When a non-exempt landlord builds a facility and leases it to a Texas tax-exempt charter school, is the construction contract exempt from sales tax, and how long does the lease term need to be?

Plain-English summary

A Texas tax-exempt open-enrollment charter school entered a "build-to-suit" lease: a for-profit landlord agreed to buy land, construct a new campus to the school's specifications, and lease it back for 25 years, with the school paying the construction costs in monthly installments (funded by state education dollars) and holding an option to buy. The school asked whether the landlord's construction contract qualified as an exempt contract under Tex. Tax Code § 151.311, which would let the landlord buy materials and services for the job tax-free using exemption certificates.

The Comptroller ruled yes, applying its own two-prong test (first set out in Comptroller's Decision No. 28,391 (1993)) for whether a lease-financed improvement is for the "primary use and benefit" of an exempt entity even though a non-exempt landlord owns the building: (1) the lessee must itself qualify as a Section 151.310 tax-exempt organization, and (2) the lease term must be long enough relative to the expected useful life of the improvements that the exempt tenant — not the landlord — really gets the benefit. The school clearly met prong one. For prong two, because the school didn't specify the campus's useful life, the Comptroller used its own State Property Accounting Class Codes guideline of 264 months (22 years) for non-componentized buildings — and the 25-year lease term exceeded that, so the lease was "sufficiently long" and the contract qualified as exempt.

What this means for you

Charter schools, exempt nonprofits, and other Section 151.310 organizations doing build-to-suit deals

If you're an exempt organization financing new construction through a lease with a non-exempt landlord (a common charter-school and nonprofit financing structure), your landlord's construction contract can qualify as tax-exempt under Section 151.311 — but only if your lease term is long enough relative to the building's useful life. This ruling shows the Comptroller will use its own 22-year Class Codes guideline as a benchmark for standard buildings when you don't specify an expected life; a lease materially shorter than that (the ruling cites a prior decision where a 5-year lease failed) risks losing the exemption.

Landlords and developers building for exempt tenants

You can issue exemption certificates instead of paying tax on materials incorporated into the realty, on consumable job-site supplies (other than machinery/equipment), and on taxable services required by or integral to the contract — but only once both prongs of the test are satisfied. Confirm your tenant's exempt status and structure the lease term with the useful-life benchmark in mind before relying on the exemption.

Accountants and tax professionals

This is a fact-specific application of the same build-to-suit charter-school exempt-contract doctrine seen in other STAR rulings from this era — the useful-life benchmark (22 years per the Class Codes) is the reusable takeaway when a taxpayer's lease doesn't state an expected life. The ruling is also notable for confirming Section 151.311 doesn't require the exempt organization to own the real property — a lease-based arrangement can qualify. Note the ruling is prospective only from its date under Rule 3.1(d)(1) and doesn't resolve any refund claim.

Common questions

Q: Does the exempt organization have to own the building for the construction contract to be exempt?
A: No. Section 151.311 doesn't require ownership — a lease arrangement can qualify if both prongs of the Comptroller's test are met.

Q: What happens if the lease term is too short relative to the building's life?
A: The contract won't qualify as exempt. The ruling cites Comptroller's Decision No. 31,505 (1994), where a 5-year lease term failed the second prong because the improvements' useful life was much longer.

Q: How is the "useful life" of the improvements determined if the lease doesn't say?
A: The Comptroller has not set a fixed standard, but here it used its own State Property Accounting Class Codes guideline (264 months / 22 years for non-componentized buildings) as a benchmark.

Q: Can any other charter school or exempt organization rely on this ruling?
A: No. It binds the Comptroller only for the taxpayer and facts in the request; a lease with a materially different term-to-useful-life ratio, or a tenant that isn't exempt under Section 151.310, could be treated differently.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.311 (exempt contract for improvement of realty of an exempt entity); § 151.310 (exempt organizations)
• 34 Tex. Admin. Code § 3.291(a)(5) (Contractors — exempt contract definition); § 3.1(d)(1) (prospective reliance); § 3.325 (refunds and payments under protest)
• Tex. Educ. Code § 12.105 (charter school status), § 12.106 (state funding), § 12.128 (property purchased or leased with state funds)

Cited prior guidance:

• Comptroller's Decision No. 28,391 (1993) — origin of the two-prong primary-use-and-benefit test
• Comptroller's Decision No. 31,505 (1994) — 5-year lease term failed the second prong

Source

• Landing page (STAR search): https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/202002020L

Original ruling text

February 6, 2020

RE: Private Letter Ruling No. 20190802164411

**, 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 June 27, 2019. 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

** (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 on Sept. 5, 2003. As of Sept. 6, 2002, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax outlined in Rule 3.322 (Exempt Organizations).

Taxpayer provided its federal exemption letter, documentation regarding its charter, and a Build to Suit Lease and Option (Lease). The facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented.

On March 15, 2005, Taxpayer entered into a charter contract with the Texas Education Agency (TEA) to operate an open-enrollment charter school through July 31, 2009. The charter contract was renewed on April 6, 2010 through July 31, 2019. Taxpayer qualifies for automatic renewal of its charter at expiration. The TEA authorized Taxpayer’s campus to be located in the CITY area (Campus). The Campus will serve students in pre-kindergarten through grade twelve.

On January 29, 2019, Taxpayer entered into the Lease with COMPANY (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 term beginning on the Commencement Date, as defined in the Lease, and continuing for a period of 25 years after the Rent Commencement Date, which is defined in the Lease as the Substantial Completion Date. Per Taxpayer’s June 27, 2019 submission, Substantial Completion had not occurred. Under the Lease, Taxpayer has the option to purchase the Campus during the period described in the Lease.

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 described within Exhibit C to the Lease. 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 (Status) states that an open- enrollment charter school is 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 (State Funding). Taxpayer uses state funds to lease the Campus. Texas Education Code Section 12.128 (Property Purchased or Leased with State Funds) 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).

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 an exempt contract under Section 151.311 because it is a contract to improve realty for the primary use and benefit of an exempt entity.

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

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

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. See 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.

Taxpayer did not state the Campus’s expected useful life. The Comptroller’s State Property Accounting Process User’s Guide – Appendix A – Class Codes (Class Codes) provides guidance when calculating the expected useful life for building improvements. According to the Class Codes, the useful life for buildings and building improvements – non-componentized is 264 months (22 years).

Using the Class Codes guideline, the Campus’s expected useful life of 22 years is less than the 25-year term found in the Lease. Therefore, the 25-year term of the Lease is sufficiently long to ensure that Taxpayer has 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 Section 151.311.

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 contracts. 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 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 No. 20190802164411.

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.