When a landlord builds a new charter-school campus and leases it to the school for 25 years, can the construction contract qualify as tax-exempt, and can the landlord's suppliers avoid paying sales tax on materials used in the build?

Plain-English summary

A Texas nonprofit open-enrollment charter-school operator, exempt from sales/use tax as a § 501(c)(3) organization, entered into build-to-suit leases with private landlords to construct two new campuses (a K-8 campus and a high school campus) on previously unimproved land. Under the leases, the landlords build the facilities to the school's specifications and lease them back for a 25-year primary term, with the school able to buy either campus within the first four years after substantial completion. The school pays for construction costs through the lease payments, funded by state education dollars, and the property is legally deemed state-owned property held in trust for students. The operator asked whether these leases qualify as tax-exempt construction contracts, and whether the landlords can buy materials for the job tax-free.

The Comptroller said yes, applying its established two-prong test (from a 1993 decision) for whether a contract to improve real property for a lessee qualifies as an "exempt contract" under § 151.311:

1. The lessee must be a qualified exempt entity. The charter-school operator is exempt under § 151.310 — satisfied.
2. The lease term must be long enough, relative to the improvements' useful life, that the exempt entity gets the improvements' primary use and benefit. Using the school's own asserted useful-life figure (22 years, per the state's official capital-asset depreciation schedule for buildings), the 25-year lease term exceeds that useful life — satisfied.

Because both prongs are met, the leases are exempt § 151.311 contracts, and the landlords may issue exemption certificates in lieu of paying sales tax on: (a) materials incorporated into the realty, (b) other materials (excluding machinery/equipment) that are necessary and essential to the job and completely consumed at the job site, and (c) qualifying taxable services performed at the job site that the contract requires or that are integral to performing it. The ruling applies prospectively only from its date and doesn't validate any past refund claim.

What this means for you

Charter schools and other § 501(c)(3) organizations using build-to-suit leases

The key number to check is the relationship between your lease term and the building's official useful life — not just whether your organization is exempt. A shorter lease relative to a longer useful life can fail the second prong even for an otherwise-qualifying exempt tenant (see the contrasting 5-year-lease-vs-longer-useful-life failure cited in this ruling's own analysis).

Landlords and developers building for exempt tenants

Confirm your tenant's exempt status AND get a defensible useful-life figure for the building type before assuming your construction contract qualifies for the § 151.311 exemption — the useful-life prong is a fact question the Comptroller doesn't pre-set a bright-line standard for (it accepted the taxpayer's own asserted 22-year figure here, sourced from the state's capital-asset accounting guide).

Related rulings

This ruling is one of a batch of same-day (August 4, 2017) private letter rulings addressing materially identical build-to-suit charter-school lease structures for different campuses and landlords, all reaching the same two-prong-test conclusion — the fact patterns differ only in campus count, landlord identity, and specific lease dates, not in the governing legal analysis.

Common questions

Q: Does a charter school have to own its campus building to get the § 151.311 construction-contract exemption?
A: No — per this ruling, § 151.311 doesn't require the exempt organization to own the real property; a qualifying long-term lease works too.

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, the Comptroller compares the lease term to the improvements' expected useful life; here a 25-year lease against a 22-year useful life was sufficient, while a 5-year lease against a longer useful life failed in a cited prior decision.

Q: Can a landlord who built the school building keep the sales tax it would otherwise owe on construction materials?
A: The landlord doesn't "keep" the tax — per this ruling, once the contract qualifies as exempt, the landlord can issue exemption certificates to avoid paying sales tax in the first place on qualifying materials and services, rather than paying and 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(d)(1) (PLRs apply prospectively; doesn't address refund validity)
• 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/201708004L

Original ruling text

August 4, 2017

RE: Private Letter Ruling No. 170620035

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 February 27, 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

With its request for a private letter ruling, ** (Taxpayer) provided its federal exemption letter, documentation regarding its charter, and a Build to Suit Lease and Option (Lease). The following facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented, without independent verification or approval of the Taxpayer’s application of the State Property Accounting Process User’s Guide.

Taxpayer 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. As of August 19, 2013, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax outlined in Rule 3.322, Exempt Organizations. Taxpayer holds a charter from the Texas Education Agency (TEA) to operate an open-enrollment charter school. The TEA authorized Taxpayer to add two additional campuses in ** County (Campuses).

Taxpayer entered into a lease with ** (Landlord) to finance the construction of the K-8 campus. Taxpayer also entered into a lease with **, **, and ** (collectively, Landlords) to finance the construction of the High School campus. Under both leases, the Landlords agreed to acquire a site for the Campuses, construct new facilities on the Campuses per Taxpayer’s specifications, and lease the Campuses to Taxpayer for a primary term of 25 years. Under the Leases, Taxpayer has the option to purchase either campus within the first four years following the “Substantial Completion Date” as defined in the Leases.

The site of each new campus requires the construction of new facilities on previously unimproved real property. The Leases require Landlords to implement the construction projects and make all of the improvements to the Campuses. 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 Landlords shall adopt any changes to the plans requested by Taxpayer unless the changes would not comply with applicable governmental rules and regulations.

The Campuses are leased by and used exclusively by Taxpayer as open-enrollment charter schools. Texas Education Code Section 12.105 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. Taxpayer uses state funds to lease the Campuses. 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. 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).

Taxpayer 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. This response relies upon the Taxpayer’s assertion that the useful life of the facilities is 22 years.

Questions, Rulings, and Analysis

Our restatement of your questions is below, followed by our responses and analysis.

Question One: Are the Leases between Taxpayer and Landlords exempt contracts under Section 151.311?

Ruling: The Leases are exempt contracts under Section 151.311 because they are contracts to improve realty for the primary use and benefit of an exempt entity.

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. 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.

The Campuses’ expected useful life of 22 years is less than the 25-year (300-month) term found in the Leases. Therefore, the 25-year term of the Leases is sufficiently long to ensure that Taxpayer has the primary use and benefit of the improvements under the Leases. The second part of the test is met, and the Leases are exempt under Section 151.311.

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

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

Analysis:

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 contract. 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 and STAR documents 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 #170620035.

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.