REIT special dividend is preferential and threatens qualification

Plain-English summary

A privately held REIT proposed two common-share classes whose mix would depend on the size of each investor's investment. Class B shares would receive a special dividend designed to offset a reduced investment advisory fee, while the cost of that dividend would reduce both classes' net asset values. The IRS concluded that the two classes were not meaningfully separate for the preferential-dividend rule because their other rights were substantially identical and the arrangement implemented tiered advisory fees based on investment size. The special dividend therefore would be a preferential dividend under IRC § 562(c). That treatment disallows the dividends-paid deduction for the entire distribution, not merely the special portion. The resulting deduction loss could cause the REIT to miss its 90% distribution requirement and fail to qualify under § 856. The IRS did not otherwise rule on the taxpayer's REIT qualification.

Ruling snapshot

• Question: Would the proposed two-class structure avoid preferential-dividend treatment and preserve the taxpayer's REIT qualification?
• Outcome: Denied
• Key authorities: IRC §§ 561, 562(c), 856, and 857(a)(1); Treas. Reg. § 1.562-2; Rev. Proc. 99-40

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201444022 Third Party Communication: None
Release Date: 10/31/2014 Date of Communication: Not Applicable
Index Number: 856.00-00, 562.03-00
Person To Contact:
-------------------------------------------- -----------------, ID No. ----------------
---------------------------------- Telephone Number:
------------------------------------ --------------------
------------ Refer Reply To:
---------------------------- CC:FIP:B02
PLR-117653-13
Date:
July 21, 2014

Legend:

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

State X = ------------

Year 1 = ------

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

a = ------

b = --------------

c = -----

d = -----

e = ---

f = -----

g = ---

h = ---

i = ------

j = ---

PLR-117653-13 2

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

   This is in reply to a letter dated April 11, 2013, requesting rulings on behalf of

Taxpayer concerning Taxpayer’s proposed restructuring that will result in two classes of
common shares, with the mix of class shares held by an investor dependent upon the
size of the investor’s investment in Taxpayer (as described below). You requested
rulings that (1) dividends paid by Taxpayer with respect to Taxpayer’s two classes of
common shares (as described below) will not be treated as preferential dividends within
the meaning of section 562(c) of the Internal Revenue Code, and (2) the existence of
the two classes of common shares (as described below) will not cause Taxpayer to fail
to qualify as a real estate investment trust (REIT) under section 856 of the Code.

                                      FACTS

   Taxpayer is a privately held State X limited liability company that, at all times

since Year 1, has been treated as a corporation for federal income tax purposes and
has elected under section 856(c) to be treated as a REIT.

    Taxpayer currently has two classes of outstanding limited liability company

interests: (i) common shares (“Common Shares”) and (ii) preferred shares (“Preferred
Shares”). The Common Shares are participating, voting common interests that are
neither limited nor preferred as to distributions or on liquidation. The Preferred Shares
are non-participating, non-voting interests that are limited and preferred as to
distributions and on liquidation.

    Taxpayer is an externally managed REIT. Taxpayer’s independent board has

delegated to Advisor the authority to manage Taxpayer’s investments and operations.
As consideration for these services, Taxpayer pays Advisor a quarterly management
fee (“Base Fee”) currently equal to a% (per annum) of the Taxpayer’s net asset value
(“NAV”) as of the beginning of the relevant quarter. Taxpayer also pays Advisor an
annual incentive management fee (”Incentive Fee”), computed monthly, that is equal to
the product of (i) b, (ii) the NAV of Taxpayer as of the beginning of the relevant month,
and (iii) a specified measure of year-over-year income generated by assets held by
Taxpayer for a specified minimum holding period.

    Taxpayer proposes to enter into certain transactions to create two classes of

shares, Class A Shares and Class B Shares (collectively, “Shares”). Taxpayer
proposes to amend its management agreement with Advisor such that the Base Fee will
be determined only by reference to the portion of Taxpayer’s NAV that is attributable to
the Class A Shares (“Class A NAV”), and the Incentive Fee will accrue on and be
payable with respect to the Class A NAV and the portion of Taxpayer’s NAV that is
attributable to the Class B Shares (“Class B NAV”) separately but on otherwise identical

PLR-117653-13 3

terms (i.e., pursuant to the same formula but based on each class’s share of Taxpayer’s
NAV).

   Taxpayer proposes to amend its existing governing agreement to convert all

outstanding Common Shares into Class A Shares and authorize the issuance of Class
B Shares. Taxpayer will not alter the manner in which the Base Fee affects the NAV of
the Shares. The Base Fee will reduce the Class A NAV and the Class B NAV on a pro
rata basis.

   Taxpayer proposes to extend a one-time offer to its shareholders pursuant to

which a shareholder eligible to subscribe for Class B Shares may elect to convert a
specified number of Class A Shares into Class B Shares representing the same portion
of Taxpayer’s NAV (“Conversion Offer”). Pursuant to the Conversion Offer, each such
shareholder will be entitled to convert a number of Class A Shares such that,
immediately following such conversion, the number of Class B Shares held by such
shareholder would not exceed the number of Class B Shares that a new investor could
purchase if such new investor made a cash investment in Taxpayer equal to the NAV of
such shareholder’s aggregate investment in Taxpayer.

   New investors purchasing less than $c million of Shares will receive solely Class

A Shares. Investors purchasing at least $c million of Shares may elect to receive a
combination of Class A Shares and Class B Shares, as follows: (i) for purchases of at
least $c million but less than $d million, up to e% Class B Shares and the remainder
Class A Shares; (ii) for purchases of at least $d million but less than $f million, up to g%
Class B Shares and the remainder Class A Shares; and (iii) for purchase of $f million or
more, up to h% Class B Shares and the remainder Class A Shares.

   An existing shareholder who acquires additional Shares (other than by dividend

reinvestment) will receive solely Class A Shares, except that if the NAV of the
shareholder’s aggregate investment in Taxpayer immediately after acquisition of such
additional Shares is at least $c million, the shareholder will be entitled to elect instead to
receive a combination of Class A Shares and Class B Shares (or solely Class B Shares,
as the case may be) such that, immediately after acquisition of such additional Shares,
the number of Class B Shares held by the shareholder does not exceed the number of
Class B Shares that a new investor could purchase if making a cash investment in
Taxpayer equal to the NAV of the shareholder’s aggregate investment in Taxpayer.

   Except as otherwise provided in Taxpayer’s existing governing agreement, each

outstanding Class A Share and each outstanding Class B share will have one vote. The
Shares will vote jointly on matters affecting Taxpayer as a whole. Class A Shares and
Class B Shares will vote separately as a class on any matter that may have an adverse
effect on the respective class of Shares, including for the Class B Shares any changes
to the amount or other terms of the Special Dividends (“Special Dividends” as described
below).

PLR-117653-13 4

     On each quarterly dividend date, after each Preferred Share has received its

preferred dividend in accordance with its terms (i) first, each Class B Share will be
entitled to receive on a pro rata basis any accumulated but unpaid Special Dividends,
which will be equal to i% of the Class B NAV as of the beginning of each quarter, and
(ii) thereafter, each Class A and Class B Share will be entitled to receive regular
Common Dividends paid in an equal amount per Share. The Special Dividend will
initially be equal to the reduction in the amount of the Base Fee formerly charged by the
Advisor with respect to the portion of the aggregate NAV of the Class B Shares.

   If in the future the Base Fee is charged on a different basis, the amount of the

Special Dividend would not be adjusted in the absence of a shareholder vote approving
the adjustment, with Class A and Class B Shares voting separately. A proposed
increase in the amount of Special Dividends payable on the Class B Shares would be
subject to a class vote by just the Class A Shares, and a proposed decrease in the
amount of Special Dividends payable on the Class B Shares would be subject to a class
vote by just the Class B Shares.

   For purposes of determining the NAV of each class of Shares (and thus the

computation of dividend entitlements and the amount payable by Taxpayer on the
redemption of a share of any class), the Special Dividend will be treated as an amount
similar to an expense that is borne pro rata by the Class A Shares and the Class B
Shares, and will therefore reduce the Class A NAV and the Class B NAV on a pro rata
basis.

   If a shareholder elects to reinvest a dividend payable on its Class A Shares,

Class B Shares, or both pursuant to Taxpayer’s dividend reinvestment program, j% of
the dividend will be reinvested in Class A Shares and e% of the dividend will be
reinvested in Class B Shares, without regard to the NAV of the shareholder’s aggregate
investment in Taxpayer.

   Shareholders holding Class A Shares and Class B Shares will be entitled to

tender for redemption solely Class A Shares, solely Class B Shares, or a combination of
Class A Shares and Class B Shares. If sufficient cash to redeem all tendered Shares is
unavailable, the Class A Shares and Class B Shares tendered by a shareholder will be
redeemed on a pro rata basis based on the relative NAVs of the Class A Shares and
Class B Shares tendered by the shareholder.

                             LAW AND ANALYSIS

   Section 857(a)(1) of the Code requires, in part, that a REIT’s deduction for

dividends paid for a tax year (as defined in section 561, but determined without regard
to capital gains dividends) equal or exceed 90% of its REIT taxable income for the tax

PLR-117653-13 5

year (determined without regard to the deduction for dividends paid and by excluding
any net capital gain).

   For purposes of section 857, section 561(a) defines the deduction for dividends

paid to include dividends paid during the taxable year.

   Section 561(b) applies the rules of section 562 to identify dividends eligible for

the section 561(a) dividends paid deduction.

    Until 1986, section 562(c) provided that the amount of any distribution would not

be considered as a dividend for purposes of computing the section 561 dividends paid
deduction unless the distribution was pro rata. Section 562(c) further provided that the
distribution must not prefer any shares of stock of a class over other shares of stock of
that same class. In addition, section 562(c) provided that the distribution must not
prefer one class of stock over another class except to the extent that one class is
entitled (without reference to waivers of their rights by stockholders) to that preference.

   Section 1.562-2 of the Income Tax Regulations, which was promulgated in 1956

and has not since been amended, provides that a corporation will not be entitled to a
deduction for dividends paid with respect to any distribution upon a class of stock if
there is distributed to any shareholder of such class (in proportion to the number of
shares held by him) more or less than his pro rata part of the distribution as compared
with the distribution made to any other shareholder of the same class. Nor will a
corporation be entitled to a deduction for dividends paid in the case of any distribution
upon a class of stock if there is distributed upon such class of stock more or less than
the amount to which it is entitled as compared with any other class of stock. Under the
regulation, a preference exists if any rights to preference inherent in any class of stock
are violated. In addition, the disallowance, when a preference in fact exists, extends to
the entire amount of the distribution and not merely to a part of such distribution.

    In 1986, Congress amended section 562(c) to provide that a distribution by a

regulated investment company (“RIC”) to a shareholder who made an initial investment
of at least $10,000,000 in the RIC will not be treated as being preferential if the only
reason for the increase in the distribution is a reduction in the administrative expenses
of the RIC. The conference report explains this provision as follows:

   The conference agreement provides that differences in the rate of
   dividends paid to shareholders are not treated as preferential dividends
   (within the meaning of section 562(c)), where the differences reflect
   savings in administrative costs (but not differences in management fees),
   provided that such dividends are paid by a RIC to shareholders who have
   made initial investments of at least $10 million.

PLR-117653-13 6

H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-246 (1986). The General Explanation
of the Tax Reform Act of 1986 (P.L. 99-514) provides further explanation for the 1986
amendment to section 562(c), stating:

  The Congress believed that preferential dividends that reflect only savings
  in administrative costs attributable to the size of a shareholder’s holdings
  (and not differences in investment advisory fees) are not the type of
  preferential dividends that were intended not to qualify for the dividends
  paid deduction. The Congress believed that such preference dividends
  should be allowed only in cases where the shareholder who receives the
  preferential dividend was required to make an initial investment of at least
  $10 million.

Staff of the Joint Committee on Taxation, 100th Cong., 1st Sess., General Explanation
of the Tax Reform Act of 1986, at 382 (Comm. Print 1987).

    In Rev. Proc. 99-40, 1999-2 C.B. 565, the Service described conditions under

which distributions made to shareholders of a RIC may vary and nevertheless be
deductible as dividends under section 562. Rev. Proc. 99-40 provides, in part, that
variations in distributions to shareholders that exist solely as a result of certain
allocations of fees and expenses described in the revenue procedure do not prevent the
distributions from being dividends eligible for the dividends paid deduction under the
provisions of section 561 and section 562. The requirements of Rev. Proc. 99-40 are
based on similar requirements contained in Rule 18f-3, 17 C.F.R. 270.18f-3, under the
Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq. (1940 Act). Consistent with
section 562(c), Rev. Proc. 99-40 and the 1940 Act require that the advisory fee
generally must not be charged at different rates for different groups of shareholders.
The groups of shareholders may be allocated and may pay a different advisory fee,
however, to the extent that any difference in amount paid is the result of the application
of the same performance fee provisions in the advisory contract to the different
investment performance of each group of shareholders.

   In 2010, Congress further amended section 562(c) to repeal the preferential

dividend rule for publicly offered RICs, which are defined in section 67(c)(2)(B).
Regulated Investment Company Modernization Act of 2010, Pub. L. No. 111-325, 124
Stat. 3537, § 307.

   REITs were created to provide an investment vehicle similar to RICs for small

investors to invest in real estate and real estate mortgages. Congress and the Service
have acknowledged the similarity between RICs and REITs in many areas and have
afforded them similar treatment in many situations. The legislative history underlying
the provisions governing the tax treatment of REITs indicates that, except where
specifically provided otherwise, Congress generally intended to equate the tax

PLR-117653-13 7

treatment of REITs with the treatment accorded to RICs. See H.R. Rep. No. 2020, 86th
Cong., 2d Sess. 3 (1960).

   Congress did not, however, extend the liberalization of the RIC preferential

dividend rules to REITs. Moreover, even if Taxpayer were a RIC, neither the 1986 nor
the 2010 liberalization would expressly apply to the preference Taxpayer proposes.
Taxpayer proposes to provide a preference for investment advisory fees for
shareholders. The 1986 liberalization is specifically limited to “savings in administrative
costs attributable to the size of a shareholder’s holdings (and not differences in
investment advisory fees).”1 The 2010 liberalization is limited to publicly offered RICs,
as defined in section 67(c)(2)(B).2

      Taxpayer asserts that the dividends it will pay with respect to its Class A Shares

and Class B Shares will not be preferential within the meaning of section 562(c)
because (i) the two classes qualify as separate classes of stock for this purpose and
(ii) all shareholders within each class will receive the same amount of dividends as
every other shareholder of that class, in accordance with the dividend rights of that
class.

    To accept Taxpayer’s argument on the facts presented here would significantly

undermine the preferential dividend rules. The 1986 revision to section 562(c) and its
legislative history indicate Congress’ understanding and intent that, while differences in
distributions paid to certain larger shareholders of a class to reflect reductions in
associated administrative expenses are permissible and do not cause the distributions
to be preferential dividends, differences in distributions due to a reduction in investment
advisory fees for a particular class are not permissible. The purpose and effect of
Taxpayer’s proposed share arrangements are, however, precisely to differentially
allocate investment advisory fees to shareholders holding shares with otherwise
identical share rights based on the amount of their respective investments in Taxpayer.

   The Class A Shares and Class B Shares proposed by Taxpayer would confer the

same voting, dividend, redemption, and liquidation rights, except for provisions that
would enable holders of Class B Shares to receive, and preserve their rights to, the
Special Dividend. The Special Dividend is an additional fixed and periodic distribution
that represents the amount of the reduction in the Advisor Base Fee charged to
Taxpayer under the proposed two common share class structure (as described above).
Even though it is payable only to holders of Class B shares, the Special Dividend would
be allocated between the Class A Shares and the Class B Shares pro rata, and
accordingly it would reduce the Class A NAV and the Class B NAV on a pro rata basis.

1
Staff of the Joint Committee on Taxation, 100th Cong., 1st Sess., General Explanation of the Tax
Reform Act of 1986, at 382 (Comm. Print 1987) (emphasis added). The preferential dividend relief
provided for RICs by Rev. Proc. 99-40 is similarly inapplicable to advisory fees.
2
Taxpayer’s REIT shares are not publicly offered.

PLR-117653-13 8

The net effect would generally be that holders of Class B Shares (in their capacity as
such) would not bear the cost of the Advisor Base Fee, and that the Advisor Base Fee
would be borne entirely by the holders of Class A Shares (in their capacity as such).
Moreover, the provisions regarding the acquisition of Class B shares are intended to
ensure that only shareholders making investments in Taxpayer above certain
thresholds, or having such level of investments at the time of the Conversion Offer, may
acquire Class B shares, and then only in proportions that depend on the amount of their
investments. Accordingly, in substance, the proposed arrangement would exist to
implement a tiered investment advisory fee structure based on the amount invested for
shareholders whose shares otherwise confer substantially the same rights and
obligations. Under these circumstances, the Class A and Class B shares are not
appropriately recognized as separate classes for purposes of section 562(c).3

   Taxpayer additionally asserts that, although the Special Dividend will initially be

equal to the reduction in the Advisor Base Fee for the Class B Shares, the Special
Dividend is not linked to the amount of the Advisor Base Fee paid because if the
Advisor Base Fee were charged on a different basis in the future, the amount of the
Special Dividend would not be adjusted in the absence of a shareholder vote approving
the adjustment. This fact does not change the substance of the proposed dividend,
which is to permit a difference in investment advisory fees between shareholders with
otherwise substantially identical rights that own Class A Shares and Class B Shares in
different proportions based on the amount of their respective investments in Taxpayer.

    Based on the above facts and circumstances, and for the reasons stated above,

we conclude that the Special Dividend paid by Taxpayer with respect to the proposed
two classes of common shares (as described above) will be treated as a preferential
dividend within the meaning of section 562(c). Pursuant to section 562(c), no dividends
paid deduction is allowed for a preferential dividend, and under section 1.562-2(a) of the
regulations, the disallowance of the deduction will extend to the entire amount of the
distribution and not merely to a part of such distribution. Accordingly, Taxpayer’s
payment of a Special Dividend on the Class B shares (as described above) will cause
Taxpayer’s entire distribution made to the Class A and Class B shares to be a
preferential dividend under section 562(c), making the distribution ineligible for the
dividends paid deduction under section 561. In turn, the preferential dividend may
result in Taxpayer failing to meet its 90% distribution requirement under section
857(a)(1), and may cause Taxpayer to fail to qualify as a REIT under section 856 of the
Code.

   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

3
Indeed, if Taxpayer’s assertions were accepted, the 1986 revision to section 562(c) would have been
unnecessary, as any RIC or REIT could have differentiated between shareholders based on
administrative expenses by setting up otherwise identical “classes” of shares with different dividend rights
tied to administrative expense differentials.

PLR-117653-13 9

of the Code. Specifically, we are not ruling on 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. 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 representatives.

                                   Sincerely,


                                   __________________________
                                   K. Scott Brown
                                   Branch Chief, Branch 3
                                   Office of Associate Chief Counsel
                                   (Financial Institutions & Products)

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