Private Letter Ruling
202335005
Released September 1, 2023
Approved
A publicly traded REIT's D&O insurance payouts are excluded from its income tests, so recovering litigation costs won't threaten REIT status
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This page covers one taxpayer's ruling from 2023, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.
Not precedent. Under 26 U.S.C. § 6110(k)(3), this written determination may not be used or cited as precedent. It resolved one taxpayer's situation on its specific facts, and identifying details were redacted by the IRS before release. The official IRS release (linked on this page as a PDF) is the authoritative source.
About this page: The plain-English summary and ruling snapshot below were written by Ezel based on the official IRS release. The full text is the IRS's own document.
View official IRS release (PDF)
Plain-English summary
A publicly traded real estate investment trust (REIT) must keep its income mostly passive: at least 95% from listed sources like rents and interest, and at least 75% from real-estate sources. Income outside those categories can put its REIT status at risk. This REIT, which also owns a REIT subsidiary, carries directors-and-officers (D&O) liability insurance. After shareholder lawsuits arising out of a real estate transaction, the D&O insurance paid settlement amounts and defense costs, and the REIT expected to include part of those payments in income. Insurance proceeds are not rent or interest, so on their face they are "bad" income under the REIT income tests. The REIT asked the IRS to treat them as not counting against those tests. The IRS agreed. Under section 856(c)(5)(J)(i), it ruled that the D&O insurance proceeds are excluded from gross income for both the 95% and 75% income tests. The proceeds only restored the REIT to where it would have been without the lawsuits, did not enrich it, and traced back to fiduciaries defending real-estate-related litigation, so counting them would not serve the purpose of the income tests. This is the companion to PLR 202335004, which reached the same conclusion for the affiliated subsidiary REIT. The ruling does not decide whether the REIT otherwise qualifies. It matters because it lets a REIT use insurance to cover litigation costs without inadvertently flunking the income tests that define its tax status.
Ruling snapshot
- Question: Are the REIT's D&O insurance proceeds treated as gross income for the section 856(c)(2) and (c)(3) income tests?
- Outcome: approved (proceeds excluded from the income tests)
- Key authorities: IRC § 856(c)(2), (c)(3), (c)(5)(J)(i); IRC § 61(a); Treas. Reg. § 1.856-4(b)(5)(ii)
Full text (IRS public release)
Internal Revenue Service Department of the Treasury
Washington, DC 20224
Number: 202335005 Third Party Communication: None
Release Date: 9/1/2023 Date of Communication: Not Applicable
Index Number: 856.01-00
Person To Contact:
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------------------- Telephone Number:
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---------------------------------------- Refer Reply To:
----------------------------- CC:FIP:B03
------------------------------ PLR-117335-22
Date:
April 02, 2023
Legend
Taxpayer = ----------------------------------------------
State 1 = ------------
State 2 = -------------
Subsidiary = ---------------------------------------------------------------
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Operating Partnership = --------------------
Assets = ---------------------------------------------------------------
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Company = -----------------------------------
Year = -------
Judgment = ---------------------------------------------------------------
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Date 1 = --------------------------
Date 2 = --------------------------
PLR-117335-22 2
Date 3 = -------------------
Date 4 = -------------------------
Date 5 = -------------------------
Date 6 = -------------------
Date 7 = -------------------
Date 8 = ---------------------
Date 9 = ----------------------
Date 10 = -------------------------
a = ------
b = ---
c = ---
d = -----------------
e = ---
f = ---------------
g = -------------
Transaction 1 = ---------------------------------------------------------------
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Transaction 2 = ---------------------------------------------------------------
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Transaction 3 = --------------------------------------------------------------
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PLR-117335-22 3
Lawsuit 1 = ---------------------------------------------------------------
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Lawsuit 2 = ---------------------------------------------------------------
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Lawsuit 3 = ---------------------------------------------------------------
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Lawsuit 4 = ---------------------------------------------------------------
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Lawsuit 5 = ---------------------------------------------------------------
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Consequence 1 = ---------------------------------------------------------------
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Consequence 2 = ---------------------------------------------------------------
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Dear ------------------:
This ruling responds to a letter dated September 9, 2022, and subsequent
correspondence, requesting a ruling on behalf of Taxpayer. Taxpayer requests a ruling
that its D&O Insurance Proceeds (defined below) will not be treated as gross income for
purposes of section 856(c)(2) and (c)(3) of the Internal Revenue Code (the Code).
FACTS
Taxpayer is a State 1 corporation that elected to be taxed as a real estate
investment trust (“REIT”) within the meaning of section 856(a) beginning with its first
taxable year ended Date 1. Taxpayer is a publicly traded REIT which owns an a percent
PLR-117335-22 4
indirect interest in Subsidiary through Operating Partnership. Subsidiary is a State 2
corporation that elected to be taxed as a REIT beginning with its first taxable year
ended Date 2. Operating Partnership is a State 2 limited partnership that is treated as a
partnership for U.S. federal income tax purposes.
Taxpayer is in the business of owning and leasing Assets, which Taxpayer
represents are primarily composed of real property for purposes of section 856.
Taxpayer represents that it has qualified as a REIT under section 856 beginning with
the year in which Taxpayer first elected to be taxed as a REIT and every year
thereafter. Taxpayer similarly represents that Subsidiary has qualified as a REIT under
section 856 beginning with the year in which Subsidiary first elected to be taxed as a
REIT and every year thereafter.
On Date 3, Company and Taxpayer engaged in Transaction 1, Transaction 2,
and Transaction 3. Transaction 3 resulted in Taxpayer leasing a substantial portion of
Assets to Company. Immediately after Transaction 3, approximately b percent of the
gross income of Taxpayer, Operating Partnership, and Taxpayer’s direct and indirect
subsidiaries (collectively, the “Enterprise”) was derived from rent payments made by
Company. At all times since Transaction 3, at least c percent of the gross income of the
Enterprise has been derived from rent payments made by Company.
In Year, Lawsuit 1, relating to Transaction 1, Transaction 2, and Transaction 3,
was filed. On Date 4, the court in Lawsuit 1 entered Judgment. On Date 5, as a result of
Judgment, Consequence 1 occurred, which resulted in Consequence 2. Consequence 2
led certain of Taxpayer’s shareholders to bring Lawsuit 2, Lawsuit 3, Lawsuit 4, and
Lawsuit 5.
As is customary among publicly traded companies, Taxpayer purchases
insurance policies for certain potential losses that may arise in the ordinary course of
business, including Directors, Officers and Corporate Liability Insurance (the “D&O
Insurance”). Insurance such as the D&O Insurance generally is intended to protect a
public company and its officers and directors from liability and related defense costs
arising from certain types of lawsuits, including shareholder securities class actions and
derivative lawsuits. The D&O Insurance has an aggregate coverage of d dollars for
claims first made between Date 6 and Date 7 (the “Coverage Period”). The D&O
Insurance for the Coverage Period covers Taxpayer, any entity in which Taxpayer
directly or indirectly owns more than e percent of the issued and outstanding securities
representing the right to vote (i.e., Subsidiary), and Taxpayer’s officers and directors.
On Date 8, a settlement agreement was reached in Lawsuit 2 for f dollars, to be
funded entirely by the D&O Insurance. The D&O Insurance paid out on claims equal to
the amount of the settlement plus related defense costs of approximately g dollars.
Lawsuit 3 was dismissed, and the appeal of the dismissal was denied on Date 9. The
D&O Insurance paid out on claims equal to the defense costs related to Lawsuit 3. On
Date 10, settlement agreements were reached in Lawsuit 4 and Lawsuit 5. In
PLR-117335-22 5
connection with the settlements of Lawsuit 4 and Lawsuit 5, which remain subject to
finalization of definitive settlement documents and court approval, the D&O Insurance
carrier has agreed to pay on claims for plaintiff’s attorney’s fees and the amount of the
settlement plus any related defense costs. As a named defendant in Lawsuit 2, Lawsuit
3, Lawsuit 4, and Lawsuit 5 and a named insured under the D&O Insurance, Taxpayer
expects to include a portion of these D&O Insurance payments relating to Lawsuit 2,
Lawsuit 3, Lawsuit 4, and Lawsuit 5 (collectively, the “D&O Insurance Proceeds”) in
gross income.
Taxpayer represents that its officers were acting in their fiduciary capacities in
settling Lawsuit 2, Lawsuit 4, and Lawsuit 5 to avoid the costs of additional litigation in
the best interests of Taxpayer, Subsidiary, and Taxpayer’s shareholders. Taxpayer
represents that the D&O Insurance Proceeds will merely restore Taxpayer to the
position it would have been had no lawsuits been filed, and that Taxpayer will not
receive a net financial or economic benefit therefrom. Taxpayer will not profit from the
D&O Insurance Proceeds and the D&O Insurance Proceeds will not exceed Taxpayer’s
expenses associated with the relevant lawsuits.
LAW & ANALYSIS
Section 61(a) provides that, except as otherwise provided, gross income includes
all income from whatever source derived.
Section 856(c)(2) provides that at least 95 percent of a REIT’s gross income
must be derived from dividends, interest, rents from real property, gain from the sale or
other disposition of stock, securities, and real property (other than property in which the
corporation is a dealer), abatement and refunds of taxes on real property, income and
gain derived from foreclosure property, commitment fees, and gain from certain sales or
other dispositions of real estate assets.
Section 856(c)(3) provides that at least 75 percent of a REIT’s gross income
must be derived from rents from real property, interest on obligations secured by real
property, gain from the sale or other disposition of real property (other than property in
which the corporation is a dealer), dividends from REIT stock and gain from the sale of
REIT stock, abatements and refunds of taxes on real property, income and gain derived
from foreclosure property, commitment fees, gain from certain sales or other disposition
of real estate assets, and qualified temporary investment income.
Section 856(c)(5)(J) provides that to the extent necessary to carry out the
purposes of part II of subchapter M of chapter 1 of the Code, the Secretary is authorized
to determine, solely for purposes of such part, whether any item of income or gain which
(i) does not otherwise qualify under section 856(c)(2) or (3) may be considered as not
constituting gross income for purposes of section 856(c)(2) or (3), or (ii) otherwise
constitutes gross income not qualifying under section 856(c)(2) or (3) may be
considered as gross income which qualifies under section 856(c)(2) or (3).
PLR-117335-22 6
The legislative history underlying the tax treatment of REITs indicates that a
central concern behind the gross income restrictions is that a REIT's gross income
should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th
Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, at 822-23 states, “[o]ne of the principal
purposes of your committee in imposing restrictions on types of income of a qualifying
real estate investment trust is to be sure the bulk of its income is from passive income
sources and not from the active conduct of a trade or business.”
Section 1.856-4(b)(5)(ii) of the Income Tax Regulations provides that the trustees
or directors of the REIT are not required to delegate or contract out their fiduciary duty
to manage the trust itself, as distinguished from rendering or furnishing services to the
tenants of its property or managing or operating the property. The Trustees or directors
may do all those things necessary, in their fiduciary capacities, to manage and conduct
the affairs of the trust itself. For example, the trustees or directors may deal with
insurance relating to the trust's property.
Taxpayer’s receipt of the D&O Insurance Proceeds does not relate to the active
conduct of a trade or business, but rather, is traceable to Taxpayer’s leasing of real
estate assets to Company. Taxpayer represents that it maintains the D&O Insurance to
protect itself and its directors and officers from liability and to cover related defense
costs arising from certain types of lawsuits. After a settlement agreement in Lawsuit 2,
was reached, Taxpayer received proceeds from the D&O Insurance to recover its
expenses related to the settlement in addition to related defense and other costs.
Similarly, after the appeal in Lawsuit 3 was denied, Taxpayer received proceeds from
the D&O Insurance to recover related defense costs. Subject to finalization of definitive
settlement documents and court approval of the settlement agreements in Lawsuit 4
and Lawsuit 5, Taxpayer will receive proceeds from the D&O Insurance to recover its
expenses associated with the settlements in addition to related defense costs. The D&O
Insurance Proceeds do not represent an economic enrichment to Taxpayer, but rather
merely restore Taxpayer to the position it would have been in had Lawsuit 2, Lawsuit 3,
Lawsuit 4, and Lawsuit 5 not occurred.
The D&O Insurance Proceeds constitute gross income to Taxpayer that is of a
type not listed in section 856(c)(2) and (3). However, the consequences of Taxpayer’s
and Taxpayer’s fiduciaries exercising their fiduciary duty to defend and settle lawsuits
stemming from Transaction 3, a real estate transaction, should not cause Taxpayer to
fail to qualify as a REIT. Based on all the facts and circumstances, treating the D&O
Insurance Proceeds as excluded from gross income for purposes of section 856(c)(2)
and (3) does not interfere with Congressional policy objectives in enacting the income
tests under those provisions.
PLR-117335-22 7
CONCLUSION
Based on the facts submitted and representations made, we rule that, pursuant
to section 856(c)(5)(J)(i), the D&O Insurance Proceeds will be excluded from
Taxpayer’s gross income for purposes of section 856(c)(2) and (3).
This ruling's application is limited to the facts, representations, Code sections,
and regulations cited herein. Except as expressly provided herein, no opinion is
expressed or implied concerning the tax consequences of any aspect of any transaction
or item discussed or referenced in this letter. In particular, no opinion is expressed
whether Taxpayer otherwise qualifies as a REIT under subsection M, part II of Chapter
1 of the Code. Additionally, no opinion is expressed or implied whether any amount
qualifies as rents from real property under section 856(d).
This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)
provides that it may not be used or cite as precedent. In accordance with the Power of
Attorney on file with this office, a copy of this letter is being sent to Taxpayer’s
authorized representatives.
Sincerely,
Bernard Audet
Senior Technician Reviewer, Branch 3
Office of the Associate Chief Counsel
(Financial Institutions & Products)
cc:
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