A REIT's share of self-charged management fees is left out of the gross-income tests

Plain-English summary

A real estate investment trust (REIT) plans to restructure so that it indirectly owns a slice of the outside manager that runs its real estate portfolio. Because the REIT would then be a partner in that manager, part of the management fees the REIT pays would loop back to the REIT as income. REITs must earn most of their income from passive real estate sources (the 95% and 75% gross-income tests of § 856(c)), so this recycled fee income could threaten qualification. The taxpayer asked the IRS to disregard its share of those management fees. Using the Secretary's authority under § 856(c)(5)(J), the IRS ruled that the REIT's allocable share of the management fees will not count as gross income for the § 856(c)(2) and (3) tests, because it duplicates income the REIT already reports and reflects the REIT paying itself for work it could do directly. The IRS expressed no opinion on whether the taxpayer otherwise qualifies as a REIT.

Ruling snapshot

• Question: May a REIT's allocable share of self-charged management fees be excluded from gross income for the § 856(c)(2) and (3) income tests?
• Outcome: Approved
• Key authorities: IRC § 856(c)(2), (3), (5)(J); Treas. Reg. §§ 1.856-3(g), 1.856-4(b)(5)(ii)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202102002 Third Party Communication: None
Release Date: 1/15/2021 Date of Communication: Not Applicable
Index Number: 856.00-00, 856.01-00
Person To Contact:
--------------- -------------------------, ID No. -----------------
------ Telephone Number:
--------------------------------- --------------------
------------------------------------------------------ Refer Reply To:
--------------------------------- CC:FIP:B01
PLR-110109-20
Date:
October 16, 2020

Legend:
Taxpayer = --------------------------------------------------------------------------------
---------------------
Operating = --------------------------------------------------------------------------------
Partnership ------------------------
Company X = --------------------------------------------
Company Y = ----------------------------------
Manager = -------------------------------------------------
Joint Venture A = --------------------------------------------------------------------------------
------------------------
Joint Venture B = --------------------------------------------------------------------------------
------------------------
State A = ------------
State B = -------------
Date 1 = --------------------
Date 2 = --------------------------
Date 3 = ---------------------------
Date 4 = --------------------------
Year = -------
a = ------
b = ------
c = ----
d = ---
e = ------
f = ---
g = ----
h = ---
i = --
PLR-110109-20 2

Dear -------------:

   This ruling responds to a letter dated April 10, 2020, and supplemental

submissions, submitted on behalf of Taxpayer. Taxpayer requests a ruling regarding
the treatment of Taxpayer’s allocable share of management fees for purposes of the
gross income tests under section 856(c)(2) and (3) of the Internal Revenue Code
(“Code”).

                                     FACTS

    Taxpayer is a State A corporation. Taxpayer was formed on Date 1 and elected

under section 856 to be a real estate investment trust (“REIT”) beginning with its taxable
year ended Date 2. Taxpayer expects to complete an initial public offering of its stock in
the third quarter of Year.

   Taxpayer conducts substantially all of its business through Operating

Partnership, a State B limited liability company. Taxpayer owns the sole general
partnership interest in Operating Partnership through its wholly owned subsidiary
Company X, a State B limited liability company. Company X is a disregarded entity for
federal income tax purposes. Taxpayer also directly owns a limited partnership interest
in Operating Partnership. For federal income tax purposes, Operating Partnership is a
disregarded entity.

     Operating Partnership is the sole owner of Company Y, a State B limited liability

company. Company Y elected to be treated as a corporation for federal income tax
purposes. Company Y and Taxpayer jointly elected to treat Company Y as a taxable
REIT subsidiary of Taxpayer. Company Y owns a percent of Manager, a State B limited
liability company treated as a partnership for federal income tax purposes. Manager
owns a small minority interest in Taxpayer (b percent as of Date 3). Manager’s
ownership interest is expected to change each quarter as Manager is paid a portion of
its management fees in Taxpayer’s common stock, but will not exceed c percent.

    Operating Partnership’s primary business is to acquire, invest in, and manage a

portfolio of commercial real estate, multi-family residential properties, and mixed-use
retail/residential properties (collectively, the “Properties”). Operating Partnership may
occasionally acquire mortgage loans secured by commercial real estate and multi-family
residential and commercial mixed-use retail/residential properties (collectively, the
“Mortgages”). Additionally, and to a lesser extent, Operating Partnership will lend to
investors via mezzanine debt that converts to preferred equity upon sale or refinancing
(the “Mezzanine Debt”) and may enter into sale-leaseback arrangements on certain
properties (the “Leaseback Properties”). Operating Partnership will occasionally acquire
the properties securing the Mortgages through foreclosure (“REO” and, together with
the Properties, Mortgages, Mezzanine Debt, Leaseback Properties, the “Investments”).
Operating Partnership does not expect foreclosure on REO very often.
PLR-110109-20 3

  In the ordinary course of business, Operating Partnership will receive interest

and rental income from Investments (“Investment Income”). Taxpayer represents that
substantially all of the Investment Income received by Taxpayer will be qualifying gross
income under section 856(c)(2) and (3).

    Operating Partnership may form joint ventures with unrelated third parties

classified as partnerships for federal income tax purposes (“Joint Ventures”). Operating
Partnership is currently a d-percent member in Joint Venture A and a e-percent member
in Joint Venture B, which both hold commercial real estate assets. Taxpayer represents
that Operating Partnership expects to own at least a f-percent interest in any future Joint
Venture that owns Investments.

    On Date 4, Manager entered into a management agreement with Taxpayer and

Operating Partnership (“Management Agreement”). Pursuant to the Management
Agreement, Manager (i) implements Operating Partnership’s business strategy,
(ii) manages Operating Partnership’s business and investment activities and day-to-day
activities and, (iii) provides Operating Partnership with a management team and
necessary administrative and support personnel (the “Services”). Taxpayer represents
that the Services provided by Manager will be usual and customary asset management
services for the Investments. The Management Agreement provides that in the future,
Manager may provide services to third parties under the condition that its Services to
Taxpayer are not impaired. Manager does not currently provide services to any entities
other than Operating Partnership. In the future, Manager may also provide Services to
the existing Joint Ventures and other Joint Ventures, and will be compensated directly
by the Joint Ventures.

  Manager will not be the servicer of the Mortgages or provide any services to

tenants. A third-party independent contractor will service the Mortgages and provide
any necessary property management, lease management, and renovation
management.

    Manager is compensated through fees paid by Operating Partnership. For

Manager’s Services to Operating Partnership, Operating Partnership pays a base
management fee and an incentive fee to Manager (the “Management Fees”). The base
management fee is g percent of Taxpayer’s consolidated stockholders’ equity per
annum. Taxpayer’s consolidated stockholders’ equity is the sum of the net proceeds
from any issuances of equity by Taxpayer or Operating Partnership since inception, plus
Taxpayer’s and Operating Partnership’s retained earnings less (i) any amount Taxpayer
or Operating Partnership pays to repurchase its common stock or units since inception,
(ii) any unrealized gains and losses and other non-cash items that have affected
consolidated stockholder’s equity, and (iii) any amount related to one-time events
caused by changes in GAAP, and certain non-cash items not otherwise discussed
above. The base management fee will be paid in a combination of cash and shares of
Taxpayer’s common stock.
PLR-110109-20 4

   The incentive fee will be payable quarterly in an amount equal to h percent of the

dollar amount by which the sum of (A) aggregate cash dividends declared out of the
REIT taxable income of Taxpayer and (B) distributions declared out of the taxable
income of the Operating Partnership (without duplication) exceeds the product of
i percent and the book value per share of Taxpayer’s common stock as of the end of
each quarter. The incentive fee is payable in cash.

    Taxpayer intends to restructure its operations. Company Y will either distribute

its a-percent interest in Manager to Operating Partnership or liquidate in a taxable or
tax-free liquidation pursuant to section 331 or section 332. Thereafter, Operating
Partnership will directly own the a-percent interest in Manager. Manager will continue to
manage the Investments and be compensated as provided in the Management
Agreement (as described above). Because Taxpayer (through disregarded Operating
Partnership) will be a partner in Manager, Taxpayer will have gross income attributable
to its share of the Management Fees.

   Taxpayer represents that all activities Manager performs for Operating

Partnership in exchange for Management Fees are activities that a REIT may, under the
Code and the Income Tax Regulations (the “Regulations”), perform in managing the
assets of the REIT as well as managing the REIT itself without adverse tax
consequences. Taxpayer represents that it will treat its gross income attributable to any
fees earned by Manager from third parties as non-qualifying income for purposes of
section 856(c).

                              LAW AND ANALYSIS

   Section 856(c)(2) provides that, for a corporation to qualify as a REIT, at least 95

percent of the corporation’s gross income (excluding gross income from prohibited
transactions) must be derived from sources that include dividends; interest; rents from
real property; gain from the sale or other disposition of stock, securities, and real
property (including interests in real property); and abatements and refunds of taxes on
real property.

   Section 856(c)(3) provides that, for a corporation to qualify as a REIT, at least 75

percent of the corporation's gross income (excluding gross income from prohibited
transactions) must be derived from sources that include rents from real property,
interest on obligations secured by mortgages on real property or interests in real
property, gain from the sale or other disposition of real property (including interests in
real property), dividends from REIT stock and gain from the sale of REIT stock, and
abatements and refunds of taxes on real property.

   Section 856(c)(5)(J) provides that to the extent necessary to carry out the

purposes of part II of subchapter M, 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
PLR-110109-20 5

income not qualifying under section 856(c)(2) or (3) may be considered as gross income
which qualifies under section 856(c)(2) or (c)(3).

  Section 1.856-3(g) of the Regulations provides that a REIT that is a partner in a

partnership is deemed to own its proportionate share of each of the assets of the
partnership and is deemed to be entitled to the income of the partnership attributable to
such share. For purposes of section 856, the interest of a partner in the partnership’s
assets is determined in accordance with the partner’s capital interest in the partnership.
The character of the various assets in the hands of the partnership and items of gross
income of the partnership retain the same character in the hands of the partners as in
the hands of the partnership for all purposes of section 856.

    Section 1.856-4(b)(5)(ii) provides that the directors or trustees of a REIT are not

required to delegate or contract out their fiduciary duty to manage the REIT itself, as
distinguished from rendering or furnishing services to the tenants of the REIT’s property
or managing or operating the property. Thus, the trustees or directors may do all things
necessary, in their fiduciary capacities, to manage and conduct the affairs of the trust
itself. For example, the trustees or directors may establish rental terms, choose
tenants, enter into and renew leases, and deal with taxes, interest, and insurance,
relating to the REIT’s property.

  Section 61(a) of the Code provides that, except as otherwise provided, gross

income includes all income from whatever source derived.

   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.”

    After the restructuring, Operating Partnership will (a) earn Investment Income

from Investments, (b) pay Management Fees to Manager, and (c) be allocated
a percent of those Management Fees for purposes of section 856(c) as a a-percent
partner in Manager. Because Taxpayer owns 100 percent of Operating Partnership,
100 percent of the Management Fees represent an expense of Taxpayer for services to
Taxpayer. Taxpayer will therefore include gross income attributable to both the
Investment Income and the Management Fee income. Because the Management Fees
are derived from the same Investments that generate the Investment Income, including
Taxpayer’s share of the Management Fees in Taxpayer’s gross income would cause
the amounts to be counted twice for purposes of the gross income tests under section
856(c). Moreover, Taxpayer’s gross income attributable to Manager’s Management Fee
income represents an amount that Taxpayer, as a partner in Manager, is charging itself
to perform functions that, based on Taxpayer’s representations, Taxpayer could perform
directly without adverse tax consequences. Under these circumstances, excluding
PLR-110109-20 6

Taxpayer’s share of the Management Fees from Taxpayer’s gross income for purposes
of section 856(c)(2) and (3) is consistent with the purposes of part II of subchapter M.

                                   CONCLUSION

   Based on the facts submitted and representations made by Taxpayer, Taxpayer's

gross income attributable to its allocable share of the Management Fees will be treated
under section 856(c)(5)(J) as not constituting gross income for purposes of section
856(c)(2) or (3).

    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. Specifically, no opinion is expressed or implied as to whether
Taxpayer otherwise qualifies as a REIT; whether the Investment Income is qualifying
REIT income under section 856(c)(2) or (3); whether the REOs qualify as foreclosure
property; whether the sale of any REO is a prohibited transaction under section
857(b)(6); or whether any of Manager’s activities under the Management Agreement are
activities the REIT may perform itself without adverse tax consequences.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representatives.

                                   Sincerely,



                                   _________________________
                                   Steven Harrison
                                   Branch Chief, Branch 1
                                   Office of Associate Chief Counsel
                                   (Financial Institutions and Products)

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