IRS partially revokes previously issued private letter ruling on percentage rent
Where is the line between “adjusted revenue” and “income”? The Internal Revenue Service (IRS) recently shared its view with taxpayers and the real estate investment trust (REIT) industry in the context of percentage leases. On February 4, 2022, the IRS released Private Letter Ruling (PLR) 202205001 and reminded taxpayers that names do not matter – calling something “revenue” does not disguise the fact that it may be subject to recast by the IRS as “income” for purposes of the Internal Revenue Code of 1986, as amended (the Code) and the Treasury Regulations promulgated thereunder.
In this practice note, we review (a) the rule relating to “percentage rent” under Code Section 856(d)(2)(A); (b) the history of PLR 202205001; (c) the holding of PLR 202205001; and (d) related prior PLRs from the IRS.
Congress enacted the REIT rules in 1960 as part of the Cigar Excise Tax Extension Act. The legislative history suggests that Congress wanted to provide all investors, especially smaller retail investors, with a tax-efficient vehicle to invest in professionally managed passive income-producing real estate.
Prior to the creation of the REIT vehicle, investment in commercial real estate was largely limited to financial institutions, big businesses and wealthy individuals. Although the REIT rules have significantly evolved since 1960, the tax policy of limiting REITs to predominantly generating passive rental income from real estate continues to be a guiding principle today under modern REIT rules. Accordingly, REITs are limited in the commercial activities that they are permitted to conduct. A REIT is generally not permitted to directly operate active businesses.
To further the tax policy underlying the favorable tax treatment provided to REITs, the REIT rules under Code Sections 856(c)(2) and 856(c)(3) provide that a REIT is required to predominantly generate “rents from real property” in order to maintain its REIT status. Code Section 856(d)(2)(A) further provides that “rents from real property” shall not include:
any amount received or accrued, directly or indirectly, with respect to any real or personal property, if the determination of such amounts depends in whole or in part on the income or profits derived by any such person from any such property (emphasis added).
The term “income or profits” as used in Code Section 856(d)(2)(A) is broad and can be “in whole or in part”. However, Code Section 856(d)(2)(A) continues to provide a carveout for rents based on “fixed percentage or percentages of receipts or sales” that are permissible and treated as qualifying rents from real property.
In addition, Treasury Regulations Section 1.856-4(b)(3) provides that adjustments for returned merchandise, or federal, state, or local sales taxes are permissible. Adjustments for certain escalation receipts are also permissible.Furthermore, the percentage rent formula must be fixed at the time of entering into the lease and cannot be renegotiated during the term of the lease.
Therefore, the distinction between revenue (with permitted adjustments) and income is a key distinction between qualifying and non-qualifying rents from real property in typical percentage rent leases.
A brief history of PLR 202205001
In 2012, the IRS issued PLR 201337007, which related to a tax-free spinoff of real estate assets into a REIT by an operating business that was structured as a “C” corporation (“Opco/Propco REIT Spinoff”) (as shown in the diagram immediately below). The taxpayer formed a controlled corporation (“Propco”) to primarily hold casino real estate assets that would be leased back to the distributing business (“Opco”). Immediately following the distribution, Propco, holding only real estate assets, would elect REIT status. Subsequently, Propco would lease back the real estate assets to Opco in exchange for rent payments. The rent paid by Opco was presumably tax deductible. In PLR 201337007 the IRS provided the taxpayer with a tax-efficient method to split off its real estate holdings from the operational side of its business and a tax efficient holding structure for the spun off real estate assets.
Against this backdrop, in PLR 201337007 the IRS asked whether the percentage rent master lease between Opco and Propco was qualifying rent from real property. The master lease was calculated based on a percentage of “Net Revenues.,” defined in the master lease as the amount received by Opco from patrons plus gross receipts of Opco generated through goods and services minus the retail value of services.
Taxes and expenses were specifically not deducted in the calculation of Net Revenue. In addition, the rental payments under the master lease were subject to certain escalation and other adjustments (“Escalation and Other Adjustments”). Without providing a detailed discussion of Escalation and Other Adjustments, the IRS held in PLR 201337007 that the amounts under the master lease were qualifying rents from real property.
Summary of PLR 202205001
PLR 202205001 reconsidered a portion of the percentage rent ruling from PLR 201337007. Specifically, in PLR 202205001, the IRS reviewed the Escalation and Other Adjustments provisions in the master lease. The Escalation and Other Adjustments were calculated based on “Adjusted Revenue,” which was calculated based on the net revenue of the lessee minus interest expense, income tax expense, depreciation and amortization expense, rent expense and certain other expenses or EBITDAR. This is to be distinguished from the definition of Net Revenues discussed above in PLR 201337007, which did not deduct taxes and expenses from its definition. The IRS held that rents calculated based on “Adjusted Revenue” was a measure of income and profits of the lessee and therefore not treated as qualifying rents from real property.
How does PLR 202205001 fit in with older PLRs?
This distinction between gross revenue and net income has been the subject of many REIT PLRs. Compiled below is a sample of past PLRs on point. As illustrated below, ultimately, this is a facts and circumstances analysis. While PLRs are indicative of administrative practice, only the taxpayer that requested the specific PLR from the IRS is entitled to rely on such guidance.
The IRS ruled that the percentage rent paid by tenants of billboard sites as adjusted for agency fees and continuity discounts does not depend in whole or in part on the income or profits derived by any person at the billboard site.
The IRS ruled that amounts received by a REIT from tenants based on electricity cost savings from systems installed by the REIT’s operating partnership at rental properties do not depend in whole or in part on the income or profits derived by any person from the leased property.
The IRS ruled that gross receipts could be adjusted for returns of merchandise to the tenant, refunds, sales of fixtures used by the tenant and taxes payable out of gross receipts.
The IRS ruled that reimbursement of attorneys’ fees, costs of litigation, punitive damages and recovery of previously deducted expenses constitute gross income.
The IRS ruled that rent based on a fixed percentage of a prime tenant’s gross income from subtenants, as reduced by escalation receipts received from the subtenants (i.e., amounts intended to cover increases in certain property operating expenses incurred by the prime tenant, such as property taxes, insurance, etc.) will qualify as rents from real property.
The IRS ruled that certain tenant expenses such as cash or credit refund, allowance, discount or rebate, and sales tax can be subtracted from gross receipts.
These PLRs demonstrate the IRS’s willingness to modernize the archaic 1960 rules and to evolve the REIT rules while adhering to the basic policy of not allowing REITs to participate in earning active business income. To a certain degree, basing rent on a percentage of gross receipts with certain permitted deductions may economically approximate income. These PLRs illustrate that there is a fine line between subtracting permitted deductions from the definition of gross receipts that should be respected as adjusted revenue versus building in too many deductions that might be recast by the IRS as income. PLR 202205001 illustrates that percentage rent based on EBITDAR is too far over the line. Overall, we do not view PLR 202205001 as a marked departure from prior IRS guidance on point.
A lot has changed since 1960, when REITs were first created under the Cigar Excise Tax Extension Act.
Since 1960, both Congress and the IRS have generally shown a willingness to expand their interpretation of “rents from real property” and to liberalize the REIT rules. For example, in order to allow REITs to provide substantial tenant services, Congress created the TRS regime in 1999 under the REIT Modernization Act. In addition, in recent years, the IRS issued a series of PLRs to allow REITs to enter into new asset classes such as cold storage and to allow REITs to provide best in class physical amenities to tenants.
Nevertheless, PLR 202205001 serves as a reminder that the views of the IRS are constantly evolving. PLR 202205001 was rendered because the IRS had determined that a portion of one of its 50 rulings in PLR 201337007 was no longer in accord with its current views. REIT taxpayers are encouraged to consult with their REIT tax advisors to review percentage rent leases, including the defined terms in such leases.
Learn more about the implications of PLR 202205001 by contacting any of the authors.
 Pub. L. No. 86-779 (2d. Sess. 1960).
 REITs are provided preferential tax treatment under the Code by effectively allowing for one level of taxation on income pursuant to a dividends paid deduction, compared to traditional “C” corporations which are subject to double taxation. This favorable tax treatment is predicated on REITs satisfying various organizational and operational requirements designed to ensure that REITs derive income predominantly from passive investment in real estate as opposed to deriving income from an operating business.
 REITs often use a taxable REIT subsidiary (“TRS”) to indirectly conduct operating businesses that they are not permitted to directly conduct under the REIT rules. Unlike a REIT, a TRS is a traditional “C” corporation and subject to full corporate entity level tax with no dividends paid deduction offset regime.
 Treasury Regulations Section 1.856-4(a) provides that “rents from real property” generally means “the gross amounts received for the use of, or the right to use, real property of the real estate investment trust.”
 Treasury Regulations Section 1.856-4(b)(3) provides that escalation receipts include “amounts received by a prime tenant from subtenants by reason of an agreement that rent shall be increased to reflect all or a portion of an increase in real estate taxes, property insurance, operating costs of the prime tenant, or similar items customarily included in lease escalation clauses.”
 Treasury Regulations Section 1.856-4(b)(3).
 Percentage rent leases are common in retail, parking, and hotel and lodging Opco/Propco leases.
 The IRS subsequently had a change of heart and issued Notice 2015-59, 2015-40 I.R.B. 459 and Rev. Proc. 2015-43, 2015-40 I.R.B. 467 to put taxpayers on notice. On December 18, 2015, Congress enacted the Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113, 129 Stat. 3031 (2015) which essentially shut down such Opco/Propco REIT spinoff transactions.
 See, also, a series of related PLRs: PLR 201411002, PLR 201433007, and PLR 201528006.
 “Taxes and Expenses” was defined in the Master Lease to include “salaries, income taxes, employment taxes, supplies, equipment, cost of goods and inventory, rent, office overhead, marketing and advertising, and other general administrative costs.”
 The terms “Escalation” and “Other Adjustments” were redacted from PLR 201337007. There was also no specific mention of the definition of “Adjusted Revenue” in PLR 201337007 which is the subject of discussion in PLR 202205001.
 Pub. L. 106-170 (2d. Sess. 1999).
 See, eg, PLR 202012003.
 See, eg, PLR 201812009.