Is a charter school's 10-year campus lease (with renewal options) an exempt improvement-to-realty contract if the campus's useful life is 22 years?

Plain-English summary

The Texas Comptroller ruled that a charter school's 10-year initial campus lease term is NOT an exempt improvement-to-realty contract, because 10 years falls far short of the campus's 22-year useful life — even though the lease also included two 5-year renewal options and a purchase option, the ruling's analysis measured only the guaranteed initial term against the useful-life benchmark, not the potential total if renewals are exercised.

The same two-prong test used across the Comptroller's charter-school lease rulings (from Comptroller's Decision No. 28,391 (1993)) applied here: the school easily met prong one as a qualified 501(c)(3) educational tax-exempt entity. On prong two, the Comptroller compared the lease's stated 10-year (120-month) initial term against its own 22-year (264-month) useful-life benchmark for buildings — and found the initial term "does not meet the minimum threshold of 22 years," without factoring in the lease's own 5-year renewal options into that comparison. Because the second prong failed, the lease wasn't an exempt contract, and the landlord couldn't buy construction materials or qualifying services tax-free under Section 151.311.

What this means for you

Charter schools structuring leases with renewal options rather than one long guaranteed term

This ruling suggests the Comptroller's "sufficiently long" analysis looks at the lease's guaranteed initial term, not the maximum possible term if optional renewals are exercised — a 10-year initial term with 5-year renewal options (potentially 20 years total) still failed against a 22-year useful-life benchmark. If your organization wants to secure the Section 151.311 exemption, negotiate for a longer GUARANTEED initial term, not just optional extensions.

Developers and landlords building for tax-exempt tenants with shorter initial lease terms

Don't assume renewal options will be added to the initial term for exempt-contract purposes — this ruling treated the 10-year initial term as the relevant figure, distinct from several companion rulings in this same series where 25+ year GUARANTEED initial terms passed the test.

Accountants and tax professionals

Compare this ruling against the companion charter-school lease rulings that found 25-year and 28-year guaranteed terms exempt (all applying Comptroller's Decision No. 28,391 (1993) and the 22-year Class Codes useful-life benchmark) — the consistent pattern across this series is that only the GUARANTEED lease term is measured against the useful-life benchmark, not optional renewal periods.

Common questions

Q: Does a lease's renewal options count toward the "sufficiently long" requirement for the Section 151.311 exemption?
A: Based on this ruling, no — the Comptroller measured only the guaranteed 10-year initial term against the 22-year useful-life benchmark, without adding the lease's 5-year renewal options to reach that threshold.

Q: What lease term would likely have passed this test?
A: Companion rulings in this same series found guaranteed initial terms of 25 years and 28 years sufficient against the same 22-year useful-life benchmark — so a guaranteed term at or above roughly the property's useful life is the pattern that succeeds.

Q: Can another charter school with a similar shorter-term-plus-renewal-options lease rely on this ruling?
A: No. It's binding on the Comptroller only for the requesting taxpayer and facts presented, and cannot be relied on by any other taxpayer.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity)
• Tex. Tax Code § 151.310 (Religious, Educational, and Public Service Organizations)
• 34 Tex. Admin. Code § 3.291(a)(5) (Contractors — exempt contract definition)
• 34 Tex. Admin. Code § 3.322 (Exempt Organizations)
• Comptroller's Decision No. 28,391 (1993) (originating two-prong test)
• Comptroller's Decision No. 31,505 (1994) (five-year lease failed second prong)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201711024L

Original ruling text

November 30, 2017

RE: Private Letter Ruling No. 2017010118

Dear **:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters. [ENDNOTE 1] We are responding to your request dated June 8, 2016. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

You requested guidance on the exemption in Section 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity) for tangible personal property and taxable services purchased for use in the performance of a contract to improve realty for an organization exempt under Section 151.310 (Religious, Educational, and Public Service Organizations).

Facts Presented

In its request for a private letter ruling, ** (Taxpayer) provided its federal exemption letter, documentation regarding its charter, and Agreement of Lease with Option to Purchase (Lease). The following facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented, without independent verification or approval of the Taxpayer’s application of the State Property Accounting Process User’s Guide.

Taxpayer is a Texas non-profit corporation granted tax-exempt status by the Internal Revenue Service pursuant to Section 501(c)(3) of the Internal Revenue Code. As of Feb. 14, 2013, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax as outlined in Rule 3.322 (Exempt Organizations). Taxpayer holds a charter from the Texas Education Agency (TEA) to operate an open-enrollment charter school. The TEA authorized Taxpayer to add an additional campus in COUNTY located at ADDRESS, CITY, Texas (Campus).

On April 3, 2015, Taxpayer entered into the Lease with ** (Landlord) to finance the construction of the Campus. Under the Lease, Landlord agreed to acquire a site for the Campus, construct new facilities on the Campus per Taxpayer’s specifications, and lease the Campus to Taxpayer for an initial term of 10 years. Taxpayer has the option to renew the Lease for two additional five-year periods. Under the Lease, Taxpayer has an option to purchase the Campus at any time during the Lease.

The site of the new campus requires the construction of new facilities on previously unimproved real property. The Lease requires Landlord to implement the construction projects and make all of the improvements to the Campus. The costs of the improvements are incorporated into the Lease and paid for by Taxpayer in monthly installments using funds received from the State of Texas (State). All construction plans are subject to Taxpayer’s approval, and Landlord shall adopt any changes to the plans requested by Taxpayer unless the changes would not comply with applicable governmental rules and regulations.

The Campus is leased by and used exclusively by Taxpayer as an open-enrollment charter school. Texas Education Code Section 12.105 states that an open-enrollment charter school is a part of the Texas public school system.

Taxpayer receives its funding from the State through a funding system known as the Foundation School Program as authorized by Texas Education Code Section 12.106. Taxpayer uses state funds to lease the Campus. Texas Education Code Section 12.128 states that property, whether purchased or leased, is considered public property for all purposes allowed by state law and is deemed state property held in trust by the charter holder for the benefit of the students. The property may be used only for a purpose for which a school district may use school district property.

Taxpayer holds the deemed state-owned property in trust for the benefit of the attending students. If Taxpayer closes or ceases to exist, the Texas Commissioner of Education, on behalf of the State, takes immediate possession and assumes control over the property, including leasehold rights, under Texas Education Code Section 12.128(c)(1).

Taxpayer references Appendix A, titled “Class Codes,” of the State Property Accounting Process User’s Guide for depreciation of state capital assets that sets 264 months (22 years) as the useful life for buildings and building improvements. This response relies upon the Taxpayer’s assertion that the useful life of the facilities is 22 years.

Questions, Rulings, and Analysis

Our restatement of your questions is shown below, followed by our responses and analysis.

Question One: Is the Lease between Taxpayer and Landlord an exempt contract under Section 151.311?

Ruling One: The Lease is not an exempt contract under Section 151.311 because the Lease is not sufficiently long in relation to the life of the improvements themselves to qualify as an exempt contract.

Question Two: Can Landlord issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the contract with Taxpayer?

Ruling Two: No, the contract between Taxpayer and Landlord does not meet the definition of an exempt contract in Section 151.311. The exemptions provided in Section 151.311 do not apply to Landlord’s purchases.

Analysis:

In relevant part, Section 151.311 addresses contracts for an improvement to realty for an organization exempted from sales and use tax under Section 151.310. Section 151.311 does not require that the exempt organization own the real property improvements. The Section may apply where the exempt organization leases the real property.

An “exempt contract” includes a contract with a non-exempt entity to improve real property for the primary use and benefit of an organization exempted under Section 151.310. Rule 3.291(a)(5) (Contractors). The Comptroller developed a two-prong test to determine whether improvements to real property are for the primary use and benefit of the exempt entity. The test was first set forth in Comptroller’s Decision No. 28,391 (1993).

First, the lessee must qualify for exempt status. Based on the facts presented, Taxpayer is a qualified tax-exempt entity under Section 151.310; therefore, it meets the first prong of the test.

Second, the term of the lease must be sufficiently long in relationship to the life of the improvements themselves. The Comptroller has consistently applied this test. See, for example, Comptroller’s Decision No. 31,505 (1994), which found extensive renovations and improvements failed to meet the second prong of the test because the life of the improvements exceeded the term of the lease, which was only five years.

Determining the life of the real property improvements for the second prong of the test is a fact issue, and the Comptroller has not developed a standard for when the test is met.

The Campus’ expected useful life of 22 years is more than the 10-year (120 month) term found in the Lease. Therefore, the Lease is not sufficiently long to ensure that Taxpayer has the primary use and benefit of the improvements because the term does not meet the minimum threshold of 22 years. The second part of the test is not met, and the Lease is not exempt under Section 151.311.

Since the contract between Taxpayer and Landlord does not meet the definition of an exempt contract as provided in Section 151.311, Landlord cannot issue exemption certificates in lieu of paying tax on purchases of tangible personal property and taxable services used or consumed in the performance of the contract.

Comptroller’s Decisions and STAR documents cited can be found on the Comptroller’s State Tax Automated Research (STAR) system. The Texas Tax Code, Texas Administrative Code, and the STAR system are accessible at www.comptroller.texas.gov/taxes/.

If you have questions about this private letter ruling, please email us through our website at https://comptroller.texas.gov/web-forms/tax-help/ and reference Private Letter Ruling No. 2017010118.

Sincerely,

Tax Policy Division – Indirect Taxes

Texas Comptroller of Public Accounts

ENDNOTE

1. Unless otherwise indicated, all references to “Section” are to the Texas Tax Code, and all references to “Rule” are to Title 34 of the Texas Administrative Code.