The IRS recently released two private letter rulings relating to real estate investment trusts ("REITs").  One private letter ruling rules that taxable income earned from certain refundable state tax credits will be disregarded in applying the income tests for REIT qualification, and the other clarifies the application of the deduction limitation of Section 162(m) of the Internal Revenue Code to compensation paid for services performed for the operating partnership of a publicly-held REIT.[1]  A private letter ruling ("PLR") is not binding on the IRS except as to the taxpayer that requested and received the ruling, and cannot be relied upon as precedent by other taxpayers.  Nevertheless, a PLR provides other taxpayers with some indication of the IRS’ ruling position on a particular legal issue as applied to a set of facts.

REIT Income Test Impact of Refundable State Tax Credits

In PLR 200614024 (Dec. 28, 2005), the REIT’s sole asset was an interest in a limited liability company, which was to construct, own and operate a mixed-use real estate project.  The project was to be constructed on contaminated land designated by the State as eligible for refundable State tax credits enacted by the State legislature to promote clean up and development of contaminated sites.  The amount of available credits was based upon the cost of site preparation, the cost of certain tangible property principally used for conservation, and the cost of on-site groundwater remediation.  The REIT expected the refundable tax credits to account for more than five percent of the REIT’s gross revenues during the early years of operation.  Substantially all of the REIT’s other income was expected to be qualifying income under the REIT income tests.

In general, the tax credit payments would be includible in gross income under Section 61(a).  Under Sections 856(c)(2) and 856(c)(3), certain gross income tests must be met in order to qualify for REIT status.  The tax refund payments do not appear to fall within any of the enumerated categories of qualifying income under Sections 856(c)(2) and 856(c)(3).

PLR 200614024 notes that the legislative history indicates that one of the principal purposes of the REIT gross income tests was to ensure that a large part of a REIT's gross income would include passive income, and that the tax treatment of REITs was intended to be equated with the treatment accorded regulated investment companies ("RICs"). Thus, PLR 200614024 reasons that, because of Congress' intent to equate the tax treatment of REITs with that of RICs, it is appropriate to consider Rev. Rul. 64-247, 1964-2 C.B. 179, and Rev. Rul. 74-248, 1974-1 C.B. 167, both applicable to RICs and rendered obsolete in part by a subsequent ruling, in determining how the tax refund payments should be treated for purposes of the gross income tests applicable to REITs.

In Rev. Rul. 64-247, a RIC recovered excess management fees from its investment manager following legal action against the company's former officers and directors who had owned the investment manager.  In Rev. Rul. 74-248, a RIC's former investment advisor repaid an amount that the advisor improperly received for assigning its advisory contract.  Both Rev. Rul. 64-247 and Rev. Rul. 74-248 held that, while the amounts received were not included in the permissible sources of income for RICs under Section 851(b)(2), the inclusion of these amounts would not cause the taxpayer to fail to meet the definition of a RIC in Section 851.  Rev. Rul. 64-247 and Rev. Rul. 74-248 were rendered partially obsolete by Rev. Rul. 92-56, 1992-2 C.B. 153, which held that a reimbursement received by a RIC from its investment advisor that was includible in the RIC's gross income was qualifying income under Section 851(b)(2).

In PLR 200614024, the IRS found that the State public policy to encourage clean-up of contaminated sites did not interfere with or impede the policy objectives behind the income tests in Sections 856(c)(2) and 856(c)(3), and that the tax credits therefore should not cause the project to fail to be a qualifying REIT asset or prevent the rental income from the property from constituting qualifying income.  Accordingly, the IRS ruled that the taxable income associated with the receipt of the State tax credits would be disregarded in determining whether the taxpayer satisfied the REIT income tests in Sections 856(c)(2) and 856(c)(3). 

Application of Section 162(m) to REIT Operating Partnership Structure

In PLR 200614002 (Dec. 14, 2005), a REIT owned a general partnership interest and preferred units in a partnership ("OP").  Under the securities laws, the REIT was required to disclose the compensation paid to its chief executive officer and four other highest compensated officers ("Officers").  The Officers were therefore "covered employees" with respect to the REIT for purposes of Section 162(m), which limits a publicly-held corporation’s deduction for certain compensation in excess of $1 million paid to a covered employee of the corporation.

The Officers were also employees and officers of the OP, and provided only a small portion of their services as employees of the REIT.  The Officers received base salary and participated in various bonus and executive compensation plans based on their services for both entities.  Each Officer’s employment contract specified the percentage of his or her compensation for services provided to each entity, and the percentages were subject to adjustment from time to time.  The OP reported the Officers’ compensation on IRS Form W-2 and withheld all applicable taxes.  It was expected that the total compensation of one or more of the Officers for services performed for the OP would exceed $1 million and would not qualify for an exclusion from Section 162(m), assuming Section 162(m) applied.

Without citing any authority aside from Section 162(m) and related provisions of the Internal Revenue Code, the IRS ruled that (1) the deduction limitation of Section 162(m) did not apply to the OP with respect to compensation paid by the OP to the Officers for their services as employees of the OP, and (2) the deduction limitation also did not apply to the REIT with respect to its distributive share of income or loss from the OP that included compensation expense paid by the OP to the Officers for their services as employees of the OP.  The IRS specifically noted that it expressed no opinion on the allocation of the compensation between the REIT and the OP.