When a charter school finances a new campus through a 25-year build-to-suit lease with private landlords, does the two-prong exempt-contract test let the landlords' contractor buy construction materials tax-free?

Plain-English summary

A newly-chartered open-enrollment charter school (a 501(c)(3) nonprofit exempt from Texas sales/use tax) needed a campus but didn't own land or a building yet. It entered a "build-to-suit" lease: a group of private landlords agreed to buy a site, construct a new K-2 campus to the school's specifications, and lease it to the school for 25 years, with the school paying via a Foundation School Program (state funding) in monthly installments and having an option to eventually purchase the campus. The school asked whether this lease qualifies as an "exempt contract," which would let the landlords' contractor buy construction materials tax-free instead of paying sales tax and passing the cost through.

Texas ruled yes, applying a two-prong test the Comptroller has used since 1993. First prong: the tenant (lessee) must itself be a tax-exempt organization — easily met here since the charter school qualifies under Section 151.310. Second prong: the lease term must be long enough relative to the expected useful life of the improvements being built, so that the exempt tenant genuinely gets the primary benefit of what's constructed (a short lease relative to a long-lived building would suggest the landlord, not the tenant, is the real beneficiary). Since the school didn't specify an expected useful life, the Comptroller used its own standard reference table for public-building improvements, which pegs a non-componentized building's useful life at 22 years — shorter than this lease's 25-year term. Because the lease term comfortably covers the building's expected life, the school is found to have the primary use and benefit, making the whole construction project tax-exempt.

What this means for you

Charter schools and nonprofit tenants financing a facility through a lease

A build-to-suit lease can qualify for the governmental/exempt-organization construction exemption even though private landlords own and finance the building — the key is making sure your lease term is at least as long as the building's expected useful life, so the numbers clearly show you (not the landlord) are the primary beneficiary.

Landlords and developers building for exempt tenants

If your lease term is short relative to the building's useful life (the ruling cites a prior case where a 5-year lease failed this test for a long-lived improvement), your construction materials likely won't qualify for this exemption — plan lease terms with this test in mind if tax-exempt construction treatment matters to your deal economics.

Contractors and accountants

The Comptroller's default 22-year useful-life figure for non-componentized buildings (from its State Property Accounting Process User's Guide) is a useful benchmark whenever a taxpayer doesn't specify an expected useful life — expect this same reference point to reappear in similar exempt-contract rulings. Also note the ruling's caveat: it applies prospectively from the ruling date and doesn't validate any refund claim, which follows the separate refund procedure in Rule 3.325.

Common questions

Q: Does the exempt organization need to own the property for this exemption to apply?
A: No. Section 151.311 doesn't require ownership — leasing qualifies, as shown here, as long as the two-prong test (exempt lessee, sufficiently long lease term) is satisfied.

Q: What happens if the lease term is shorter than the building's useful life?
A: The ruling cites Comptroller's Decision No. 31,505 (1994), where extensive renovations failed the second prong because a 5-year lease was too short relative to the improvements' life — in that scenario, the exemption would not apply.

Q: Can the charter school (or its landlords) claim a refund of tax paid before this ruling?
A: This ruling applies prospectively only; it doesn't address or validate any refund claim, which is governed separately by Rule 3.325 (Refunds and Payments Under Protest).

Q: Does this ruling apply to my school's or nonprofit's facility lease?
A: Not automatically. This is a private letter ruling binding only on the Comptroller as to this taxpayer's specific facts. A shorter lease term or a tenant that doesn't independently qualify as tax-exempt would change the outcome.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.310 (exemption for qualifying religious/educational/public service organizations)
• Tex. Tax Code § 151.311 (exemption for improvements to realty of an exempt entity)
• 34 Tex. Admin. Code § 3.291(a)(5) (exempt contract definition)
• 34 Tex. Admin. Code § 3.322 (Exempt Organizations)
• 34 Tex. Admin. Code § 3.1(d)(1) (prospective reliance on private letter rulings)
• 34 Tex. Admin. Code § 3.325 (Refunds and Payments Under Protest)
• Tex. Educ. Code § 12.105, § 12.106, § 12.128 (charter school status, state funding, and public-property treatment)
• Comptroller's Decision No. 28,391 (1993) (origin of the two-prong test)
• Comptroller's Decision No. 31,505 (1994) (5-year lease too short relative to improvement 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/202007018L

Original ruling text

July 31, 2020

RE: Private Letter Ruling No. 20200522101913

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 May 20, 2020. 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 (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 May 9, 2018. As of May 9, 2018, 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 Oct. 21, 2019, Taxpayer entered into a charter contract with the Texas Education Agency (TEA) to operate an open-enrollment charter school through July 31, 2025. Taxpayer does not qualify for automatic renewal of its charter at expiration. The TEA authorized Taxpayer’s campus to be located in the City of **, **County (Campus). The Campus will serve students in kindergarten through grade two.

On January 30, 2020, Taxpayer entered into the Lease with LANDLORD A, LANLORD B, LANLORD C, and LANLORD D (Landlords) to finance the construction of the Campus. Under the Lease, Landlords 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 May 20, 2020 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 Landlords 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 Landlords 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 Landlords 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 Landlords 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: Landlords 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. 20200522101913.

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.