September 6, 2023
IRS rules that D&O insurance proceeds will be excluded from gross income for purposes of REIT income tests
In two substantially similar private letter rulings obtained by professionals at EY (PLRs 202335004 and 202335005), the IRS ruled that proceeds from D&O Insurance claims related to the settlement and legal defense costs of certain lawsuits will be excluded from gross income for purposes of the REIT gross income tests under IRC Sections 856(c)(2) and (c)(3).
The IRS issued PLRs 202335004 and 202335005 to two Taxpayers, a publicly traded REIT (Parent) and its subsidiary REIT (Subsidiary). Both Taxpayers are in the business of owning and leasing real property. As is customary among publicly traded companies, Parent purchases D&O Insurance to protect itself, its officers and directors, and certain subsidiaries (including Subsidiary) from liability and related defense costs arising from certain types of lawsuits, including shareholder securities class actions and derivative lawsuits.
Parent engaged in three transactions with another company (Company) that resulted in Parent leasing a substantial portion of its real property assets to Company. A lawsuit related to the transactions was filed, resulting in a court-entered judgment, which then led to Parent's shareholders bringing four additional lawsuits (the Shareholder Lawsuits). Settlements were subsequently reached in three Shareholder Lawsuits (with two such settlements still subject to finalization and approval by the court at the time the PLRs were issued), and one Shareholder Lawsuit was dismissed.
The D&O Insurance funded or is expected to fund the costs of the settlements, the Taxpayers' defense costs and certain plaintiffs' attorneys' fees for the Shareholder Lawsuits. Because both Taxpayers are named defendants in the Shareholder Lawsuits and named insureds under the D&O Insurance, both Taxpayers expect to include a portion of the D&O Insurance proceeds (Proceeds) in gross income.
The Taxpayers represented that their officers were acting in their fiduciary capacities in settling three of the Shareholder Lawsuits to avoid the cost of additional litigation in the best interests of both Taxpayers and their shareholders. The Taxpayers also represented that the Proceeds would merely restore them to the position in which they would have been if no lawsuits had been filed. Neither Taxpayer would receive a net financial or economic benefit from the Proceeds, and the Proceeds would not exceed the Taxpayers' expenses associated with the lawsuits.
IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specified sources of passive income, including rents from 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 (1) gain from the sale or disposition of real property and (2) rents from real property.
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.
Under Treas. Reg. Section 1.856-4(b)(5)(ii), the trustees or directors of a REIT are not required to delegate or contract out their fiduciary duty to manage the REIT. The trustees or directors may do all things necessary, in their fiduciary capacities, to manage and conduct the affairs of the REIT itself, including dealing with insurance relating to the REIT's property.
The IRS exercised its discretionary authority under IRC Section 856(c)(5)(J) to rule that the Proceeds will be excluded from the gross income of both Taxpayers for purposes of IRC Sections 856(c)(2) and (3), noting that doing so does not interfere with Congressional policy objectives of ensuring that REITs primarily derive income from passive sources and not from the active conduct of a trade or business.
In so ruling, the IRS noted that the Taxpayers represented that they maintain D&O Insurance to protect themselves and their directors and officers from liability and to cover related defense costs arising from certain types of lawsuits. The IRS found that the Proceeds did not represent an economic enrichment to either Taxpayer, but merely restored them to the position in which they would have been if no lawsuits had been filed. The IRS observed that receipt of the Proceeds did not relate to the active conduct of a trade or business but rather was traceable to the Taxpayers' leasing of real estate assets to Company and that the consequences of the Taxpayers and the Taxpayers' fiduciaries exercising their fiduciary duty to defend and settle lawsuits should not cause the Taxpayers to fail to qualify as REITs.
PLRs 202335004 and 202335005 are the first PLRs to address the treatment of a REIT's income attributable to D&O Insurance proceeds received to cover a REIT's costs incurred in defending and settling a lawsuit filed against the REIT. The IRS previously ruled pursuant to its authority under IRC Section 856(c)(5)(J) that where a REIT was a plaintiff or claimant in a lawsuit related to a real estate investment, the amounts received for settling and pursuing such claims were excluded from gross income for purposes of IRC Section 856(c)(2) and (3) (see PLRs 201145008 and 201122016). The IRS concluded in the earlier rulings that excluding the amounts received in settlement of the REIT's claims did not interfere with Congressional policy objectives in enacting the gross income tests. Accordingly, the rulings in PLRs 202335004 and 202335005 are consistent with prior rulings involving amounts received by a REIT in connection with litigation, even though such amounts were received in settlement of the REIT's claims and not as insurance proceeds to cover the costs of settling and defending a litigant's claims against the REIT.
PLRs 202335004 and 202335005 can be contrasted with PLR 202237004, in which the IRS recently ruled, pursuant to its authority under IRC Section 856(c)(5)(J), that a REIT's proceeds from business interruption insurance (BII) claims would be treated as qualifying income for purposes of IRC Sections 856(c)(2) and (3) (see Tax Alert 2022-1413). The BII proceeds at issue in PLR 202237004 arose from claims related to two natural disasters that damaged certain marinas owned indirectly by the REIT, resulting in a temporary suspension of ordinary operations while the marinas were repaired. In concluding that treating the BII proceeds as qualifying income for purposes of IRC Sections 856(c)(2) and (3) did not interfere with Congressional policy objectives in enacting the gross income tests, the IRS observed that the Taxpayer represented that the BII proceeds related only to lost revenue that would otherwise constitute qualifying income under IRC Sections 856(c)(2) and (3) and that the proceeds were calculated to avoid a windfall.
In contrast to the BII proceeds addressed in PLR 202237004, the Proceeds at issue in PLRs 202335004 and 202335005 did not replace the Taxpayers' lost revenue that would otherwise constitute qualifying income under IRC Sections 856(c)(2) and (3). Accordingly, rather than the IRS using its discretionary authority under IRC Section 856(c)(5)(J) to treat the Proceeds as qualifying income, the IRS instead used its discretionary authority to exclude the Proceeds from the Taxpayers' gross income for purposes of IRC Sections 856(c)(2) and (3) (consistent with PLRs 201145008 and 201122016). As noted, the IRS pointed to the fact that the Proceeds were traceable to the Taxpayers' leasing of real estate assets to Company in reaching its conclusions in PLRs 202335004 and 202335005. Because the Proceeds were received as a consequence of Taxpayers and Taxpayers' fiduciaries properly exercising their fiduciary duty to defend and settle lawsuits, it is unclear whether the IRS would reach a different conclusion were a REIT to receive D&O Insurance proceeds in connection with defending a lawsuit not related to a real estate transaction.
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor