In certain recent transactions, a corporation distributes a subsidiary corporation holding the distributing corporation’s real estate assets to the distributing corporation’s shareholders in a tax-free “spin-off.”  Not only is the spin-off tax-free to the distributing corporation and the distributing corporation’s shareholders, but the spun-off company elects real estate investment trust (REIT) status and thus enjoys potentially substantial tax savings going forward due to pass-through treatment of a REIT.  Recently, the Internal Revenue Service has issued at least two favorable private letter rulings for such transactions.  This type of transaction could be of significant relevance to a corporation owning significant real estate assets.

Background

Tax-Free Spin-Offs

As a general rule, a distribution of property by a corporation to its shareholders is taxable to both the distributing corporation and its shareholders.  Under the spin-off provisions of Section 355 of the Internal Revenue Code, however, a distribution by a corporation of the stock of a controlled subsidiary corporation can be tax-free to both the distributing corporation and its shareholders if several requirements are satisfied. 

One of the requirements for a tax-free spin-off is the so-called business purpose requirement.  The distribution must be motivated, in whole or substantial part, by one or more non-federal-tax corporate business purposes.  The business purpose requirement for a spin-off is viewed as a high standard (higher than the standard for the business purpose requirement for tax-free reorganizations generally).  In addition, in determining the extent to which a corporate business purpose motivated the distribution, the regulations state that the potential for the avoidance of federal taxes by the distributing or controlled corporations (or a corporation controlled by either) is relevant.  In terms of satisfying the requirements for a tax-free spin-off of a corporation that will make a real estate investment trust (REIT) election (which could result in substantial tax savings after the spin-off), the business purpose requirement is likely to be the main pressure point.

Another requirement for a tax-free spin-off is that the transaction cannot be used principally as a device for the distribution of the earnings and profits of the distributing corporation, the controlled corporation or both (the no-device requirement).  This no-device requirement should also be considered, particularly if the distributed corporation’s main activity is to lease real estate back to the distributing corporation. 

Over the years, the Internal Revenue Serve (IRS) has substantially carved back the spin-off issues on which it will issue a private letter ruling (PLR).  For years up until 2003, in ruling whether transactions qualified for nonrecognition under Section 355, the IRS would consider whether the business purpose and no-device requirements were satisfied.  Starting in 2003, the IRS stopped ruling on certain requirements it perceived as being highly factual, including the business purpose and no-device requirements, but continued to rule on whether a transaction otherwise qualified for nonrecognition under Section 355.  Last year, the IRS carved back its ruling policy again.  Starting with any ruling request submitted after August 23, 2013, the IRS discontinued ruling on whether transactions qualified for nonrecognition under Section 355, limiting the scope of rulings to only specific “significant issues.” 

REIT

A REIT is a type of entity that generally enjoys pass-through status.  That is, a REIT generally is not subject to U.S. federal income tax on the REIT taxable income that it distributes to its shareholders.  A company's qualification as a REIT depends on its ability to meet various complex requirements, including that at least 75 percent of the value of the REIT’s assets consist of cash, cash items, government securities and “real estate assets.”  Because of these stringent requirements, a company with substantial non-real estate assets generally would not be eligible to elect REIT status.  Transferring real estate assets into a subsidiary and distributing the subsidiary, however, could enable the subsidiary to elect REIT status, provided the REIT requirements are met.  

Recent PLRs / Transactions

The IRS has recently issued PLRs for at least two spin-offs of real estate holding companies for which there were plans to elect REIT status immediately after the spin-offs (sometimes referred to as REIT spin-offs).  These appear to be the first favorable PLRs issued for REIT spin-offs.

PLR 201337007 (the 2013 PLR) appears to have been issued to Penn National Gaming, Inc. (Penn National) based on publicly available facts relating to the distribution by Penn National of a company holding substantially all of Penn National’s real estate assets (e.g., casino-related real estate) to Penn National’s shareholders.  The 2013 PLR contained several important rulings:  Based in part on taxpayer representations regarding business purpose and device, the PLR concluded that the spin-off qualified for nonrecognition under Section 355 despite the stated intention to elect REIT status for the real estate holding company.  As discussed further below, however, the PLR contained the standard caveat that the IRS expressed no opinion on satisfaction of the business purpose and no-device requirements.  The PLR also concluded that certain properties constituted “real estate assets” for purposes of the relevant REIT tests (and it appears the properties at issue were “barge-based facilities,” based on publicly available facts). 

An important aspect of the 2013 PLR is that after the spin-off and REIT election by the spun-off company, the spun-off company would lease back most of the real estate assets to the distributing corporation in exchange for rent payments.  The rent paid by the distributing corporation would presumably be tax-deductible.  In addition, due to the pass-through treatment provided to REITs, the rental income earned by the REIT would generally not be subject to corporate-level U.S. federal income tax (assuming the unrealized net built-in gains in the REIT assets are not triggered).

Regarding business purpose, the 2013 PLR included the following representations: 

The External Distribution is being carried out to facilitate strategic expansion opportunities for Business D by providing Controlled the ability to (i) pursue transactions with Competitors that would not pursue transactions with Distributing 2, (ii) diversify into different businesses in which Distributing 2, as a practical matter, could not diversify, (iii) pursue certain transactions that Distributing 2 otherwise would be disadvantaged by or precluded from pursuing due to regulatory constraints, and (iv) fund acquisitions with its equity on significantly more favorable terms than those that would be available to Distributing 2.  The External Distribution is motivated in whole or substantial part by one or more of the corporate business purposes.

PLR 201411002 (the 2014 PLR) appears to have been issued to CBS Corp. (CBS) based on publicly available facts relating to the distribution by CBS of a company holding certain of CBS’s billboard displays to CBS’s shareholders in exchange for CBS stock in a so-called “split-off.”  Similar to the 2013 PLR, the 2014 PLR concluded, based in part on taxpayer representations regarding business purpose and device, that the REIT spin-off qualified for nonrecognition under Section 355 and contained the standard caveat that the IRS expressed no opinion on satisfaction of the business purpose and the no-device requirements. 

Regarding business purpose, the 2014 PLR included the following representations: 

Distributing has determined that the Separation of Business B from Business A will serve the following corporate business purposes: (i) to enable the management team of each business to focus on its relevant business and its requirements and performance without the distraction of one or more businesses operating under a different business model; (ii) to provide Distributing and Controlled with a more attractive equity currency for acquisitions; (iii) to enhance and align the equity-based incentive programs of Distributing and Controlled to better reflect the specific business objectives, goals, and financial performance of each business; and (iv) to better enable each of Distributing and Controlled to independently optimize its capital structure and return of capital policies (collectively, the “Corporate Business Purpose”). 

The External Distribution is being carried out for, and is motivated by, the Corporate Business Purpose.

CBS recently announced that it received a favorable REIT ruling from the IRS.  Based on public facts, it appears this most recent ruling is a separate PLR that addresses the treatment of the billboard structures and sites as real estate assets for purposes of the relevant REIT tests.  This third PLR has not yet been released for public inspection.

Significance of PLRs / Transactions

As noted above, both the 2013 PLR and the 2014 PLR contained the standard caveat that the IRS expressed no opinion on satisfaction of the business purpose requirement, and the business purpose requirement is likely the main pressure point for satisfaction of the spin-off requirements. 

William Alexander, IRS Associate Chief Counsel (Corporate), recently suggested that the IRS believes that the potentially substantial tax savings from a REIT election following a spin-off would not preclude a spin-off from satisfying the business purpose requirement.  Mr. Alexander said that even though the IRS does not rule on whether a good business purpose has been established in a Section 355 transaction, “if we were sure it couldn't be done [in a REIT spinoff], then you would know that.”  Amy S. Elliot, ABA Meeting:  Alexander Sets Reachable Bar for Business Purpose in REIT Spinoffs, 2014 TNT 19-5 (Jan. 29, 2014).

Regardless of any potential inference on business purpose, taxpayers typically seek legal opinions from tax counsel on satisfaction of requirements for which the IRS will not rule, including the business purpose and no-device requirements (more important now that the IRS generally will rule only on specific issues and not generally under Section 355).  In addition, a PLR cannot be used or cited as precedent for any taxpayer other than the taxpayer to whom the PLR is addressed. 

Importantly, these PLRs illustrate tax-efficient separations of real estate and tax-efficient ownership of real estate on a going forward basis, including through a REIT election, under certain circumstances. 

Legislative Development

It should also be noted that the discussion draft released by Chairman Dave Camp of the Committee on Ways and Means in February 2014 contained several provisions on REITs, including a proposed prohibition on spin-offs of REITs by non-REITs and REITs.  The Administration’s 2015 budget proposal released in March 2014 did not contain a similar provision.

Conclusion

These recent developments could be of particular interest to any corporate business with significant real estate assets.