February 11, 2021 Self-charged management fees excluded from REIT income tests In PLR 202102002, the IRS ruled that a real estate investment trust's (REIT) allocable share of management fee income from a partnership that received the management fees from providing management services to the REIT will be treated under IRC Section 856(c)(5)(J) as not constituting gross income for purposes of the 95% and 75% income tests of IRC Section 856(c)(2) and (3). Accordingly, the REIT's allocable share of management fee income will not adversely affect the REIT's compliance with the income tests. Facts Taxpayer is a REIT that intends to complete an initial public offering of its stock. Taxpayer's business includes the acquisition and management of a portfolio of commercial real estate, multi-family residential properties, and mixed-use retail/residential properties and may include the acquisition of commercial mortgage loans (collectively, the Investments). Taxpayer will receive rental income and interest income from the Investments (Investment Income). Taxpayer represents that substantially all the Investment Income will be qualifying gross income for purposes of the 95% and 75% income tests. Taxpayer also owns all the stock of Company, an entity that qualifies as a taxable REIT subsidiary. Company owns an interest in Manager, an entity treated as a partnership for federal income tax purposes. Taxpayer pays a base management fee and incentive fee (Management Fees) to Manager for asset management services. Taxpayer intends to restructure its ownership structure so it will directly own an interest in Manager, and Manager will continue to provide asset management services to Taxpayer and receive the Management Fees. As a result of becoming a partner in Manager, Taxpayer will have gross income attributable to its allocable share of the Management Fees received by Manager. Taxpayer represents that all activities Manager performs for it are activities that a REIT may perform in managing the assets of the REIT, as well as managing the REIT itself, without adverse tax consequences. Taxpayer also represents that it will treat gross income attributable to any fees earned by Manager from third parties as non-qualifying income for purposes of the REIT income tests. Law and analysis IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including dividends; interest; rents from real property; and certain gains from the sale of stock, securities and real property. IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources of real estate source income, including rents from real property, interest on mortgages and gain from the sale or other disposition of real property. Under Treas. Reg. Section 1.856-3(g), a REIT that is a partner in a partnership is deemed to own its proportionate share of each of the assets of the partnership and to be entitled to the income of the partnership attributable to that share for purposes of applying the asset and income tests. IRC Section 856(c)(5)(J) authorizes the IRS to determine, to the extent necessary to carry out the REIT provisions' purposes, whether items of income or gain that are not qualifying income under the 95% or 75% income tests may nevertheless be (1) disregarded for purposes of the 95% or 75% income tests or (2) treated as qualifying income for purposes of the 95% or 75% income tests. The legislative history of the REIT provisions of the tax code indicates that the primary concern of the REIT income tests is to ensure that a REIT's gross income is largely passive income. After the restructuring, the IRS explained, Taxpayer will earn Investment Income and also receive an allocable share of the Management Fee income from Manager. Because the Management Fees are derived from the same Investments that generate the Investment Income, the inclusion of Taxpayer's allocable share of the Management Fees in Taxpayer's gross income would cause the amounts to be "counted twice" for purposes of the REIT income tests. In addition, the IRS noted that Taxpayer's allocable share of the Management Fee income represents an amount that Taxpayer, as a partner in Manager, is "charging itself" for functions that Taxpayer could perform directly without adverse tax consequences. Accordingly, the IRS determined under IRC Section 856(c)(5)(J) that excluding Taxpayer's allocable share of the Management Fees from Taxpayer's gross income for purposes of the REIT income tests is consistent with the purposes of the REIT provisions of the tax code. Implications PLR 202102002 is the second private letter ruling (PLR) issued during the past five years in which the IRS ruled under IRC Section 856(c)(5)(J) that a REIT may exclude, for purposes of the 95% and 75% income tests, its allocable share of management fees received from a lower-tier partnership that is providing management services to the REIT (or an upper-tier partnership of the REIT). See PLR 201620001. In years predating the enactment of IRC Section 856(c)(5)(J) (which applies to tax years beginning after July 30, 2008), the IRS issued many other PLRs involving "self-charged management fees." These PLRs concluded that if a REIT owns a significant interest in a partnership that owns rental real property and the REIT is providing management services to the partnership in consideration for fees, the REIT may disregard the portion of the fee income received from the partnership that is attributable to the REIT's capital interest in the partnership for purposes of the income tests, while the portion of the fee income that is attributable to the other partners' interests in the partnership will be treated as nonqualifying income. See PLRs 199952084, 9808011, 9701028, 9646027, 9552038, 9535014, 9521010, 9515005, 9502037, 9452032, 9431005, 9428018 and 9343027. The IRS's rationale for these rulings was similar to that in PLRs 202102002 and 201620001 — the management fees are already reflected in the REIT's allocable share of rents derived by the partnership or are self-charged (or fees for services provided by the REIT to its own properties or itself). In addition, the IRS has issued several "self-charged loan" PLRs in which the IRS concluded that a REIT may ignore the "self-charged" portion of a loan (and related interest income) to a partnership (in which the REIT is a significant partner) for purposes of applying the asset and income tests to avoid a double counting of income and assets. See PLRs 201118015, 200740004, 200234054 and 9514006. Finally, the IRS has issued several "self-charged rent" PLRs concluding that a REIT may ignore its allocable share of rental income from a "lessor partnership" to avoid a "double-counting" of income to the extent of the REIT's allocable share of related rental deductions of the "lessee partnership" for purposes of the income tests. See PLRs 201407011, 201204006, 200705019 and 200405007 (PLR 201407011 contains a recital of IRC Section 856(c)(5)(J) but does not expressly indicate that the ruling was given under the IRS's discretionary authority under IRC Section 856(c)(5)(J)). ———————————————
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