If a charter school already owns undeveloped land it can't afford to build on, SELLS it to landlord entities who then build the campus and lease it back for 25 years, does that sale-leaseback financing structure still qualify for the § 151.311 construction exemption?

Plain-English summary

A Texas nonprofit charter-school operator running seventeen campuses already owned undeveloped land for a new campus — but couldn't afford to develop it. To finance construction, the school sold that land to two Idaho LLCs acting jointly as "Landlord," then entered a build-to-suit lease and purchase option with them: Landlord built the new facility to the school's specifications and leased it back for a 25-year primary term, with the school able to buy the campus during years two through five.

Applying the two-prong test under § 151.311, citing the operator's own recent ruling (STAR Document 201409958L) as the most similar precedent:

1. Is the lessee a qualified exempt entity? Yes — the school is exempt under § 151.310.
2. Is the lease term long enough relative to the improvement's useful life? The 25-year lease term exceeds the campus's 22-year expected useful life (the school's own figure), so yes.

Both prongs being met, the build-to-suit lease is exempt under § 151.311 — the fact that the land itself originated with the school (via a sale to the landlord, rather than the landlord acquiring it independently) didn't change the analysis.

What this means for you

Charter schools that already own land they can't afford to develop

Selling your own undeveloped land to a landlord entity, then leasing back the finished building, is a viable financing structure that this ruling confirms still gets the § 151.311 exemption — the Comptroller looked at the final lease term and the school's exempt status, not at where the land came from.

Related rulings

This is one of a same-day (November 6, 2014) trio of rulings for the same 17-campus charter-school operator, each for a different campus. It's a close companion to another same-day ruling using an identical sale-leaseback structure for yet another campus — the main difference here is that TWO Idaho LLCs jointly hold the landlord role, rather than one.

Common questions

Q: Does selling my own land to a landlord before leasing it back change the exemption analysis?
A: Not per this ruling — the Comptroller applied the same two-prong test regardless of whether the landlord acquired the land independently or bought it from the school itself.

Q: What lease term is long enough to satisfy the "primary use and benefit" test?
A: There's no fixed bright line — per this ruling, a 25-year lease against a 22-year useful life was sufficient.

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 Rule 3.291(a)(5) (Contractors — exempt-contract definition)
• 34 Tex. Admin. Code Rule 3.1; Rule 3.10 (Taxpayer Bill of Rights — detrimental reliance)

Cited prior guidance:

• Comptroller's Decision No. 28,391 (1993) — source of the two-prong "primary use and benefit" test
• STAR Document 201409958L (September 19, 2014) — this operator's own prior ruling for a different campus, cited as the most recent similar precedent

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201411981L

Original ruling text

November 6, 2014

RE: Private Letter Ruling # 142680530

Dear ****

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated September 22, 2014. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance on the comptroller’s interpretation of the exemption in
Tax Code Section 151.311 for tangible personal property and taxable services
purchased for use in the performance of a contract to improve realty for an
organization exempt under Tax Code Section 151.310. The agency has addressed
similar facts presented by this inquiry; most recently in another private
letter ruling, STAR Document No. 201409958L issued on September 19, 2014.
However, because guidance on this issue is not expressly provided for in
statute or agency rule, we also issue this private letter ruling.

Facts Presented

COMPANY A is a Texas non-profit corporation granted tax-exempt status by the
Internal Revenue Service (“IRS”) pursuant to Section 501(c)(3) of the Internal
Revenue Code. On February 12, 2010, COMPANY A met the qualifications for
exemption from Texas Sales or Use tax outlined in Rule 3.322 relating to exempt
entities.

COMPANY A received a charter from the Texas Education Agency (“TEA”) to operate
an open-enrollment charter school. COMPANY A presently operates seventeen
campuses in central and south central Texas. One campus, CAMPUS A, has had a
new facility constructed at ****, Texas. In order to finance the
construction of the facility, COMPANY A sold the undeveloped property, which it
already owned but had been unable to develop, to COMPANY B and COMPANY C, all
Idaho Limited Liability Companies (“Landlord”). COMPANY A entered into a build
to suit lease [ENDNOTE 1] and option (“Lease”) with Landlord, where Landlord
agreed to construct the new facility per specifications and to lease the CAMPUS
A to COMPANY A for an initial term of twenty-five (25) years. Under the Lease,
COMPANY A has the option to purchase the campus during all or parts of the
second through fifth years of the Lease.

The Lease specifies that all structural and equipment specifications are
subject to governmental review and approval. As set out in Article 5 of the
Lease, all plans are subject to COMPANY A’s approval and any changes to the
plans shall be adopted by the Landlord unless the changes will not be approved
by the applicable governmental agencies.

The site of the new campus will require the construction of a new facility on
previously unimproved real property. The Lease requires Landlord to implement
the construction project and make all of the improvements to CAMPUS A with the
cost incorporated into the Lease and paid for by COMPANY A either in monthly
payments or by exercising its option to purchase. The campus is being improved
for, leased by, and used exclusively by COMPANY A as an open-enrollment center,
which, under Texas Education Code Section 12.105 is a part of the Texas public
school system.

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

The charter holder—in this case COMPANY A—holds the state-owned property in
trust for the benefit of the attending students. If COMPANY A 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). The commissioner then
is charged with disposition of the property under Texas Education Code Section
12.128(c)(2).

RULING AND ANALYSIS

Our restatement of the ruling you requested is shown below, followed by our
response and analysis.

Is the build-to-suit lease at issue an exempt contract as contemplated by Texas
Tax Code Section 151.311, thereby allowing the tax-free purchase of taxable
items by the taxable entity for incorporation into property leased by the
tax-exempt entity?

RESPONSE: This question is not addressed by statute or rule and the response
provided will be memorialized in a future amendment to Rule 3.291
(Contractors). The build-to-suit lease at issue is an exempt contract as
contemplated by Texas Tax Code Section 151.311 because it is a contract to
improve real property for the primary use and benefit of an exempt entity.
Tangible personal property or taxable services meeting the requirements
expressed in Texas Tax Code Section 151.311 are exempt from Texas sales or use
tax.

Texas Tax Code Section 151.311 provides, in part, that the purchase of tangible
personal property for use in the performance of a contract for an improvement
to realty for an organization exempted under Sections 151.309 or 151.310 is
exempt if the tangible personal property is incorporated into realty in the
performance of the contract. Tax Code Section 151.311 further provides that the
purchase of a taxable service for use in the performance of a contract for an
improvement to realty performed for such an organization is exempt if the
service is performed at the job site and if the contract expressly requires the
specific service to be provided or purchased by the person performing the
contract or the service is integral to the performance of the contract.

Rule 3.291(a)(5) defines an exempt contract to include a contract for the
improvement of real property with an entity that is exempt under Section
151.309 or 151.310. An example of an exempt contract is a contract with a
non-exempt entity to improve real property for the primary use and benefit of
an organization exempted under Section 151.309 or 151.310. See Rule
3.291(a)(5).

Tax Code Section 151.311 does not require that the real property be owned by
the exempt organization. For situations involving an exempt lessee and a
non-exempt lessor, the agency 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 DECISION NO. 28,391
(1993).

First, the lessee must qualify for exempt status under Section 151.309 or
151.310. Based on the facts presented, COMPANY A 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. This test has been consistently applied
by the comptroller. See for example, COMPTROLLER 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 (5) years.

Determining the life of the real property improvements for the second prong of
the test is a fact issue, and the agency has not developed any standard for
when the test is met. COMPANY A references Appendix A, “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. The twenty-five (25) year term of the Lease is
sufficiently long to ensure that COMPANY A will have the primary use and
benefit of the improvements under the Lease; therefore, the second part of the
test is met and the Lease is exempt under Section 151.311.

If you have questions about this private letter ruling, please email us at the
following link, https://www.window.state.tx.us/taxhelp/ and reference Private
Letter Ruling #142680530.

Sincerely,

Tax Policy Division

ENDNOTES:
1.The Association of Corporate Counsel defines a build-to-suit (or
design-build) lease to be “essentially a landlord/developer’s agreement to
construct a purpose built building, usually for a single tenant. The landlord
will typically own or ground lease the lands (and once constructed, the
building) and has the option of re-letting the building to a new tenant upon
the expiry of the term of the build-to-suit lease to the original tenant.
Build-to-suit leases typically are for a longer term than a normal lease in
order to permit the landlord to recoup its investment over the duration of the
lease term.”