In late September, the IRS sent up as large of a red flag as possible concerning Real Estate Investment Trust (“REIT”) spinoffs in IRS Notice 2015-59 and Rev. Proc. 2015-43. While these issuances did not change existing law, they did state a new no-rule policy with regard to tax-deferred PropCo/OpCo spin-offs under Section 355 of the Internal Revenue Code (In these types of transactions, a property-holding company (“PropCo”) which is a subsidiary of an operating company (“OpCo”), purchases real estate owned by OpCo, then leases it back to OpCo and claims status as an REIT). Under the latest word from the IRS, unless there are “unique and compelling” circumstances, IRS will not issue private letter rulings on these types of transactions if real property owned by either PropCo or OpCo is the basis for REIT election for either company. Coupled with statements from the agency that these spin-offs and conversions give the agency “significant concerns,” these proclamations create significant market uncertainty as to the validity of such transactions.
To do such an REIT spin-off transaction, an existing company must qualify that the REIT has a 5-year history as an active trade or business. It became a matter of course that such a company would ask the IRS for a private letter ruling on this qualification. Now, however, the IRS feels that these types of transactions might pose problems under Section 355 when the transaction spins off an REIT from a C corporation.
For one thing, both PropCo and OpCo must both be engaged in an active trade or business, and a spin-off to merely hold property may fail this requirement. The IRS also expanded the exclusion on private letter rulings to include transactions where less than 5% of a corporation’s assets are relied upon to fulfill the active trade or business requirement, so the IRS takes this requirement especially seriously. The spin-off must also have a substantial non-tax business purpose – the transaction cannot be a mere tax avoidance measure. Finally, the transaction cannot serve mainly as a device for the distribution of earnings or profits for either company. To put it plainly, a company cannot spin off an REIT to a property-holding subsidiary merely for the tax benefit and expect the transaction to be tax-deferred, and the IRS is no longer going to give its seal of approval to such transactions up front.
The tax consequences of such a transaction failing to qualify under Section 355 can be significant, so this move on the part of the IRS injects a chill into the REIT marketplace. These releases suggest that the IRS will pay closer attention to such transactions in the future as well, so they should be structured with the utmost care and with significant emphasis placed on meeting the requirements of Section 355.