In PLRs 202002009 and 202002012, the IRS ruled that a hotel manager would not fail to qualify as an eligible independent contractor (EIK) under IRC Section 856(d)(9)(A) with respect to a real estate investment trust (REIT) solely as a result of (1) the hotel manager being a brother-sister affiliate of an external investment advisor of the REIT, and (2) taxable REIT subsidiaries (TRSs) receiving certain incentive income from the external investment advisor.

Facts

In PLR 202002009, Taxpayer is a REIT that owns hotels and leases them to its TRSs. The TRSs have engaged certain EIKs, including Manager, to manage the hotels.

HoldCo is a publicly traded corporation that conducts its business primarily through two indirect corporate subsidiaries, AdvisorCo and ServiceCo. Taxpayer has engaged AdvisorCo to provide it with asset management and advisory services. AdvisorCo also periodically provides certain non-cash incentives (Incentives) to Taxpayer's TRSs in connection with Taxpayer's acquisition of hotel properties. Currently, Taxpayer and its TRSs own some HoldCo stock, but will completely dispose of the stock prior to the Proposed Transaction described below.

All the interests in Manager are collectively owned by Individual 1, who serves as HoldCo's, AdvisorCo's, and ServiceCo's chief executive officer and serves as chairman of the board of directors of Taxpayer and HoldCo, and Individual 2, who is related to Individual 1. Individual 1 and Individual 2 also own some Taxpayer stock and HoldCo stock.

Under the Proposed Transaction, ServiceCo will acquire all interests in Manager, and Manager will become a disregarded entity of ServiceCo. AdvisorCo and ServiceCo will continue to be indirect subsidiaries of HoldCo and brother-sister affiliates and will continue to operate as separate entities that keep separate books and records. AdvisorCo and ServiceCo will each have separate employees but will share the same CEO and a limited number of overlapping employees performing certain general and administrative (G&A) functions. AdvisorCo and ServiceCo will each have at least a specified number of board members, of which one may be overlapping.

PLR 202002012 has a similar fact pattern.

Law and analysis

IRC Section 856(c)(2) requires at least 95% of a REIT's gross income be derived from, among other sources, rents from real property, and IRC Section 856(c)(3) requires at least 75% of a REIT's gross income be derived from, among other sources, rents from real property.

Under IRC Section 856(d)(2)(B), except as provided in IRC Section 856(d)(8), "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 voting power or value of the equity interests of such person.

Under IRC Section 856(d)(8)(B), rents received by a REIT from the lease of a qualified lodging facility or qualified health care property to its TRS are not excluded from rents from real property under IRC Section 856(d)(2)(B) if the facility or property is operated on behalf of the TRS by an EIK.

IRC Section 856(d)(9)(A) defines an "EIK," with respect to any qualified lodging facility, as "any independent contractor if, at the time such contractor enters into a management agreement or similar service contract with the TRS to operate such qualified lodging facility, such 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."

IRC Section 856(d)(3) defines an independent contractor (IK) as "(A) any person who does not own, directly or indirectly, more than 35% of the REIT's shares, or certificates of beneficial interest; and, (B) if such person is a corporation, not more than 35% of the total combined voting power of whose stock (or 35% of the total shares of all classes of whose stock), if such person is not a corporation, not more than 35% of the interest in whose assets or net profits is owned directly or indirectly, by one or more persons owning 35% or more of the shares or certificates of beneficial interest in the REIT."

In Revenue Ruling 74-471, the IRS determined that a corporation's status as an investment adviser and fiduciary to a REIT under an advisory agreement with the REIT disqualifies the investment adviser from qualifying as an independent contractor of the REIT.

In Revenue Ruling 75-136, the IRS determined that "a wholly owned subsidiary of an investment advisor is not precluded from qualifying as an independent contractor if the subsidiary operates as a separate entity with its own separate officers and employees and keeps its own separate books and records that clearly reflect its activities in the management of the property." The ruling explained that "it is the relationship of the entity or individual (such as an employee or trustee) to the [REIT] itself that precludes the entity from qualifying as an independent contractor." Assuming the other requirements for qualification as an independent contractor are met, a relationship between the entity or individual and the REIT's trustee, employee, or investment advisor would not in itself disqualify the entity.

Revenue Rulings 77-23, 73-194 and 2003-86 also address certain scenarios involving IK or EIK qualification.

In PLR 202002009, the IRS recited that Taxpayer represents that, after the Proposed Transaction, (i) ServiceCo will operate as a separate entity from AdvisorCo, maintain its own books and records, and, aside from the very limited employee sharing and common single officer and director arrangement previously described, have separate employees and officers from AdvisorCo; (ii) each management contract under which ServiceCo will manage hotel properties for a TRS of Taxpayer will represent an arm's-length arrangement reflecting market terms; and (iii) the ownership restrictions of IRC Section 856(d)(3) will not be violated. The IRS explained that, despite an overlapping officer and director, a limited number of shared employees performing G&A functions, and common elements of ownership, ServiceCo and AdvisorCo will operate as distinct, independent entities after the Proposed Transaction, and Taxpayer and ServiceCo will deal with each other solely at arm's length. Based on these facts, the IRS ruled that ServiceCo will not fail to qualify as an EIK under IRC Section 856(d)(9) with respect to Taxpayer solely due to its brother-sister affiliation with AdvisorCo.

Next addressing the Incentives, the IRS recited that the Taxpayer additionally represents that (i) the Incentives derive from AdvisorCo's desire to incentivize the acquisition of additional hotel properties by Taxpayer and will not depend on the relationship between Taxpayer and ServiceCo; and (ii) AdvisorCo will receive no funding directly or indirectly from ServiceCo and will not make any loans to ServiceCo. Based on these facts, the IRS ruled that ServiceCo will not fail to qualify as an EIK under IRC Section 856(d)(9) with respect to Taxpayer solely due Taxpayer's TRSs receiving the Incentives from AdvisorCo.

Implications

PLRs 202002009 and 202002012 are the first private letter rulings in many years to address whether certain relationships between a REIT's investment advisor and an IK could cause the IK to fail to qualify as such (and thus also fail to qualify as an EIK). This ruling serves to remind REITs and their advisors of the IRS's position in Revenue Ruling 74-471 that a REIT's investment advisor (which is bound by the fiduciary duty of loyalty) may not also qualify as an IK because the investment advisor's fiduciary position conflicts and is inconsistent with purported status as an independent contractor dealing with the REIT as an independent third party. Externally advised REITs will want to take note of this ruling.

———————————————