Does a mid-term termination-fee option in a 28-year charter-school ground lease defeat the exempt improvement-to-realty contract test, if the property reverts to the school on termination?

Plain-English summary

The Texas Comptroller ruled that a charter school's 28-year Ground Lease and Lease relocating its campus remains an exempt improvement-to-realty contract under Section 151.311 despite an early-termination option — because unlike a similar arrangement that failed the test, here the property reverts to the school itself, not to a third-party landlord, if the school exercises that option.

The school (a Florida-chartered 501(c)(3) doing business in Texas) structured the deal with a Ground Lease granting the landlord rights to the land and improvements, plus a separate Lease under which the landlord built the new campus and leased it back for a term running through 2046 — roughly 28 years from the 2018 estimated completion date, against the Comptroller's 22-year useful-life benchmark for buildings. The lease also gave the school an option to terminate between months 37 and 60 of the term, in exchange for a termination fee. Normally an early-termination right that lets a tenant walk away before the useful life expires can defeat the "sufficiently long" prong of the exempt-contract test (as happened in a companion 2018 ruling on a different school's lease). Here, the Comptroller reached the opposite result: because the Ground Lease provisions mean the campus reverts to the school as owner if the termination option is exercised, the school retains the primary use and benefit of the improvements either way — through the full lease term, or through outright ownership if it terminates early. Both prongs of the test were satisfied, and the exemption applied.

What this means for you

Charter schools and nonprofits structuring ground-lease financing

Where you can be structured to hold reversionary ownership rights if a lease is terminated early, an early-termination option won't necessarily defeat the Section 151.311 exemption — what matters is whether your organization keeps the primary benefit of the improvements, by continued lease OR by taking ownership, not simply whether the stated term is uninterrupted.

Developers financing exempt-organization campuses via ground leases

Structuring the deal so that the improvements revert to the exempt tenant (rather than staying with the landlord) on early termination can preserve exempt-contract status even where the lease includes a buyout/termination option — contrast this with a companion ruling where a termination right that didn't include reversion to the tenant caused the exemption to fail.

Accountants and tax professionals

This ruling and a companion 2018 charter-school ruling (finding a lease NOT exempt due to an early-termination right) together show that the Comptroller's "sufficiently long" analysis isn't purely about the stated term length — it's about who ends up with the primary use and benefit of the improvements in every scenario the lease allows, including early exit. Reversion-to-tenant terms are the key distinguishing fact here.

Common questions

Q: Does any early-termination option in an exempt organization's lease disqualify it from the Section 151.311 exemption?
A: Not necessarily. If the termination option results in the property reverting to the exempt organization itself (rather than staying with a third-party landlord), the organization still retains the primary benefit of the improvements, and the exemption can survive.

Q: What's the difference between this ruling and a similar one that found NO exemption?
A: In the ruling that failed, the school could simply walk away from the lease with no reversion of the improvements to the school; here, exercising the termination option gives the school ownership of the campus outright.

Q: Can another organization with a similar ground-lease structure 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 — the reversionary structure of your specific lease needs its own review.

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)
• 34 Tex. Admin. Code § 3.1(d)(1) (prospective reliance); § 3.325 (Refunds and Payments Under Protest)
• Tex. Educ. Code §§ 12.105, 12.106, 12.128 (charter schools as public property held in trust)
• 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/201805021L

Original ruling text

May 30, 2018

RE: Private Letter Ruling No. 2017010164

** Taxpayer No. **

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, 2017. 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

** (Taxpayer) is a Florida non-profit entity registered to do business in Texas and granted tax-exempt status by the Internal Revenue Service pursuant to Section 501(c)(3) of the Internal Revenue Code. As of May 5, 1997, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax outlined in Rule 3.322 (Exempt Organizations).

Taxpayer provided its federal exemption letter, documentation regarding its charter, and documentation regarding the purchase and lease of property. The facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented.

On April 2, 2014, Taxpayer received a renewal charter from the Texas Education Agency (TEA) to operate an open-enrollment charter school through July 31, 2020. The TEA authorized Taxpayer to relocate one of its campuses to **, CITY, Texas * (Campus) effective Sept. 1, 2017. The Campus includes an elementary, middle, and high school.

COMPANY A purchased Campus from a seller through a Purchase and Sale Agreement and then transferred its rights in the Purchase and Sale Agreement to Taxpayer. Simultaneously, the seller conveyed Campus to Taxpayer through a Special Warranty Deed. To operate a public school at the property, construction and improvements were required to existing buildings. To help finance the construction, on Nov. 1, 2016, Taxpayer granted a Ground Lease to COMPANY B (Landlord) for the property described on Exhibit A to the Ground Lease and any improvements on the property (Ground Lease).

On Nov. 1, 2016, Taxpayer also entered into a Lease Agreement with Landlord (Lease). Under the Lease, Landlord agreed to construct the Campus per Taxpayer’s specifications and to lease the Campus to Taxpayer for a term beginning on the Substantial Completion date, as defined in the Lease (estimated around Aug. 1, 2018), and ending June 30, 2046. The Lease also gives Taxpayer an option to terminate the Ground Lease and Lease in consideration for a termination fee between the 37th and 60th months of the Lease term.

The Lease requires Landlord to implement the construction projects and make all of the improvements to the Campus described within Exhibit 6.1-1 to the Lease. 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 change 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 (Status) 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 (State Funding). Taxpayer uses state funds to lease the Campus. Texas Education Code Section 12.128 (Property Purchased or Leased with State Funds) 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).

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 an exempt contract under Section 151.311 because it is a contract to improve realty for the primary use and benefit of an exempt entity.

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

Ruling Two: Landlord may issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the exempt contract. Taxable items include tangible personal property incorporated into the realty in the performance of the exempt contract; tangible personal property, other than machinery and equipment, that is necessary and essential for the performance of the exempt contract and completely consumed at the job site; and taxable services that meet the requirements in Section 151.311(c).

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. See 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, Taxpayer 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.

Taxpayer did not state the Campus’s expected useful life. The Comptroller’s State Property Accounting Process User’s Guide – Appendix A – Class Codes (Class Codes) provides guidance when calculating the expected useful life for building improvements. According to the Class Codes, the useful life for buildings and building improvements – non-componentized is 264 months (22 years).

Using the Class Codes guideline, the Campus’s expected useful life of 22 years is less than the 28-year term found in the Lease. Therefore, the 28-year term of the Lease is sufficiently long to ensure that Taxpayer has the primary use and benefit of the improvements under the Lease. Further, Taxpayer has the primary use and benefit of the improvements if it executes the termination option in the Lease because the Campus reverts back to Taxpayer as the owner at the time of termination. The second part of the test is met, and the Lease is exempt under Section 151.311.

Section 151.311 creates an exemption from sales tax on the purchase of tangible personal property that is incorporated into the realty in the performance of an exempt contract. Section 151.311(a). Section 151.311 also exempts the purchase of tangible personal property, other than machinery or equipment and its accessories and repair and replacement parts, in the following circumstances: (1) the tangible personal property is necessary and essential for the performance of the exempt contract; and (2) the tangible personal property is completely consumed at the job site. Section 151.311(b).

The statute further provides that the purchase of a taxable service for use in the performance of an exempt contract is exempt if the service is performed at the job site and either (1) the contract expressly requires the specific service to be provided or purchased by the person performing the contract, or (2) the service is integral to the performance of the contracts. Section 151.311(c).

Under Rule 3.1(d)(1), these rulings may be relied on prospectively from the date of this response and do not address the validity of any refund claim that might be submitted by Taxpayer. Any refund request is subject to the requirements of Rule 3.325 (Refunds and Payments Under Protest).

Comptroller’s Decisions cited are 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. 2017010164.

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.