a taxpayer must capitalize amounts paid to facilitate a stock issuance.

Section 1.263(a)-5(a)(8) of the Income Tax Regulations. The regulations provide an
exception to this general rule by providing that amounts paid by an open-end RIC to
facilitate an issuance of its stock are treated as amounts that do not facilitate a
transaction unless the amounts are paid during the initial stock period. Section
1.263(a)-5(c)(5). The exception is based upon Revenue Ruling 94-70, 1994-2 C.B. 17,
which amplifies Revenue Ruling 73-463, 1973-2 C.B. 34. Notice of proposed
rulemaking and notice of public hearing , REG-125638-01, 2003-1 C.B. 373, 377.

  Rev. Rul. 73-463 holds that stock issuance expenses of an open-end RIC,

except those incurred during the initial stock offering period, a 90-day period after the
PLR-148739-12 5

day its registration statement is first declared effective, are deductible under § 162(a).
Rev. Rul. 73-463 distinguishes an open-end RIC from other corporations in that there is
a constant possibility of withdrawal of all or part of the capital by means of redemption.
It was these “unique circumstances” which led to the revenue ruling’s conclusion that
the continuous capital-raising efforts after the initial stock offering period are an
essential part of the company’s day-to-day business operations, and, thus, the stock
issuance expenses incurred with these efforts are deductible under § 162.

   Rev. Rul. 94-70, which amplifies Rev. Rul. 73-463, holds that fees incurred by an

open-end RIC pursuant to a Rule 12b-1 plan are indistinguishable from the stock
issuance expenses deductible under Rev. Rul. 73-463. Fees that are incurred under a
Rule 12b-1 plan include advertising expenses, compensation of underwriters, dealers,
and sales personnel, the expenses for printing and mailing prospectuses to other than
current shareholders, and the expenses of printing and mailing sales literature. 17
C.F.R. § 270.12b-1(a)(2).

   In general, the distribution and dealer manager fees at issue are not deductible

under § 162 as stock issuance expenses. Section 1.263(a)-5(a)(8). Further, the fees
do not clearly fall under the holding of Rev. Rul. 73-463 because Taxpayer is not an
open-end RIC.

    Congress and the Service have acknowledged similarity between RICs and

REITs in many areas and have afforded them similar treatment in many situations. The
legislative history underlying the tax treatment of REITs indicates Congress generally
intended to equate the tax treatment of REITs with the treatment accorded RICs. REITs
were created to provide an investment vehicle similar to the RIC for small investors to
invest in real estate and real estate mortgages. See H.R. Rep. No. 2020, 86th Cong., 2d
Sess. 3 (1960).

    Taxpayer operates in a manner similar to an open-end RIC, in that there is the

possibility that Taxpayer’s capital will be withdrawn by redemptions of shares pursuant
to Taxpayer’s daily offers to repurchase a portion of the outstanding shares after the
one-year holding period. Also, Taxpayer does continuously offer its shares and does
not list its shares on an exchange. Furthermore, Taxpayer offers its shares on a daily
basis to replace shares that have been repurchased.

   Additionally, Taxpayer represented that the distribution and dealer manager fees

are equivalent to fees charged for activities described by Rule 12b-1. The distribution
and dealer manager fees are similar to compensation paid to underwriters, dealers and
sales personnel. Thus, we will treat the deferred dealer manager fees and distribution
fees as comparable to the Rule 12b-1 Fees in Rev. Rul. 94-70.

    Accordingly, based on the above facts and circumstances, we hold that the

distribution and dealer manager fees, except those incurred by Taxpayer during the
PLR-148739-12 6

one-year period after the dates of initial issuance of the Class A Shares and Class M
Shares, respectively, are deductible under §162. Taxpayer must continue to capitalize
the distribution and dealer manager fees incurred during the one-year period after the
dates of the initial issuance of the Class A and Class M Shares.

   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.

  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.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representative.

                                   Sincerely,



                                   Thomas D. Moffitt
                                   Branch Chief, Branch 2
                                   (Income Tax & Accounting)