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In Letter Ruling 200825034, the Service ruled that a hotel management company with which a TRS contracted to operate hotels qualifies as an eligible independent contractor under Section 856(d)(9)(A).

Facts

A publicly traded REIT ("Taxpayer") owns substantially all of its assets and conducts most of its operations through a limited partnership ("OP") in which Taxpayer owns substantially all of the interests. OP owns all of the stock of a taxable REIT subsidiary ("TRS").

OP owns hotels and leases them to TRS. TRS contracts with hotel management companies to operate the hotels.

In Month 1, TRS entered into management agreements with a hotel management company ("Management") wholly owned by Taxpayer's Chairman and Taxpayer's President and Chief Executive Officer, to operate four hotels. In Month 2, TRS entered into management agreements with Management to operate six additional hotels. As of Date 2, Taxpayer's Chairman owned approximately b percent of Taxpayer's common stock and approximately c percent of OP. At the same time, Taxpayer's President and Chief Executive Officer also owned approximately b percent of Taxpayer's common stock and approximately c percent of OP. Taxpayer has represented that the terms of the management agreements with Management were approved by Taxpayer's independent directors and were based on customary arrangements.

In Month 1, when TRS entered into the management agreement with Management to operate the four hotels, Management and persons related to Management within the meaning of section 856(d)(9)(F) ("Management Group") operated Hotels A, B, and C for persons unrelated to Taxpayer and TRS. In Month 2, when TRS entered into management agreements with Management to operate the other six hotels, Management Group no longer operated Hotel C. Management Group provides substantially all the management and operational functions in connection with the operation of the Hotels with its own employees. As of Date 2, Management Group manages e hotels for Taxpayer.

Management Group and its predecessor entities have been in the hotel management business for more than d years. Through Year 1, Management Group operated approximately d hotels for persons unrelated to Taxpayer or TRS. The decline in the number of hotels operated by Management Group is due primarily to sales of hotel properties that were managed by Management Group, including some acquired by Taxpayer. Management Group has continued to actively pursue hotel management contracts with parties unrelated to Taxpayer and TRS. Management Group has recently agreed to manage Hotel D, at which it employs approximately d employees and contractors.

Analysis

To qualify as a REIT, an entity must derive at least 95% of its gross income from sources listed in Section 856(c)(2) and at least 75% of its gross income from sources listed in Section 856(c)(3). "Rents from real property" are among the sources listed in both of those sections.

Generally, under Section 856(d)(2)(B), the term "rents from real property" does not include any amount received or accrued directly or indirectly from any person if the REIT owns, directly or indirectly 10% or more of the value or voting interests of such person. However, Section 856(d)(8)(B) provides an exception to the general rule. Section 856(d)(8)(B) provides that amounts paid to a REIT by a TRS shall not be excluded from "rents from real property" by reason of Section 856(d)(2)(B) when a REIT leases a qualified lodging facility to a TRS, and the property is operated on behalf of the TRS by a person who is an eligible independent contractor.

Section 856(d)(9)(A) provides that the term "eligible independent contractor" means, with respect to any qualified lodging facility, any independent contractor if, at the time such contractor enters into a management agreement or similar service contract with the TRS to operate the facility, the contractor (or any related person) is actively engaged in the trade or business of operating qualified lodging facilities for any person who is not a related person with respect to the REIT or the TRS.

Section 856(d)(9)(D)(i) generally provides that the term "qualified lodging facility" means any lodging facility unless wagering activities are conducted at or in connection with such facility by any person who is engaged in the business of accepting wagers and who is legally authorized to engage in the business at or in connection with such facility.

In the ruling at hand, it is represented that Management is an independent contractor within the meaning of Section 856(d)(3), so the issue presented is whether Management is actively engaged in the trade or business of operating qualified lodging facilities.

The Service explained that although not definitive with respect to determining whether an independent contractor is "actively engaged" in the trade or business of operating qualified lodging facilities under Section 856(d)(9)(A), Reg. Section 1.355-3(b)(2)(iii) is instructive in determining if that requirement is satisfied. The regulation provides that the determination of whether a trade or business is actively conducted will be made from all of the facts and circumstances. In defining "active conduct " of a trade or business, Reg. Section 1.355-3(b)(2)(iii) indicates that for a trade or business to be actively conducted, substantial management and operational activities generally must be directly carried on by the corporation itself, and such activities generally do not include the activities of others outside the corporation, including independent contractors.

The Service then noted that at the time that Management and TRS entered into management contracts for Management to operate the hotels, Management operated f lodging facilities for parties other than Taxpayer or TRS. The facts indicate that Management Group has a history of managing or operating many hotels throughout the United States. Substantially all of the management and operational activities provided by Management Group are conducted through employees.

The Service found that the facts and circumstances indicate that the activities and business conduct of Management are sufficient for Management to be treated as being actively engaged in the trade or business of operating qualified lodging facilities. Accordingly, The Service concluded that Management qualifies as an eligible independent contractor under section 856(d)(9)(A) with respect to hotels it manages or operates for TRS, provided that Management continues to qualify as an independent contractor within the meaning of Section 856(d)(3).

Implications

The related-party rent exception for the leasing of hotels by a REIT to a TRS under Sections 856(d)(8) and (9) was enacted in 1999 and became effective for years beginning after December 31, 2000. The Service has not yet issued regulations or other guidance describing when an independent contractor will be treated as actively engaged in the trade or business of operating hotels for unrelated parties and thus qualify as an eligible independent contractor for purposes of this exception. Thus, there has been uncertainty regarding this matter. PLR 200825034 is the first letter ruling, and authority of any type, addressing the definition of an eligible independent contractor, and thus gives taxpayers and advisors some guidance on making this determination. In this ruling, the Service adopted a facts and circumstances approach in making the determination and also looked to the "active trade or business requirement" of Section 355 and the regulations thereunder.