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November 4, 2020

IRS addresses REIT's leasing structure of health care properties to comply with state licensing requirements

In PLR 202038009, the IRS addressed a real estate investment trust's (REIT) proposed lease of certain health care properties to its taxable REIT subsidiary (TRS), including modifications to comply with state licensing requirements. The IRS ruled that the leasing structure would not: (1) cause the REIT's TRS or certain license holders to be treated as directly or indirectly operating or managing health care facilities; (2) disqualify rents paid by the TRS to the REIT from the related-party rent exception of IRC Section 856(d)(8)(B), or (3) cause the REIT to be treated as owning securities of the license holders under the assets tests of IRC Code Section 856(c)(4) or the TRS rules of IRC Section 856(l).


Taxpayer, a publicly traded REIT, owns a portfolio of qualified health care properties (Facilities) that it currently leases to an unrelated third party. The third party engages Manager to operate and manage the Facilities. Manager qualifies as an eligible independent contractor (EIK) under IRC Section 856(d)(9)(A).

Taxpayer "intends to transition the [Facilities'] leasing, operation and management to the structure described in IRC Section 856(d)(8)(B)" (the Statutory Structure). Specifically, Taxpayer intends to lease each of its Facilities, except those located in State A, to a TRS, which will enter into a management contract with Manager to operate each Facility.

State A's regulations govern the operation of in-state facilities (State A Facilities) and require licenses to operate facilities to be granted only to natural persons or certain entities that are (i) not publicly owned or owned by other companies, or (ii) operated on a not-for-profit or governmental basis. State A's regulations also require the license holder to retain certain elements of control, including: the authority to hire and discharge workers, dispose of assets, incur liabilities and adopt certain policies on behalf of the facility; control over the facility's accounts, books and records; and approval of certain budgets, contracts and settlements.

Taxpayer proposes to implement a structure for the State A Facilities (Proposed Structure) similar to the Statutory Structure it uses for its other facilities in order to comply with the State A's regulatory requirements.

Under the Proposed Structure, Taxpayer will lease the State A Facilities to a TRS under leases that conform to the leases between Taxpayer and TRSs for the non-State A Facilities. The TRS will subsequently sublease each of the State A Facilities to a separate License Holder, each of which is a State C non-stock company, that will hold a State A license to operate the State A Facilities (License Holder). Rent under this arrangement will be a fixed amount intended to equal annual operating income, net of operating and management expenses, from the State A Facilities to the TRS.

Under management agreements between each License Holder and Manager, Manager will operate the State A Facilities, subject to the managerial rights that the License Holder must retain under State A regulations, including its authority to exercise specified powers without having employees or the capacity to perform meaningful daily operational or managerial functions. The License Holders' activities will be limited to approving proposed annual budgets and specified contracts and ensuring adequate working capital is available to Manager for operations and repairs. Manager will perform the same day-to-day operations and other functions that it does for Taxpayer's non-State A Facilities. The TRS will guarantee the License Holders' obligations under the management agreements.

In addition, the TRS and Manager will enter into a "side letter" providing, among other matters, that the structure's "intended net economic effect is that each License Holder facilitates the [TRS's] engagement of [Manager] in a direct management agreement" and "the purpose of the License Holder … is to comply with State A regulatory requirements … ." TRS and Manager will also be required to make periodic true-up payments to each other if necessary, to ensure that the economic arrangements for the State A Facilities are the same as for Taxpayer's non-State A Facilities.

Taxpayer will appoint directors of the License Holder, which may be employees and officers of Taxpayer or Manager. Taxpayer will have no rights to control the decisions or behavior of the officers and directors.

Each License Holder, as a non-stock company, will not have members. Its articles of incorporation will provide that, "upon dissolution, assets will be distributed: first, to any creditors in satisfaction of any liabilities and obligations owed by the License Holder; second, to any other claimholders of the License Holder; and finally, the residual" to Manager. Taxpayer will have no equity interest in a License Holder; upon its liquidation, none of the remaining assets will be distributed to Taxpayer or its affiliates, officers or directors.

Law and analysis

IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specific sources, including rents from real property, and IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources, including rents from real property.

The term "rents from real property" includes (1) rents received from the lease of interests in real property to tenants, (2) charges for certain customary services furnished to tenants, and (3) certain insubstantial rent from personal property (IRC Section 856(d)(1)). The term "rents from real property" does not include (1) rents based on the income or profits of a tenant, (2) rents from certain related tenants, and (3) impermissible tenant services income (IRC Section 856(d)(2)).

IRC Section 856(d)(8)(B) contains an exception to the related-party rent rule of IRC Section 856(d)(2)(B) if a REIT leases a qualified lodging facility or a qualified health care property to a TRS and the property is "operated on behalf of the TRS" by a person that qualifies as an EIK. A TRS is not considered to be operating or managing a qualified lodging facility or a qualified health care property solely because it holds a license, permit or similar instrument enabling it to do so (IRC Section 856(d)(2)(B)(i)).

IRC Section 856(l)(1) defines a TRS as a corporation whose stock is directly or indirectly owned, in full or part, by a REIT and that jointly elects with the REIT to be treated as a TRS. A corporation will not qualify as a TRS, however, if it directly or indirectly "operates or manages a lodging facility or a health care facility" (IRC Section 856(l)(3)).

In its analysis, the IRS stated that the License Holders of the State A Facilities should not be treated as managing or operating health care facilities merely because they hold the State A Facilities' licenses and retain certain control over them as required by State A, noting that IRC Section 856(d)(8)(B)(i) shows that Congress did not equate holding a license for a property with operating or managing the property. The IRS explained that the Manager, notwithstanding the rights License Holders must retain under state law, will be responsible for the day-to-day management of the State A Facilities, and thus should be treated as managing or operating the property.

The IRS also indicated that the economics of the Proposed Structure do not differ materially from those of the Statutory Structure of IRC Section 856(d)(8)(B) because the net economic effect of the Proposed Structure is that the Manager will receive a fee for managing each State A Facility under a management agreement and side letter. The IRS concluded that the interposition of the License Holders to satisfy the requirements of State A law should not disqualify the Proposed Structure under IRC Section 856(d)(8)(B) because the License Holders effectively function as conduits through which the TRS hires Manager.

The IRS also concluded that neither Taxpayer nor TRS has an economic interest in a License Holder equivalent to its stock or securities, based on representations that neither Taxpayer nor TRS holds any equity interest in a License Holder and the true-up payments under the side letter are to replicate the economics of the Statutory Structure.


PLR 202038009 is the second private letter ruling in which the IRS approved a modification to the leasing structure specifically allowed under IRC Section 856(d)(8)(B) in order to accommodate a particular state's licensing laws for operating a health care facility (see PLR 201232032). It is helpful to see that the IRS continues to be willing to work with REITs to accommodate certain state licensing requirements in private letter ruling requests.


Contact Information
For additional information concerning this Alert, please contact:
Real Estate Group
   • Mark Fisher (
   • Dianne Umberger (
   • Jonathan Silver (
   • Mark Kirshenbaum (
   • Sarah Ralph (