When a charter school relocates a campus by having a for-profit landlord build a new facility and lease it back for 30 years, with an option to buy at any time, does the construction contract qualify as a tax-exempt improvement to realty?

Plain-English summary

A Texas nonprofit open-enrollment charter-school operator, exempt under § 501(c)(3) and Rule 3.322, was relocating one of its two campuses in a city area to a newly built facility. To finance the move, it entered a build-to-suit lease with a for-profit landlord: the landlord builds the campus to the school's specs and leases it back for a 30-year primary term, with the school able to buy the campus at any point during the lease. Lease payments come from state education funding, and Texas law deems the leasehold itself state-owned property held in trust for students.

The Comptroller applied its established two-prong test (from a 1993 decision) for whether a lease to an exempt organization from a non-exempt landlord counts as an "exempt contract" under § 151.311:

1. Is the lessee a qualified exempt entity? Yes — the charter-school operator is exempt under § 151.310.
2. Is the lease term long enough, relative to the improvement's useful life, that the exempt entity gets the primary use and benefit? Using the school's own asserted useful-life figure (22 years, from the state's capital-asset depreciation schedule for buildings), the 30-year lease term comfortably exceeds it.

Both prongs being met, the lease is an exempt § 151.311 contract, and the landlord may buy construction materials and qualifying job-site services tax-free via exemption certificate rather than paying tax and seeking a refund. The ruling does not pass on any refund claim and applies prospectively only.

What this means for you

Charter schools relocating a campus via a for-profit landlord

An unrestricted right to buy the property "at any time" during the lease didn't change the analysis here — the Comptroller focused only on whether the lease term itself (30 years) exceeded the building's useful life (22 years), not on how soon the purchase option could be exercised.

Landlords and developers financing a school build-to-suit

Confirm the tenant's exempt status and get a defensible useful-life figure for the building type before assuming the construction contract qualifies — the Comptroller has no fixed bright-line useful-life standard and here simply accepted the taxpayer's own 22-year figure, sourced from the state's own capital-asset accounting guide.

Related rulings

This ruling is one of a batch of same-day/next-day (September 1-2, 2015) private letter rulings addressing materially identical build-to-suit charter-school lease structures for different campuses, landlords, and lease terms (25 and 30 years) — all applying the same two-prong test and reaching the same exempt result. This particular ruling is distinguished by its straightforward single non-exempt landlord and unrestricted purchase-option timing, unlike companion rulings involving layered holding entities or fixed purchase-option windows.

Common questions

Q: Does an unlimited "buy anytime" purchase option affect whether the lease qualifies as exempt?
A: Not per this ruling — the Comptroller's analysis turned entirely on comparing the lease term to the building's useful life, not on the purchase-option terms.

Q: What lease term is long enough to satisfy the exemption's "primary use and benefit" test?
A: There's no fixed bright line — per this ruling, a 30-year lease against a 22-year useful life was sufficient, while a 5-year lease against a longer useful life failed in a prior cited decision.

Q: Can the landlord who built the school building buy materials tax-free?
A: Per this ruling, once the contract qualifies as exempt, the landlord may issue an exemption certificate to avoid paying sales tax up front on qualifying materials and services, rather than paying and later seeking a refund.

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)
• 34 Tex. Admin. Code Rule 3.325 (Refunds and Payments Under Protest)

Cited prior guidance:

• Comptroller's Decision No. 28,391 (1993) — source of the two-prong "primary use and benefit" test
• Comptroller's Decision No. 31,505 (1994) — contrasting failure: 5-year lease term too short relative to improvements' useful life

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201509411L

Original ruling text

September 1, 2015

RE: Private Letter Ruling # 151180932

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated April 21, 2015. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance on the ’ interpretation
of the exemption in Texas Tax Code Section 151.311 for tangible personal property
and taxable services purchased for use in the performance of a contract to improve
real property for an organization exempt under Tax Code Section 151.310. The
Comptroller’s office has addressed similar facts presented by this inquiry; most recently
in other private letter rulings, particularly STAR DOCUMENT NOS. 201411982L,
201411981L, 201411980L, and 201409958L, all issued in 2014. However, we issue
this private ruling because guidance on this issue is not expressly provided in statute
or agency rule.

Relevant Facts Presented

**, doing business as *, 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. In addition, **** met the
qualifications for exemption from Texas Sales or Use ax outlined in Rule 3.322
(Exempt Organizations).

** received a charter from the Texas Education Agency (“TEA”) to
operate an open-enrollment charter school. * presently operates two
campuses in the CITY, Texas Area. * has been authorized by TEA to
relocate the CITY campus to newly constructed facilities located at
*, CITY, Texas (“Campus”). To finance the construction of the Campus,
* entered into a build-to-suit lease (“Lease”) [ENDNOTE 1] with
*, (“Landlord”), where Landlord agreed to construct the Campus per
*’s specifications and to lease the Campus to * for an
initial term of thirty (30) years. Under the Lease, **** has the option
to purchase the Campus at any time during the Lease.

Under the Lease, Landlord is required to implement a construction program to
build the Campus to **’s specifications, with the cost incorporated
into the Lease and paid for by * either in monthly payments, or by
exercising its option to purchase. The Lease requires Landlord to make all
improvements described within the exhibits to the Lease. The Campus is being
improved for, leased by, and used exclusively by **** as an
open-enrollment charter school. Texas Education Code Section 12.105 states that
an open-enrollment charter school is part of the Texas public school system.

** 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. ** used 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 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, ** —holds the state-owned property in
trust for the benefit of the attending students. If ** 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).

Requested 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 Texas Tax Code Sections 151.309 or
151.310 is exempt if the tangible personal property is incorporated into realty
in the performance of the contract. Texas 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 Texas Tax Code
Section 151.309 or 151.310. The Rule further provides that 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.

Texas 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 Comptroller’s office 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 (July 7, 1993), STAR DOCUMENT NO. 9307H1248D05.
First, the lessee must qualify for exempt status under Texas Tax Code Section
151.309 or 151.310. Based on the facts presented, ***** 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 (April 20,
1994), STAR DOCUMENT NO. 9404H1297E01, 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 Comptroller’s office has not developed a
standard for when the test is met. ***** 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. [ENDNOTE 2]

The Campus’s expected useful life of 22 years is less than the 30 year (360
month) term of the Lease. Therefore, the 30 year term of the Lease is
sufficiently long to ensure that ***** will have the primary use and
benefit of the improvements under the Lease. The second prong of the test is
met, and the Lease is exempt under Texas Tax Code Section 151.311.

This ruling does not address the validity of any refund claim that might be
submitted by **. * may request a refund of Texas Sales and
Use Tax paid on taxable items purchased for construction of the Campus.
**** must obtain a properly completed assignment of right to refund for
items on which it did not directly pay the Texas Sales and Use Tax that are
part of any refund request. Any refund request is subject to the requirements
of Rule 3.325 (Refunds and Payments Under Protest).

If you have questions about this private letter ruling, please email us at the
following link, https://www.window.state.tx.us/taxhelp/ and please be sure to
reference Private Letter Ruling #151180932.

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.”

2. In its request for a Private Letter Ruling, ** does not request a
   determination for the “building shell”. The guidance provided in this response
   does not approve or disapprove of **’s depreciation methodology or its
   choice of applicable class codes or descriptions.