Were private REITs owned by a widely held limited partnership captive REITs required to add back their federal dividends-paid deductions?

Plain-English summary

The fund's private REITs were not captive REITs because no single corporation owned the required majority interest under the constructive-ownership rules. The REITs satisfied federal REIT status and were not publicly traded, so the disputed element was whether one corporation owned or controlled more than 50% of their voting power or value.

Section 1501(a)(1.5)(C) applied IRC Section 318's constructive-ownership rules. Stock owned by a partnership was attributed proportionately to its partners. The limited partnership had more than the redacted number of partners, and its organizational documents prohibited any single investor from holding more than 10%.

IDOR said those facts were sufficient to establish that the REITs did not meet the captive-REIT definition. Accordingly, they were not required to add back their federal dividends-paid deductions when computing Illinois taxable income.

What this means for you

Map REIT ownership through every partnership tier and apply Section 318 proportionately to the partners. Retain governing documents and ownership schedules proving that no single corporate owner crosses the statutory threshold.

Common questions

Q: Did the partnership itself count as the single corporate owner?
A: No. IDOR noted that the fund was a partnership, not a corporation, and applied proportional attribution to its partners.

Q: What ownership fact was especially important?
A: The fund documents barred any single investor from owning more than 10%, well below the more-than-50% captive-REIT threshold.

Q: Was the dividends-paid deduction added back?
A: No. IDOR said these REITs were not captive and therefore did not have to make that Illinois addition.

Citations and references

• 35 ILCS 5/1501(a)(1.5)
• IRC §§ 318(a), 856

Subject

Addition Modifications – Other Rulings

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/income-tax/2010.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/income-tax/2010/ig100009.pdf

Original ruling text

IT 10-0009-GIL 04/08/2010 ADDITION MODIFICATIONS – OTHER RULINGS
General Information Letter: The attribution rules in IRC Section 318 are used to
determine ownership for purposes of determining whether a REIT is a captive REIT
required to add back its dividends-paid deduction, not for determining control.
April 8, 2010
Dear:
This is in response to your letter dated January 22, 2010 in which you state the following:
I am the Executive Director–Tax for COMPANY1, LLC (“COMPANY1”) based in CITY1,
STATE1. The purpose of this letter is to seek advice from the Department of Revenue (“DOR”)
on whether the Illinois captive REIT statute imposed pursuant to 35 Ill. Comp. Stat.
5/1501(a)(1.5) would apply to the private REITs held in our institutional real estate fund that we
formed in MONTH 200X. Illinois requires captive REITs to add to its federal taxable income the
dividends paid deduction allowed under the Internal Revenue Code of 1986, as amended
(“Code” or “IRC”). It is my belief that the statute does not apply since the REITs in the fund are
not owned or controlled by a taxable corporate entity and are not used for tax-avoidance
purposes. A detailed discussion of the facts and applicable law in support of this request is set
forth below.
FACTS
COMPANY1 is the U.S. arm of COMPANY2. COMPANY1 manages, on behalf of institutional
investors, over $XX billion of real estate assets in the U.S. and over $XX billion globally.
COMPANY1, and its predecessor COMPANY3A, have been providing real estate asset
management to institutional investors since 19XX. Since that time, our commingled real estate
fund, FUND1 (“FUND1”), has grown its net asset value to over $X.X billion. FUND1 is focused
on providing institutional investors with an actively managed portfolio of primarily equity real
estate investments located throughout the U.S. The investors are tax-exempt entities, the
majority of which are state and local governmental pension plans.
FUND1 formed the largest part of COMPANY3A’s investment management business. As part
of COMPANY3’s strategy to leave the institutional asset management business in the mid19XXs, it sold COMPANY3A in 19XX (subsequently acquired by COMPANY1 in 19XX) and
required that the real estate assets in these separate accounts come off of COMPANY3’s
balance sheet within a XX-year period. As a result, FUND1 recently converted (MONTH 1,
200X) from an insurance separate account to a limited partnership and FUND1 has been
renamed FUND2 (“FUND2” or the “Fund”).
FUND2 owns, among other investments, membership interests in three separate REITs that
are organized as limited liability companies, two of which derive a portion of their income from
properties located in Illinois, COMPANY4 (“COMPANY4”) and COMPANY5 (“COMPANY5”).
COMPANY4 owns a 99.9% limited partnership interest in COMPANY6 (“COMPANY6”), with
the remaining .1% general partnership interest owned by FUND2 REIT’s wholly owned
subsidiary, COMPANY7 (“COMPANY7”). COMPANY7 is taxed as a corporation for federal tax
purposes. COMPANY6 owns single member limited liability companies (“SMLLCs”) that are
treated as disregarded entities for federal tax purposes and other joint venture interests. It is
these SMLLCs and joint ventures that hold property and income that is sourced to Illinois for

IT 10-0009-GIL
April 8, 2010
Page 2
COMPANY4.
Similarly, COMPANY5 owns a 99.9% limited partnership interest in COMPANY8
(“COMPANY8”), with the remaining .1% general partnership interest owned by COMPANY5’s
wholly owned subsidiary, COMPANY9 (“COMPANY9”). COMPANY9 is taxed as a corporation
for federal tax purposes. COMPANY8 owns SMLLCs that are treated as disregarded entities
for federal tax purposes and other joint venture interests. One of these SMLLCs holds the
property and income that is sourced to Illinois for COMPANY5.
[Chart illustrating the relationship between the Fund, its REITs, and the investors not
transposed into this letter. Letter contains the following heading for the Chart: FUND3 as
constituted from the date of its conversion from an insurance separate account (X/X/08)
to the current date.]
Since its conversion from an insurance separate account, the general partner of the Fund has
been FUND4 (“FUND4”), a wholly-owned subsidiary of COMPANY1 that holds no units in the
Fund. All of the limited partners in the Fund are tax-exempt entities including:

1. State and local governmental pension plans which are tax exempt under IRC § 115;
2. Corporate and multi-employer (“COMPANY10”) pension plans, tax-exempt under IRC § 501;
   and
3. Foundations and endowments, also qualified as tax-exempt under IRC § 501.
   TECHNICAL DISCUSSION
   I. REITS IN THIS INSTITUTIONAL FUND DO NOT MEET THE REQUIREMENTS TO BE
   “CAPTIVE REITS.”
   Pursuant to 35 Ill. Comp. Stat. 5/1501(a)(1.5), the REITs within the Fund should not qualify as
   captive REITs. Under the statute, a REIT is a captive REIT if:
   (i) [It] is considered a real estate investment trust for the taxable year under Section 856
   of the Internal Revenue Code; (ii) the certificates of beneficial interest or shares of
   which are not regularly traded on an established securities market; (iii) and of which
   more than 50% of the voting power or value of the beneficial interest or shares, at any
   time during the last half of the taxable year, is owned or controlled, directly, indirectly, or
   constructively, by a single corporation.
   Here, the REITs in the Fund are REITs for purposes of Code § 856 and are not regularly
   traded on an established securities market.
   35 Ill. Comp. Stat. 5/1501(a)(1.5)(C) also states that “the constructive ownership rules
   prescribed under § 318(a) of the Internal Revenue Code, as modified by § 856(d)(5) of the
   Internal Revenue Code, apply in determining the ownership of stock, assets, or net profits of
   any person.” Under Code § 318(a)(2)(A), stock owned directly or indirectly by or for a
   partnership is considered as owned proportionately by the partners in the partnership. Code §

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April 8, 2010
Page 3
318(a)(5)(A) further tells us that stock constructively owned by a person by reason of
paragraph (2) is for purposes of applying paragraph (2), considered as actually owned by such
person. Therefore, under 35 Ill. Comp. Stat. 5/1501(a)(1.5)(C), which specifically refers to
Code § 318 for purposes of defining ownership, the common units of the REITs owned by the
Fund are considered to be owned proportionately by each partner in the Fund. Since the
partnership is a pass-through entity, we must look at the partners to determine whether any
corporate entities indirectly own more than 50% of the REITs. The Fund has more than XXX
partners, none of whom own more than a 50% share in the Fund. Thus, it would not be
possible for any single entity (C corporation or otherwise) to have more than 50% ownership
over the REITs (in fact, the organizational documents prohibit ownership in the Fund of over
10% by any single investor). As such, based upon FUND2’s facts, the captive REIT rules
should not apply in the current situation.
In addition, the statute specifically exempts REITs more than 50% owned or controlled by taxexempt entities from the “captive REIT” classification. Here, all of the investors in the Fund are
tax-exempt entities. By specifically exempting entities tax-exempt under Code § 501, it is
apparent that the intent of 35 Ill. Comp. Stat. 5/1501(a)(1.5)(A) was not to subject REITs held
by tax-exempt entities to Illinois income taxation. Even though the state and local pension
funds are not tax-exempt under Code § 501, but instead under Code § 115, the pension funds
are still exempt from federal and Illinois taxation. These pension funds are similar to the types
of entities the statute excludes. Thus, any REIT which is more than 50% owned by tax-exempt
entities should not be treated as a captive REIT.
II. THE CAPTIVE REIT LEGISLATION IS AIMED AT RETAIL CORPORATIONS TRYING TO
SHIELD INCOME FROM STATE TAXATION, NOT REITS HELD BY AN INSTITUTIONAL
FUND FOR TAX-EXEMPT INVESTORS.
The REITs are not engaged in the tax avoidance activities that the captive REIT legislation
was meant to address. The DOR sought enactment of 35 Ill. Comp. Stat. 5/105(a)(1.5) in
response to the state tax minimization strategies employed by large retail companies as
demonstrated in the state of STATE2’s battle with COMPANY11. Under that strategy, retail
corporations were creating abusive captive REITs to hold their own operating real estate
properties, such as stores and office space. The retail company would have all of their stores
pay rent to the REIT for use of the store space, then the REIT would issue dividends to
another subsidiary of the retail company. The captive REIT would not be subject to tax on the
rental income since it would take a deduction for the dividends paid to its shareholders and the
corporation would not be subject to state taxes since it would deduct the rental expense paid to
the REIT against the amount of the dividends received from the REIT. By disallowing the
dividends paid deduction for captive REITs, STATE3, STATE2 and other states have sought to
eliminate the ability of retail corporations to reduce or avoid paying state income taxes.
In our situation, the REITs held by the Fund are not being used for tax avoidance purposes.
First, the Fund invests in real estate and REITs were enacted specifically to be an efficient way
to hold real estate investments. Furthermore, the REITs in the Fund are not in the business of
renting space to COMPANY1 or its affiliates. In fact, COMPANY1, and its predecessor
COMPANY3A, and their affiliates were prohibited (under ERISA’s prohibited transaction rules)
from renting space from the Fund in excess of 8,000 square feet. As of MONTH 1, 200X, the
only lease in the entire Fund involving COMPANY2 or its affiliates is a CITY2 office totaling

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April 8, 2010
Page 4
7,000 square feet. Thus, the Fund is not engaged (and never will be) in rental activities to
generate any meaningful rental expense (in comparison to the value of the Fund). Finally, the
Fund itself is a pass-through entity not subject to Illinois income taxation, and the Fund is
owned entirely by tax-exempt investors who are not subject to federal and state income taxes.
Thus, the Fund and its investors have no motive to avoid state taxes through the use of captive
REITs nor is there opportunity to distort taxable income among the entities involved.
III. THE DEFINITION OF “CAPTIVE REIT” DOES NOT CLEARLY DEFINE “CONTROL.”
While it is my belief that, for the reasons stated above, the REITs in the Fund are not “captive
REITs” as defined under 35 Ill. Comp. Stat. 5/1501(a)(1.5), my concern is with the portion of
the statute that states that a captive REIT is a REIT that has more than 50% of its shares
“owned or controlled, directly, indirectly, or constructively by a single corporation” that is a C
corporation under the Code. Whereas 35 Ill. Comp. Stat. 5/1501(a)(1.5)(C) refers to “the
constructive ownership rules prescribed under § 318(a) of the Internal Revenue Code . . .
apply in determining the ownership . . .,” the statute does not clearly indicate if “control” is to be
similarly determined.
The general partner of the Fund is the FUND4, a single-member limited liability company,
disregarded for federal and state income tax purposes, that is owned by an entity that is a C
corporation. The FUND4, as the general partner of the Fund, makes certain decisions for the
Fund that do not require votes from the rest of the owners. Thus, there are some matters with
respect to the Fund and the REIT which are controlled indirectly by a C corporation.
Codification of attribution in Code § 318 was intended to define control, to provide “precise
rules of attribution where this is appropriate . . . to prevent tax avoidance.” The attribution rules
of Code § 318 were enacted in the Internal Revenue Code of 1954, to clear up uncertainty with
respect to corporate redemptions over the question of “control,” the courts having commented
that “before enactment, attribution rules were sometimes applied, and sometimes, not applied.”
Using Code § 318 to determine “control,” we would find that the voting power in the Fund
would be proportionately allocated to the partners in the Fund. Again, there is no single entity
which has a direct or indirect share of more than 50% of the Fund nor will there be under its
organizational documents, thus no single entity could control the Fund through its share of
votes.
Alternatively, prior to the passage of captive REIT legislation in Illinois, 35 Ill. Comp. Stat.
5/404 provides the DOR with the authority to adjust taxable income to properly reflect business
done in Illinois. Under this provision, Code § 482 is applied to make necessary adjustments.
Treasury Regulation § 1.482-1(i)(4) provides a broad definition of controlled:
Controlled includes any kind of control, direct or indirect, whether legally enforceable or
not, and however exercisable or exercised, including control resulting from the actions
of two or more taxpayers acting in concert or with a common goal or purpose. It is the
reality of the control that is decisive, not its form or the mode of its exercise. A
presumption of control arises if income or deductions have been arbitrarily shifted
Thus, applying the broad definition of “control” found in Code § 482, the general partner of the

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April 8, 2010
Page 5
Fund may control the REITs although it does not own greater than a 50% interest in the REITs.
Under the administration of Code § 482, however, common control is irrelevant if the
transactions at issue were conducted at arm’s length—balancing the control test against a
showing of arm’s length dealings. Here, the captive REIT control provision should be similarly
viewed in light of its purpose to limit a company’s ability to avoid Illinois income tax and should
not deter the legitimate use of REITs by the Fund.
CONCLUSIONS AND REQUEST FOR RULING
Accordingly, I respectfully request that a letter ruling be provided under which the Fund’s
REITs are not considered captive REITs pursuant to 35 Ill. Comp. Stat. 5/1501(a)(1.5) nor are
the REITs in the Fund abusive REITs that the statute is meant to apply to. Simply put, there is
no opportunity for distortion of income among the entities which ultimately the legislation was
designed to address. Thus, the REITs are entitled to take the dividends paid deduction for
purposes of calculating Illinois state income taxes.
Please confirm that you agree with this analysis of the statute and my understanding of the
legislature’s intent. In the event that your office is unable to confirm my conclusions, I would
like to reserve the right to meet with DOR to discuss this matter in further detail before a final
ruling is issued. Your attention is much appreciated.
According to the Department of Revenue (“Department”) regulations, the Department may issue only
two types of letter rulings: Private Letter Rulings (“PLR”) and General Information Letters (“GIL”).
The regulations explaining these two types of rulings issued by the Department can be found in 2
Ill.Adm.Code §1200, or on the website http://www.tax.illinois.gov/LegalInformation/regs/part1200.
Due to the nature of your inquiry and the information presented in your letter, we are required to
respond with a GIL. GILs are designed to provide background information on specific topics. GILs,
however, are not binding on the Department.
Illinois defines a captive real estate investment trust in Section 1501(a)(1.5)(A) of the Illinois Income
Tax Act (“IITA”; 35 ILCS 5/101 et seq.):
(1.5) Captive real estate investment trust:
(A) The term “captive real estate investment trust” means a corporation, trust, or association:
(i) that is considered a real estate investment trust for the taxable year under Section 856
of the Internal Revenue Code;
(ii) the certificates of beneficial interest or shares of which are not regularly traded on an
established securities market; and
(iii) of which more than 50% of the voting power or value of the beneficial interest or
shares, at any time during the last half of the taxable year, is owned or controlled, directly,
indirectly, or constructively, by a single corporation.
The facts in your letter indicate that the FUND2 Fund is a limited partnership that owns three REITs,

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April 8, 2010
Page 6
two of which receive Illinois income: COMPANY4 and COMPANY5. The Illinois income is derived
from property held by single member limited liability companies (“SMLLCs”) for the benefit of both the
COMAPNY4 and the COMPANY5. The SMLLCs are ultimately owned by FUND2 based on the chain
of ownership described in your letter: 99.9% of the SMLLCs are owned by COMPANY7/COMPANY8
(owned by FUND2 REITs) with the other .1% ownership going to COMPANY7/COMPANY9s - the
FUND4s being wholly owned subsidiaries to the FUND2 REITs who are owned by the FUND2 Fund.
Your letter acknowledges that the REITs in the FUND2 Fund are considered REITs for purposes of
IRC Section 856 and that the beneficial interest or shares of the REITs are not traded on an
established securities market. The issue is therefore whether more than 50% of the voting power or
value of the beneficial interest or shares of the REITs are owned or controlled by a single corporation.
The fact that FUND2 Fund is a partnership (not a corporation) and owns membership interests in the
REITs is an indication that the REITs at issue are not “captive” within the meaning of IITA Section
1501(a)(1.5).
Your reliance on Section 318(a)(5)(A) is appropriate given the fact that the FUND2 Fund is a
partnership and IITA Section 1501(a)(1.5)(C) states “[f]or purposes of this subsection 1.5, the
constructive ownership rules prescribed under Section 318(a) of the IRC, apply in determining the
ownership of stock, assets, or net profits of any person”. The specific language in IRC Section 318(a)
relating to partnerships states “stock owned, directly or indirectly, by or for a partnership or estate
shall be considered as owned proportionately by its partners or beneficiaries.”
The facts in your letter state that not only does the FUND2 Fund partnership consist of more than
XXX partners (making it unlikely that any one of XXX partners would own more than a 50% share
given the aforementioned IRC language), but that the organizational documents for FUND2 prohibit
ownership in the Fund of more than 10% by any single investor. These facts are enough to show that
the REITs in FUND2 Fund do not meet the requirements of “captive REITs” as defined in IITA Section
1501(a)(1.5). Accordingly, FUND2 Fund REITs will not be required to add to its federal taxable
income the dividends paid deduction for purposes of calculating Illinois state income taxes.
As stated above, this is a general information letter which does not constitute a statement of policy
that either applies, interprets or prescribes tax law. It is not binding on the Department. Should you
have additional questions, please do not hesitate to contact our office.
Sincerely,

Heidi Scott
Staff Attorney -- Income Tax