Is a 25-year build-to-suit lease of a new charter-school campus, with a 20-year early-termination option, an exempt contract that lets the for-profit landlord buy construction materials tax-free?

Plain-English summary

The Texas Comptroller ruled that a charter school's 25-year build-to-suit lease of a new campus is not an exempt improvement-to-realty contract, so the for-profit landlord who built the campus cannot buy construction materials and taxable services tax-free under Section 151.311 — even though the school itself is a tax-exempt 501(c)(3) organization and the campus is legally treated as public property.

Texas normally taxes construction materials and services purchased by contractors. Section 151.311 creates an exception when a contractor is improving real property for the "primary use and benefit" of an organization that's exempt under Section 151.310 — but only if the contract passes a two-prong test: (1) the party benefiting from the improvements must be a qualified exempt entity, and (2) the lease term must be "sufficiently long in relationship to the life of the improvements" to ensure the exempt entity, not the landlord, actually gets the benefit.

The charter school here clearly satisfied prong one — a qualified 501(c)(3) educational nonprofit whose leased campus is legally deemed state property under the Texas Education Code. It also had a facially long lease: 25 years, against a 22-year useful life for the buildings (per the state's own depreciation schedule). But the lease included a termination option after year 20 — plus additional rights to end the lease at the close of any fiscal year, school year, or if state funding for the school were discontinued. Because the school could walk away from the lease well before the buildings' 22-year useful life ran out, the Comptroller held the second prong failed: the lease wasn't reliably long enough to guarantee the school (not the landlord) gets the primary benefit of the improvements.

What this means for you

Charter schools, churches, and other exempt organizations doing build-to-suit leases

A long headline lease term isn't enough on its own — early-termination rights (fiscal-year-end outs, funding contingencies, optional buyouts) can defeat the exempt-contract analysis even when the stated term comfortably exceeds the building's useful life. If you want your landlord/contractor to buy materials tax-free under Section 151.311, minimize or eliminate early-termination options relative to the building's expected life.

Developers and landlords building for tax-exempt tenants

Don't assume a long-term lease with an exempt tenant automatically qualifies you for tax-free purchases on the construction contract. Review the termination provisions carefully — a facially 25-year lease can still fail the "sufficiently long" test if the tenant has meaningful walk-away rights partway through.

Accountants and tax professionals

The controlling framework is the two-prong test from Comptroller's Decision No. 28,391 (1993), applied here per Comptroller's Decision No. 31,505 (1994) (a five-year lease term failed the test outright). The Comptroller has not set a bright-line ratio of lease-term-to-useful-life; it's a facts-and-circumstances test, and early-termination rights weigh against exemption even against an otherwise-adequate stated term.

Common questions

Q: If my organization is tax-exempt, does that automatically make our landlord's construction purchases tax-free?
A: No. The exemption in Section 151.311 requires both that your organization qualify as exempt AND that your lease term be long enough, relative to the building's useful life, to ensure your organization gets the primary benefit — not just that you're a qualifying tenant.

Q: Why did a 25-year lease fail against a 22-year useful life?
A: Because the tenant (the charter school) could terminate the lease after year 20, plus at various fiscal-year/funding checkpoints — those early-exit rights meant the lease wasn't reliably long enough to guarantee the tenant, rather than the landlord, benefits from the improvements for their useful life.

Q: Can another charter school or nonprofit rely on this ruling for its own lease?
A: No. This ruling binds the Comptroller only as to the specific taxpayer and facts presented, and cannot be relied on by any other taxpayer. Every lease's termination terms need their own review against the two-prong test.

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 § 3.291(a)(5) (Contractors — exempt contract definition)
• 34 Tex. Admin. Code § 3.322 (Exempt Organizations)
• Tex. Educ. Code §§ 12.105, 12.106, 12.128 (charter schools as public property held in trust)
• Comptroller's Decision No. 28,391 (1993) (originating two-prong test)
• Comptroller's Decision No. 31,505 (1994) (five-year lease failed second prong)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201807006L

Original ruling text

July 9, 2018

RE: Private Letter Ruling No. 2017010179

* Taxpayer No. *

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 July 18, 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 the Lease Agreement and First Amendment to Lease Agreement with COMPANY A (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 Sept. 6, 2002, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax as 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 an additional campus in *** County (Campus).

Taxpayer entered into the Lease with COMPANY B (Landlord) to finance the construction of the Campus. Under the Lease, Landlord agreed to acquire a site for the Campus, construct new facilities on the Campus per Taxpayer’s specifications, and lease the Campus to Taxpayer for a primary term of 25 years. Under the Lease, Taxpayer has the option to purchase the campus as of the “Effective Date” as defined in the Lease.

Additionally, under the Lease, Taxpayer has a “Termination Option” which allows Taxpayer to terminate the Lease after year 20 of the primary term. Taxpayer may also terminate the Lease at the end of each fiscal year, at the end of each school year, or at the end of any special revenue fund or grant, if governmental funding for the charter school is discontinued.

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

The Campus is leased by and used exclusively by Taxpayer as an open-enrollment charter school. 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 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 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 shown below, followed by our responses and analysis.

Question One: Is the Lease between Taxpayer and Landlord an exempt contract under Section 151.311?

Ruling One: The Lease is not an exempt contract under Section 151.311 because the Lease is not sufficiently long in relation to the life of the improvements themselves to qualify as an exempt contract.

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

Ruling Two: No, the contract between Taxpayer and Landlord does not meet the definition of an exempt contract in Section 151.311. The exemptions provided in Section 151.311 do not apply to Taxpayer’s purchases.

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, 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. 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 Campus’ expected useful life of 22 years is less than the 25-year (300 month) term found in the Lease. However, Taxpayer may terminate the Lease after year 20 of the primary term. Taxpayer may also terminate at the end of each fiscal year, at the end of each school year, or at the end of any special revenue fund or grant, if governmental funding for the charter school is discontinued. Therefore, the Lease is not sufficiently long to ensure that Taxpayer has the primary use and benefit of the improvements under the Lease because Taxpayer may terminate the Lease during the useful life of the improvements. The second part of the test is not met, and the Lease is not exempt under Section 151.311.

Since the contract between Taxpayer and Landlord does not meet the definition of an exempt contract as provided in Section 151.311, Taxpayer cannot issue exemption certificates in lieu of paying tax on purchases of tangible personal property and taxable services used or consumed in the performance of the contract.

Comptroller’s Decisions and STAR documents cited are available 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 No. 2017010179.

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.