Modern Reits and the Corporate Tax: Thoughts on the Scope of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles by David F

Modern REITs and the Corporate Tax: Thoughts on the Scope of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles By David F. Levy, Nickolas P. Gianou and KevinKevin M.M JonesJones *

DavidD d FLF. Levy, NNickolasik PGP. GiGianou anddK Kevini MM.

DAVID F. LEVY is a Partner in the Jones analyze the history of both REITs and our Chicago ofﬁ ce of Skadden, Arps, Slate, corporate tax system, discuss how REITs came Meagher & Flom LLP.

NICKOLAS P. GIANOU is an Associate to fall within the corporate tax, and examine in the Chicago offi ce of Skadden, Arps, Slate, Meagher & Flom LLP. whether real estate investment companies KEVIN M. JONES is an Associate in the should ever have been subject to the corporate Chicago offi ce of Skadden, Arps, Slate, Meagher & Flom LLP. tax in the fi rst place.

Table of Contents I. Introduction ...... 219 B. Requirements to Qualify as a REIT ...... 222 A. Source of the Current REIT Debate ...... 219 1. Asset Tests ...... 222 B. Addressing the Premise Th at REITs 2. Income Tests ...... 223 Belong in the Corporate Tax...... 221 3. Special Rules for TRSs ...... 223 II. Summary of the Current REIT Tax Regime ...221 4. Distribution Requirements...... 224 A. Th e Consequences of Being a REIT: C. Special Rules for C-to-REIT Migrations ... 224 Benefi ts and Drawbacks ...... 222

III. Th e Policy Objectives of the Corporate Tax ....224 2 . Th e Development of Nontraditional A. Th e History Behind the Corporate Tax ....225 Real Estate ...... 247 B. Policy Objectives Underlying 3. C-to-REIT Conversions and REIT the Corporate Tax ...... 226 Spin-Off s...... 247 1 . Th e Regulatory View ...... 227 (a) Capital Markets Factors ...... 248 2 . Th e Capital Lock-In View ...... 227 (b) Specialization of the Firm and C. Either Way, the Corporate Tax Is the Separation of Asset Ownership About Retained Earnings ...... 229 and Usage ...... 248 IV. Historic Development of REITs in Our (c) Policy Implications of C-to-REIT Tax System...... 229 Conversions and REIT A. Th e Back-Story: Why REITs Needed Tax Spin-Off s ...... 248 Legislation in 1960...... 229 D. Concluding Th oughts on REITs, the 1 . Th e Early Development of Collective Corporate Tax and Modern Developments Investment Vehicles ...... 230 on the REIT Space ...... 249 2. REITs and the “Corporate VI. Policy Recommendations for Rationalizing Our Resemblance Test” Debacle ...... 230 System of Collective Investment Vehicles ...... 249 (a) A “Fearful Bungle” Sets the A. Collective Investment Vehicles Should Stage for a Debacle ...... 230 Not Be Subject to the Corporate Tax ...... 249 (b) Entity Classifi cation B. What Type of Income Should Collective in the Early Years ...... 232 Investment Vehicles Earn and How Should (c) Entity Classifi cation from the Th ey Earn It? ...... 251 Twenties to the Great Depression ..233 1. Moving Beyond the Words “Active” ((d) d Th e Policy Problem with the and “Passive” ...... 251 Corporate Resemblance Testst ...... 234 2. A New Wa Way To Th ink About Collective ( (e(e)e))Th Th e Corporate ResResemblancembla e Test Investmentnvestm n VeVehicles c s ...... 25353 D Debacle:le: From Mo Morrisseyrrisseyy tto C. P Pickingg th the Rightig Mode Model for Collec Collectivetive CheCh Check-the-Boxthe-Boxx ...... 2 23434 InInvestmentment VVehicleseh le ...... 254...... 5 3.3 . Th e ImImmediate FllFallout from MMorrissey : 1. Income Cl Classes f for Collectivell i Th e Revenue Act of 1936 ...... 237 Investment ...... 254 B. 1960 and Th e Revival of the REIT ...... 238 (a) Rental Assets ...... 254 1. Reviving an Old Vehicle ...... 239 (b) Sale Assets ...... 255 2. Modernizing the REIT Vehicle ...... 240 (c) Additional Safeguards ...... 255 V. Challenging the Premise Th at REITs 2. Choosing the Best Operating Should Be Subject to the Corporate Tax...... 241 Model ...... 256 A. Th e Corporate Resemblance Test as a (a) Existing Operating Models Wellspring of an Incorrect Premise ...... 241 for Collective Investment ...... 256 B. Starting from the Right Place: REITs (b) Expanding Subchapter M ...... 256 Should Never Have Been Subject to the D. Ancillary Policy Issues ...... 257 Corporate Tax ...... 244 1. What Other Changes Need to Be C. Recent Developments Do Not Change Made in Order to Ensure the Success the Conclusion Th at REITs Should Not of Collective Investment Vehicles? .. 257 Be Subject to the Corporate Tax ...... 245 2. Shareholder-Level Changes ...... 257 1 . Th e Use of TRS Entities and the 3. What About Subchapter M Entities “Operating REIT” Debate ...... 245 Th at Do Business with Noncorporate (a) TRSs Th at Earn Non-REIT Tenants and Borrowers? ...... 257 Income ...... 246 4. Should We Provide All Corporations (b) TRSs Th at Provide Tenant with a Dividends Paid Deduction or Services ...... 246 Otherwise Incentivize the Distribution (c) Concluding Th oughts on the Use of Earnings? ...... 258 of TRSs ...... 246 VII. Conclusion ...... 259

218 TAXES The Tax Magazine® MARCH 2016 It is revolting to have no better reason for a rule of law resources in order to invest in real estate and mortgages than that so it was laid down in the time of Henry IV. on real estate. By pooling their resources in this way, small It is still more revolting if the grounds upon which investors collectively can acquire a diversifi ed portfolio of it was laid down have vanished long since, and the professionally managed real estate assets, which would oth- rule simply persists from blind imitation of the past. erwise be unfeasible for most individual investors.2 REITs can thus be thought of as collective investment vehicles —Oliver Wendell Holmes1 similar to mutual funds (commonly referred to as “RICs” in tax parlance), except that instead of focusing on stocks I. Introduction and securities, REITs focus on real estate. Because Congress has historically viewed diversifi ed, professionally managed Th is article is partially a commentary on recent events assets as being inherently less risky for smaller investors than and partially an academic discourse on tax. On the com- individual direct investments, vehicles such as RICs and mentary front, this article focuses on real estate investment REITs have not been subject to the corporate tax. Th e theory trusts (REITs) and their inclusion in a high-profi le, often here has been relatively simple: If collective investment were times shrill, policy debate on the scope of the corporate tax. subject to the corporate tax while direct investment could On the academic front, this article takes a hard but honest be done without being subject to the corporate tax, the tax look at how our profession uses premises to frame policy system would incentivize small investors to pursue a riskier debates; how a tax policy debate can become skewed, savings (i.e., direct investment) strategy to avoid having and ultimately unproductive, when we fail to check our their savings diluted through the 35-percent corporate tax. premises before accepting them as the starting place for REITs can be classifi ed using any number of criteria, our policy analysis; and how a tax policy debate can turn including investing style, asset class and shareholder-level 180 degrees if faulty premises are corrected. characteristics.3 Although many of the topics discussed in Th is ararticlerticlee adadvances two arguments. First, the current this article are applicable to all types of REITs, we focus policyoliccy ddedebateebbate on ththe proper taxation of REITs has been primarily on publicly traded REITs that own real estate basedaseed upon uppon and annd driven drivrive byy our collective viewv on theth properpr catered to businessness tentenantsan because those REITs have been “default”defafault” tax classificclassifi cacation of REITs as corporations.corporations Th is dde- the eepicenterpicen of the policyli ddebateat addressed inn this article.rticle faultaultlt viewview hashas beenbeen basedbase incorrectlycorrectly on o a line of authoritiesau o ies Th e InInternalal RevRevenuenu CCodede (thethe “Cod“Code”)e”)4 providesov thatat was discdiscreditedcreditte intinintellectually,tually fofoundd unwunworkablerka le anandd REITsR Ts with wi certainrtain tax taxb benefinefits ts andd subjects subjec REIT share-sh subsequentlyently discardeddi by the government two decades ago. holders to certain tax drawbacks compared with regular As a result, startling though it may be, our profession has C corporations and their shareholders. Th e primary tax been thinking about REITs in the wrong way for a long time benefi t accorded to REITs is at the entity level: a deduc- and has relied on incorrect thinking to frame and conduct tion for dividends paid to shareholders, which results in a tax policy debate that has been skewed against REITs. the REIT not being subject to corporate tax on income Second, once we adjust the premises underlying the that is distributed to its shareholders. 5 Th e shareholder- debate to properly refl ect the policy objectives underly- level tax drawbacks include higher taxes for domestic ing the corporate tax, it becomes clear that REITs have individuals who receive dividends from a REIT 6; the in- never properly belonged in the corporate tax base. Indeed, ability of corporate shareholders to claim the dividends despite the views of some REIT critics, the REIT regime received deduction for dividends received from a REIT7 ; actually advances the policy objectives underlying the the limited ability of non-U.S. shareholders to enjoy full corporate tax. All of this suggests that the REIT regime, treaty benefi ts with respect to dividends received from a rather than being curtailed, should be expanded to include REIT8 ; and, in certain cases, the imposition of the unre- asset classes other than real estate. lated business income tax on certain pension funds that Th ose are bold statements, and we will back them up. receive dividends from a REIT.9 But we fi rst need to set the table with some background on In addition to encouraging diversifi cation through collec- the REIT industry and the dynamics aff ecting the current tive investment, these benefi ts and drawbacks were viewed debate on the proper taxation of REITs. as placing small investors in public REITs on par, from a tax perspective, with wealthy individuals and institutional A. Source of the Current REIT Debate investors that own rental real estate through private partnerships.10 Th e REIT regime thus refl ects the fact that, For the uninitiated, REITs are pretty simple creatures: they between the end of World War II and the enactment of are vehicles through which small investors can pool their the modern REIT legislation in 1960, the overwhelming

MARCH 2016 219 MODERN REITS AND THE CORPORATE TAX

majority of new rental real estate ventures were conducted value capitalized leases more favorably than mortgages with through private partnerships,11 for a simple reason: rental similar payments, which has put pressure on publicly traded real estate investments are designed to produce current companies to lease real estate from third parties rather than yield for investors, and the imposition of a corporate level own their real estate. 18 Fourth, any non-real estate company tax would shred that yield.12 Th us, if private real estate that owns the real estate in which it conducts business is rental businesses were required to operate in C corporation vertically integrated to that extent and is bucking a long- form, investors might fi nd returns from rental real estate standing general trend away from vertical integration in insuffi cient to justify investment and either shift capital to favor of specialization.19 other investments or demand harsher economic terms for Th ese developments, taken together, have contributed to real estate investments.13 Th e result would be an increase the growth of the REIT industry and the variety of busi- in the cost of capital for real estate ventures or a decrease nesses operating in REIT form. For example, the increased in the amount of capital devoted to real estate ventures trading multiples (and therefore the stock price) of REITs (or a combination of the two). Given the importance of encouraged a relatively small number of real estate–focused real estate to the national economy, Congress viewed these C corporations to convert to REIT status (so-called C- results as unacceptable. 14 Th us, when Congress adopted the to-REIT conversions) in order to take advantage of the modern REIT regime in 1960, the regime was designed increase in stock price and the corresponding reduction in both to produce for small public investors tax results similar the cost of their equity capital. Over time, the increased to those enjoyed by investors in private real estate partner- value of REIT securities helped spawn the expansion of ships and to increase the amount of capital available for REITs into “nontraditional assets,” by increasing access to real estate investment.15 Once the REIT regime was made capital markets for ventures focused on those assets, such as to work as intended, REITs expanded signifi cantly.16 To- cold storage warehouses, wireless communications towers, day, generally speaking, if rental real estate investment is records storage facilities, outdoor advertising space, elec- goingg to takee plplace, it must do so through an entity that tricity transmission and distribution systems, natural gas is nonotot susubjectbject to thet corporate tax, but only public REITs pipeline systems, fi ber-optic data-transmission networks generallyeneerallyy offeoff ere inv investmentvest opportunities for smalll iinvestors.es and storage spaceace for datada servers, commonly referred to Given Given REITs’REITs’ simsimplicity,ty, one wouwouldd be foforgivenrg ven fforor as “d“dataata ccenters.”rs.” FFavorablera le treattreatmentment of leasleaseded reareal estatestate askingskik ng jjustust hhowow RERREITsITs becameame embrembroilediled in a tatax popolicycy by ratingstings agenciesncies andnd general trendsrends awawayy from veverti- debate.baate.ate ThThe e answer,answwe , wew believe,ieve is a toxicxic mimix of severaleveral cacal integrationntegr n have bbeeneen more generallynerally responsibleponsi le for factors: capitcapitaltl markets developments that have encour- many of the recent transactions in which C corporations aged many C corporations to spin off their real estate either engaged in C-to-REIT conversions or spun off their business units, dispose of their real estate or convert to internal real estate business units in the form of newly REIT status; increased scrutiny from media and politi- created REITs (“REIT spin-off s”). 20 cal circles unfamiliar with the quirks and nuances of Moving to the second component of our toxic mix—at- REIT taxation; and a pair of faulty premises that helped tention in media and political circles—the simple truth is frame the tax policy debate in a way that demonizes the that, whenever the capital markets’ deal du jour is perceived REIT industry. as providing unique tax benefi ts, the inevitable scrutiny Turning to the fi rst component of this “toxic mix”— from the press is likely to spill over into tax policy debates changes in the capital markets—a number of developments at multiple levels. For reasons that probably have a lot to have contributed to the growth of REITs in the past 15 do with the complexity and nuances inherent in the REIT years (and in the seven or so years since the fi nancial crisis tax regime and misconceptions about the extent to which in particular). First, the requirement that REITs distribute the use of REITs reduces overall tax revenues, the public at least 90 percent of their taxable income means that REIT debate around the recent growth of REITs has been fueled stock is the type of yield-producing security that tends to by a good deal of misinformation in both the media and become extremely popular, and extremely valuable by his- political spheres. Among other things, this misinformation toric standards, when nominal interest rates in developed has created a perception among some commentators that countries stay near (and, in some cases, below) zero for a REITs in general, and C-to-REIT conversions and REIT long time, as they have since 2008.17 Second, due to changes spin-off s in particular, are motivated by tax planning rather in both technology and fi nance, REITs have been able to than business objectives and are designed more to raid the provide investors with access to new asset classes, such as fi sc than advance a bona fi de business goal.21 cell towers, fi ber-optic networks and electricity transmission Th is perception rests, we believe, on two false premises, and distribution systems. Th ird, ratings agencies generally which have skewed the tax policy debate regarding REITs:

220 TAXES The Tax Magazine® MARCH 2016 fi rst, the income of a REIT should be subject to the corpo- On the third question, after concluding that REITs do rate tax in the fi rst instance;22 second, the recent develop- not belong, and have never belonged, within the scope ments in the REIT space create a material and inappropriate of the corporate tax, we analyze the policy implications drain on the fi sc. Th e eff ect of these premises on the debate of that conclusion. One of these policy implications is on the proper taxation of REITs is easily seen in the sort that that current debate on the proper taxation of REITs of questions typically debated: whether it is appropriate is really a more general debate about the role of collective for the corporate tax base to be narrowed by carving out a investment vehicles in our tax system. Accordingly, the special “exemption”23 for REITs and whether C corpora- thrust of our policy argument is that the main problem tions should be able to “avoid tax”24 by converting to REIT status or spinning off their real estate. 25 Th e framing of these questions makes sense only if one accepts the two premises For the uninitiated, REITs are pretty stated above; and once the questions are framed this way, the “borderline hysteria” 26 of the media and political debate simple creatures: they are vehicles around REITs becomes understandable. through which small investors can Th e second of these premises—that REITs create a mate- pool their resources in order to rial and inappropriate drain on the fi sc—has been addressed impressively by Professor Borden.27 As summarized in Part invest in real estate and mortgages V.C below, Professor Borden concludes that, because of the on real estate. various distribution requirements imposed on REITs and the higher taxes generally imposed on REIT shareholders as compared with C corporation shareholders, the negative with the current system is that our two most popular col- fi scal impact of REIT spin-off s and C-to-REIT conversions lective investment vehicles—REITs and RICs—do not is in all likelihoodlikkelihhood substantially lower than most people seem represent the entire universe of potential collective invest- to blibbelieveelieve aand,nnddi, inn certain cases, may be immaterial. Th e ment vehicles. Th is means that investments in certain asset authorsuthhors aagree e who wholeheartedlyoleh edly with that analysis. classes that are suitablsuitable fforo collective investment are subject Th e reremaindermainnder of this articlerticle is therethereforefore devdevotedoted to tthehe to the thhe corporatecor ate tatax whwhilee oothersers arare nonot. BBecauseecause we sesee fi rst prepremise—thatmise—thhaat ththehhe iincomeme of a REREITT shoulshould bbe subjectu ect non taxx popolicy justifi cationtion for ththiss disparitydisparity, our pprimaryim to ththehe co corporateorporrate tat tax in the firstfi rst instance. insta e policyp cy recommendation rec mendation iss that thee REIT regimegime shouldho be expanded to include a number of other assets that can B. Addressing the Premise That REITs be owned by one party and leased to another or owned Belong in the Corporate Tax by one party and fi nanced by another. Th us, in our view, the problem with the REIT regime is not that it is too In addressing the premise that REITs belong in the corpo- broad but that it is too narrow. To us, once the premises rate tax, this article asks three questions of its own. First, of the current policy debate are corrected, this outcome should REITs have been subject to the corporate tax in is a sensible result. the fi rst instance? Second, if not, do any of the modern Part II of this article provides necessary background developments in the REIT space undercut that conclu- and context by discussing the requirements that an entity sion? Th ird, if REITs should not be subject to tax in the must satisfy in order to be a REIT. Part III discusses the fi rst instance, what implications does that conclusion hold historical policy objectives of the corporate tax. Part IV for other types of investment vehicles? discusses the historical development of REITs in our tax On the fi rst question, we analyze the historical reasons system, while Part V debunks the proposition that REITs for, and the policy objectives underlying, the corporate belong in the corporate tax system. Part VI contains our tax and conclude that, from a policy perspective, REITs policy recommendations. should never have been subject to the corporate tax and, furthermore, that the REIT regime in fact advances II. Summary of the Current rather than hinders the policy objectives underlying the corporate tax. On the second question, we analyze the REIT Tax Regime modern developments in the REIT space and conclude that those developments do not undercut the conclusion In order to appreciate the policy discussion that follows, that REITs do not belong within the scope of corporate it is necessary to review, at least briefl y, the current set of tax in the fi rst instance. tax rules governing REITs. Th e full set of rules—contained

MARCH 2016 221 MODERN REITS AND THE CORPORATE TAX

mostly in Code Sec. 856 through Code Sec. 859—are the ability of a REIT (but not a partnership) to distribute fairly complicated and technical. But the basics are rea- its income in the form of corporate dividends. Th is enables sonably digestible and provide necessary context for the a REIT (but not a partnership) to report investor income remainder of this article. on Form 1099 and, among other things, limits the extent to which (i) individual shareholders have to fi le complex federal A. The Consequences of Being a REIT: and state tax returns, (ii) tax-exempt investors have to report Beneﬁ ts and Drawbacks unrelated business taxable income, 32 and (iii) non-U.S. investors have to report “eff ectively connected income.”33 As one might suspect from all the media attention that Th is is not to say that REIT status is without its draw- REITs have received in recent years, there are a number of backs. In some respects, shareholders may get a better benefi ts to qualifying as a REIT. By far the most important result from owning a regular C corporation. For example, of these benefi ts is the ability of a REIT to deduct the dividends from most regular C corporations are treated as dividends that it pays to its shareholders.28 “qualifi ed dividend income” that is currently taxed in the Th is “dividends paid deduction,” which is not available hands of individuals at reduced maximum rates (the same to most other corporations,29 allows a REIT to eliminate 20-percent maximum rate that applies to long-term capital its corporate-level tax simply by distributing its net tax- gains), whereas REIT dividends are generally not eligible able income to its shareholders. Th e result is a single for the reduced rates on qualifi ed dividend income and shareholder-level tax on the income earned by the REIT, are thus subject to tax at rates as high as 39.6 percent.34 as illustrated in Figure 1. Similarly, corporate shareholders can generally claim a deduction for a portion of the dividend income that they FIGURE 1.1 receive from a regular C corporation but generally cannot deduct any portion of a REIT’s dividends.35 And although Regular REITs can often be very tax-effi cient investment vehicles C Corporation REIT for other special classes of investors, such as foreigners and Incomencoome $ 10100.00 $ 100.00 tax-exempt entities,tities, a C corporation is sometimes better. 36 CoCorporaterporate tataxx ratratee 35% 0% ThThe e gamutgam of REREIT ppros,s, consns anand othotherr cconsiderationsonside ation CorCorporaterporate tataxx is tooo extensive exte ve to exploree lo e in detailde ail here. SuffiS ffi ce it to say (afterftter divdividendsvidendds pa paidid dedudeduction)ed ) $ (35.00)5 00) $ – thatth the ddividendsends paid pa dd deductioneductio and the th otherther benefi b n ts Dividend $ 65.00 $ 100.00 of REIT status, though powerful, must be weighed against U.S. shareholder tax rate 23.8% 43.4% other very fact-specifi c considerations. REITs are thus often a good way to invest in real estate, but in many Tax on U.S. shareholders $ (15.47) $ (43.40) cases a partnership or a C corporation will be a better Shareholders’ after-tax distribution $ 49.50 $ 56.60 investment vehicle. ENDNOTE

1 Figure 1 illustrates the tax effects of investment in C corporations and RE- B. Requirements to Qualify as a REIT ITs by taxable U.S. shareholders only. In practice, foreign and tax-exempt investors may comprise a greater proportion of REIT shareholders than Our previous discussion of the drawbacks of REIT status of C corporation shareholders. omitted perhaps the most signifi cant one: in order to qualify for the benefi ts of being a REIT, an entity must Th e existence of the dividends paid deduction, though satisfy numerous requirements that, as a practical matter, powerful in its ability to reduce or eliminate corporate-level may make it impossible to simultaneously qualify as a tax, cannot by itself fully explain the popularity of REITs. REIT and pursue an optimal business model. Th is Part After all, real estate is commonly owned in entities treated outlines these requirements, which relate to, among other as partnerships for tax purposes—entities that do not even things, the nature of the REIT’s assets, the nature of the need a dividends paid deduction because they are not REIT’s income, the REIT’s distribution levels, the level of subject to entity-level tax in the fi rst place. And although concentration in the ownership of the REIT and certain all publicly traded entities, as a general rule, are treated other organizational matters. as taxpaying corporations per se, 30 there is an exception for publicly traded partnerships that do what REITs do.31 1. Asset Tests Why, then, would anybody choose a REIT over a non- Th e REIT asset tests, which are generally tested at the taxpaying partnership? Th e answer is largely explained by end of each quarter of the REIT’s tax year, ensure that

222 TAXES The Tax Magazine® MARCH 2016 most of a REIT’s assets consist of real estate–related assets come from some combination of sources that qualify for and certain other mutual-fund-type investments. Most the 75-percent income test and other (non-real estate) importantly, at least 75 percent of a REIT’s assets must interest, dividends and gain from the sale of securities (the consist of cash and cash items, U.S. government securities “95-percent income test”).46 and “real estate assets,”37 a term that includes actual real One aspect of the income tests is particularly worth estate ( e.g., land, buildings and certain other permanent mentioning: among the many limitations on what can structures), as well as loans secured by mortgages on real qualify as “rents from real property” are a set of rules estate38 (the “75-percent asset test”). that limit the ability of a REIT to provide services to its In addition to the 75-percent asset test, a set of other tenants. 47 Under those rules, REITs can provide their tests limits the amount of the securities that a REIT may tenants with “customary” services (examples of which own of a single issuer, relative both to the REIT’s total may include utilities or common area maintenance), assets and to the outstanding securities of that issuer. In and the portion of the monthly rent payment that rep- particular, no more than 5 percent of a REIT’s assets can resents compensation for those services will be “good” consist of the securities of a single issuer 39 (the “5-per- income for both income tests.48 But if a REIT provides cent asset test”), and a REIT may not own more than 10 noncustomary services (e.g., maid service, valet parking) percent (by vote or value) of the outstanding securities of to a tenant, all of the rent from the tenant (even the any issuer (the “10-percent asset test”).40 Securities that portion that is for the use of space rather than services) qualify for the 75-percent asset test ( e.g., U.S. govern- will generally be treated as “bad” income for both in- ment securities or debt securities secured by mortgages come tests unless the services are furnished by a TRS or on real property), as well as securities of “taxable REIT an independent contractor.49 subsidiaries” (TRSs),41 are not subject to the 5-percent So, for example, if a REIT were to lease offi ce space to and 10-percent asset tests. a tenant for a fi xed rental payment of $1,000 a month, Th e 5-5-percent-perccent asset test can be explained as a measure the REIT could provide the tenant with utilities, and all to protectprotect investorsinvestorso against concentration risk: if a REIT $1,000 would be good income. Similarly, if the REIT investsnveests ttoo mmuch hoh oof its assets in a sisingle company,m an a were to providede the tenanten with IT services (which we downturndowwnturn iinn tthehe fofortuness of that comcompanympany wwillil signisignififi - can assumassume wouldould be ttreatedated aas noncustomnoncustomary)mary) bbyy hirhir- cantlyanttllhy hhurturt tththehe valuvvaluelue of thehe REIT’sREIT’s—and—and ththereforeer or its ining thehe RREIT’s’s whwhollyly ownedwned TRSRS to do the IT wwork shareholders’—overallarrehollderss—os’—oov rallal portfolio.tfolio CCongressgress presumablyresumab y fofor an ararm’s-lengthength feefee, all $1$1,00000 wouwould likewlikewisese be thoughtht thattit it was inappropriate to bestow a dividends good income (at the cost of a corporate-level tax paid paid deduction on entities that take those kinds of by the TRS on its services fee). But if the REIT itself risks.42 But the 10-percent asset test—which applies provided the IT services, all $1,000 could be classifi ed regardless of how small the relevant issuer is, meaning as bad income. Th e rules for services thus signifi cantly that a $100 billion REIT could fail to be a REIT by restrict the ability of a REIT to earn income for its owning too much of a $10,000 company43 —cannot services (as distinguished from income for the use of be explained on investor-protection grounds. Instead, space owned by the REIT), other than through taxpay- consistent with at least one view of the original policy ing subsidiaries. objectives of the corporate tax, as described in Part III.B below, the 10-percent asset test appears to be a check 3. Special Rules for TRSs on the power of a REIT’s managers to infl uence other Before summarizing the remaining REIT requirements, companies—a check that may be grounded in a fear of a brief detour is warranted. Th e topic is TRSs, which are monopoly and other excessive corporate power.44 highly relevant to both the income and the asset tests but not to the other requirements. 2. Income Tests Most people think of REITs as “passive” investment Th ere are two REIT income tests, both of which are vehicles (a label we eschew).50 But the Code specifi cally tested on an annual basis. First, at least 75 percent of a allows REITs to engage in certain activities that some REIT’s annual gross income must come from certain real would describe as “active,” and REITs do this primarily estate–related sources, including rents from real property, through the use of TRSs. interest on real estate mortgages, gain from the sale of A TRS is defi ned as any corporation that is owned in real estate or mortgages on real estate and dividends from whole or in part by a REIT and that elects to be a TRS other REITs (the “75-percent income test”).45 Second, at of the REIT.51 In other words, becoming a TRS is wholly least 95 percent of a REIT’s annual gross income must elective, and so (with one exception noted below) there

MARCH 2016 223 MODERN REITS AND THE CORPORATE TAX

are no operational requirements in order to be a TRS. As 4. Distribution Requirements a result, a TRS can conduct almost any business or activity it wishes—whether related to the REIT’s rental operations Most people, when they think of the REIT require- (as in the case of a TRS that provides noncustomary ser- ments, think fi rst of the income and asset tests. All vices to the REIT’s tenants) or not. Th e only exception other requirements, though important, are secondary. is that a TRS cannot operate or manage a lodging facility But as will soon become evident, the REIT distribution ( e.g., a hotel) or a healthcare facility (e.g., a hospital).52 requirement may be the most important one from a But everything else is fair game. corporate-tax-policy perspective. Under that requirement, with limited exceptions, a REIT must distribute each year at least 90 percent of its net taxable This “dividends paid deduction,” income (other than long-term capital gains). Even though the distribution requirement permits a REIT to retain all which is not available to most of its long-term capital gains and up to 10 percent of its other corporations, allows a REIT other REIT taxable income, the REIT must pay regular to eliminate its corporate-level tax corporate-level taxes on any amounts that it does not distribute.55 In practice, this means that most REITs seek to simply by distributing its net taxable distribute all of their taxable income and gains, with the income to its shareholders. goal of completely eliminating any corporate-level taxes. Th is dynamic naturally limits a REIT’s ability to grow by reinvesting the money it earns, and, as a result, many REITs From a REIT’s perspective, TRSs are valuable primarily are dependent on new capital raises, in the form of periodic because, subject to the limitations described below, they stock or debt off erings, in order to grow their businesses. can ownwnn asseassetsets and earn income that would otherwise be nonqualifyingonqualiifyi ng fforor ppurposes of the asset and income tests. C. Special Rules for C-to-REIT Migrations AlthAlthoughhoughh thee TRSSstS ststructureure can provide REITs wwithh ssome flexifl exibility,ibility, tthereheere area a numbermber of limitlimitationsations oonn a REITREIT’sT’s Th e fi nal componentsponen of thehe REITEIT rules relevantrelevaant to thet e cur-cur abilitybiliblity toto use a TRS.TRS.R FirstFFirs of all, as their nameame implies,im lie TRSs,T Ss, rerent discudiscussionn are tthosese dedealingng with REITREITss that wwereer C as reregularegulaararCc C corpoccorporations,or tionio payay regularegular corporate-levelrporat -lev l taxtaxeses cocorporationsoratio orr that acacquiredqui ed asseassets from a C corporationorpora io in on theirii income.incom Th is tax is, at a minimum, the price a REIT certain carryover-basis transactions. In those situations, two must pay in order to avail itself of the benefi ts of a TRS. sets of rules come into play to ensure that the policy objec- And although a TRS may be capitalized with intercompany tives underlying the REIT rules and the corporate tax do not debt on which deductible interest is paid, the use of inter- confl ict with one another. Th e fi rst rule requires any REIT that company debt is limited in a number of respects, both by succeeds to the E&P of a C corporation (including its own REIT-specifi c rules and by more general tax principles. 53 E&P for the period before it became a REIT) to distribute that In addition to the tax cost of conducting activities E&P to shareholders before the end of the year.56 Th e second through a TRS, the asset and income tests provide only rule imposes a corporate-level tax on the built-in gain inher- so much room for TRS stock and dividends. For purposes ent in any asset that a REIT owned on the day it converted of the asset tests, even though TRS stock is exempt from from C corporation status or that the REIT acquired from a the 5-percent and 10-percent tests, it is not a qualifying C corporation in a carryover-basis transaction, in each case asset for purposes of the 75-percent asset test. As a result, to the extent that gain is recognized within fi ve years of the the stock of a TRS, together with any other nonqualifying REIT conversion or carryover basis transaction, as appli- assets, cannot represent more than 25 percent (beginning cable.57 Th e latter rule, which applies to S corporations and in 2018, 20 percent) of a REIT’s assets. 54 Similarly, for RICs as well, is designed to prevent REIT transactions from purposes of the income tests, dividends paid by a TRS circumventing the repeal of the General Utilities doctrine. 58 are good income for the 95-percent income test but are bad income for the 75-percent income test. Again, this III. The Policy Objectives means that TRS dividends, together with all other sources of bad 75-percent income, cannot represent more than 25 of the Corporate Tax percent of the REIT’s gross income. TRSs thus allow REITs, at a tax cost, to participate in a Th e current debate on the proper taxation of REITs is limited amount of “non-REIT” business activities. premised on the notion that REITs should be subject

224 TAXES The Tax Magazine® MARCH 2016 to the corporate tax in the fi rst instance. Th is seems to centuries aff ected public and policymakers’ views on the lead REIT critics to two other views that are adverse to need to regulate corporations. the REIT industry: that the REIT regime itself should As late as the 1850s, corporations were relatively rare, be viewed as a narrow exception to the corporate tax limited-purpose vehicles that were organized pursuant and that any expansion of the REIT industry—whether to the authority of specifi c state statutes.62 Beginning in through the development of new types of real estate, the 1850s, however, states began to amend their laws to C-to-REIT conversions, or REIT spin-off s—represents allow private citizens to form corporations to engage in an inappropriate exploitation of that narrow exception. commercial activity.63 Initially, most corporations were In a system governed by logic, these two views disap- closely held and owner-managed and consequently were pear if their underlying premise—that REITs should viewed from a policy perspective as aggregates of their be subject to the corporate tax as a policy matter—is owners, much the same way as general partnerships were shown to be false. later viewed.64 With regard to that premise, we were surprised to fi nd During the economic expansion of the mid-19th that, as central a role as the corporate tax plays in our pro- century, industry turned to the corporation as its entity fession, there has been relatively little written on whether of choice. Th e simple reason for this development was various provisions of the Code advance or hinder the that corporations, unlike partnerships, possessed two historical policy objectives of the corporate tax or whether attributes that made them ideal vehicles for operating those objectives continue to be relevant. large businesses, raising new debt and equity capital, and Th is article seeks to ignite that debate with respect to creating and acquiring new businesses: fi rst, the owners of the proper taxation of REITs. In laying out the histori- the corporation were not personally liable for debts and cal policy objectives of the corporate tax, we have relied obligations of the corporation; and second, the corpora- heavily on the work of Professors Reuven S. Avi-Yonah, tion could be managed by a single group of people who Stevenn A.A BankBaank and Marjorie E. Kornhauser,59 who have were responsible for developing the business strategy and eachchh producedproodducedhd thoroughthoh articles on the history of the overseeing the day-to-day operations of the company and corporateorpporatte tax tax.x. AltAlthoughtho we have supplementedsuppl d theirei re- who had the discretiodiscretionn to decide whether to retain earn- searchearcch inin places,places, wew haveh foundound that theirthe r researchresear h providesprovides ings or distributedi ute themt m too shareholders.shareholders.65 ass mmuchuchhd ddetailetail aass is availableava ble in the ppublicublic recrecordor on thehe Th e abiability of a cocorporation’spo ation’s managers ttoo retain eearn- historytoory oof the e corcorporaterporatera tax, and we aree grategratefulul fforr thetheirir ingsin was centralral to tthehe developdevelopmentment of largege inindustry,us contributionsbution to our profession. Th e following in large especially in the late 19th and early 20th centuries, for two part summarizes their work and uses their fi ndings as the reasons. First, retained earnings enabled corporations to basis for the policy arguments in Part V and our policy deploy capital without having to seek additional funding recommendations in Part VI. from lenders or shareholders, and this fl exibility provided corporations with tremendous advantages in the market- A. The History Behind the Corporate Tax place. In terms of operational fl exibility, retained earnings enabled corporations to acquire new assets, develop new For reasons that will soon become clear, the scope and products and pursue innovation much more quickly than policy objectives of the corporate tax can be understood other businesses, which had to go to capital markets to only in the broader historical context in which the corpo- fund those types of activities.66 Second, and more signifi - rate tax came into existence. In our country’s fi rst century, cantly, retained earnings allowed corporations to quickly the only federal tax imposed on income came during the consolidate through mergers and acquisitions, which Civil War, when the proceeds from a variety of taxes were accelerated the development of industrial monopolies. 67 used to fund the Union’s eff ort to win the war and then Th ese monopolies were viewed as enabling corporations reconstruct the South in the postwar years. 60 Th is tax was to raise prices above otherwise competitive levels, impose allowed to expire in 1872.61 unfair terms on customers and other businesses and drive In short, our country had a strong bias against income down real employee wages, all of which in turn could cre- taxation for the fi rst century of its existence. So, how did a ate more retained earnings, and so on. 68 country that historically reviled the idea of a tax on income It was around this time that the view of corporations develop such a complex corporate income tax regime? held by the public and many policymakers began to Th e answer lies in the development of the corporation as shift. 69 Simply stated, a corporation that had thousands a tool of industrial capitalism and the manner in which of shareholders (very few of whom had visibility into corporate behavior during the late 19th and early 20th how the corporation was being managed and what the

MARCH 2016 225 MODERN REITS AND THE CORPORATE TAX

corporation was doing on a day-to-day basis), possessed tariff s that helped provide the industrial companies of the enormous amounts of money, employed tens or hundreds Northeast with pricing advantages, and his administration of thousands of people and operated with a nationwide showed little interest in antitrust enforcement.76 It might supply, manufacturing and distribution chain stopped have been decades before antitrust enforcement received looking like an aggregate of individual owners and started another Republican vetting were it not for McKinley’s to look like an entity separate from its owners. 70 Th is view assassination in 1901 by the anarchist Leon Czolgosz at was reinforced by the American public’s growing concern Buff alo, New York, after which McKinley’s Vice President, (and not infrequent anger) over the amount of power Th eodore Roosevelt, assumed the presidency. wielded by the managers of the great industrial corpora- President Roosevelt was part of the Republican Party’s tions, which power was viewed as having resulted from progressive wing, which held a more expansive view of the unfair use of retained earnings. 71 federal power, and took the view that the power to tax Th e outcry over this combination of monopolistic pric- could be used alongside the power to regulate interstate ing and unfair trade practices, reinforced by the growing commerce in order to address the problems of monopoly view that corporations were separate from their owners, power and unfair trade practices. Th e Roosevelt adminis- reached a crescendo in the 1880s, leading to tremendous tration had some early successes on the antitrust enforce- public pressure on Congress.72 Despite the support of ment front, bringing a number of antitrust suits which, public opinion, however, plotting a course of action proved among other things, led (eventually) to the breakup of extremely diffi cult. the Standard Oil monopoly and the Northern Securities It is hard for us today to imagine the hurdles that Company railroad monopoly. 77 President Roosevelt was Congress faced in dealing with monopolies and unfair less successful on the tax front, and that work was left to his trade practices in the late 19th century. For example, if successor, Howard Taft, who won the presidential election Congress were to decide tomorrow that it wanted to hold of 1908 and took offi ce in March of 1909. hearingsngs thatt requiredreq the production of documents and Initially, President Taft was opposed to the idea of thee attendanceattennddance ofo corporate executives, it would issue a corporate tax because, among other things, he felt it subpoenasubppoennas commanding coommman g the productionproducti of documentso m might violate the SupremeSu re Court’s interpretation of the andnd thethe attendanceattenndancen of thoseose executivesexecutives before CCongress.ongress. appoapportionmentortion nt claclause,, wwhichhich hahadd been used to invinvalidatelidat ThTho osese eexecutivesxecutives wowwoulduld haveve two basibasic choiceschoices. FFirst,t, theyey an incomecome tax act in 1895.89 Th e ppresident’ssident’s hand h nd was forcedfor couldulld producepro oducce the ed documentsocucu ts and appear ap r before befo Congress.Congre s sosoonn after Taft’st’s inauginaugurationura ion in 1909,09 whwhen a numnumberbe of Second,d they could spend some time in the Capitol jail Republicans from the western United States threatened for contempt of Congress and, after they got sick of the to split the party in two if the Taft administration did not food and the accommodations, they could produce the take action to curb the power of the Northeast industrial documents and appear before Congress. Congress did not companies by reforming the tariff system and reducing wield this type of power in the 19th century, and unless a the power of those companies through a corporate tax. recipient thought that he could obtain some sort of politi- To balance his jurisprudential concerns with his political cal advantage by responding to a congressional subpoena, concerns, President Taft agreed to back a corporate “excise he typically ignored it.73 tax” that was measured with respect to income, with the In the late 19th century, whatever power Congress pos- understanding that the parties would pursue a constitu- sessed to curb monopoly and unfair trade practices was tional amendment authorizing an actual income tax.78 closely tied to its power to regulate interstate commerce. Although the scope of federal power under the commerce B. Policy Objectives Underlying clause was relatively narrow in the late 19th century, the Corporate Tax Congress was able to enact the Sherman Antitrust Act in 1890 (the “Sherman Act”), which nominally authorized With the political backdrop behind the 1909 corporate the executive branch to combat monopolies.74 tax established, we turn to the policy objectives underlying Ultimately, while the Sherman Act was undoubtedly a that tax and its immediate successors. In that regard, it is bold piece of federal legislation by 19th-century standards, important to bear in mind that, while the attributes of the it proved ineff ective at reducing the power of the great in- corporate form and the practicalities of corporate business dustrial corporations of the day.75 Th e potency of the Sher- operations had led to a widespread view that corporations man Act suff ered another blow when William McKinley were separate from their owners, this development said prevailed over William Jennings Bryan in the presidential nothing in and of itself as to whether corporations should election of 1896. McKinley was in favor of the protective be taxed. In other words, while the view of the corporation

226 TAXES The Tax Magazine® MARCH 2016 as in some way separate from its shareholders supported New York, who was responsible for drafting the 1909 the notion that corporations theoretically could be taxed corporate tax, was quite clear as to its policy objective: separately from their owners, it did not establish whether or why, as a matter of policy, corporations should be taxed. [I]t has so happened that in the development of the Th ose who dare to research U.S. tax law in the 19th business of the United States the natural laws of trade and early 20th centuries will notice right away the ab- have … put the greater part of the accumulated wealth sence of committee reports of any kind. To decipher why of the country into the hands of corporations, so that something was done, one must tease out policy objectives when we tax them we are imposing the tax upon the from the written statements of prominent politicians as accumulated income and relieving the earnings of the well as news reports and commentary concerning the cur- men who are gaining a subsistence for their old age and rent events of the day. Unsurprisingly, then, scholars have for their families after them. 82 taken diff erent views on the policy objectives underlying the corporate tax. We describe those views here, in par- Senator Albert Cummins of Iowa was a particularly ticular, the “regulatory” view of Professor Avi-Yonah and ardent advocate of using the corporate tax as a way to the “capital lock-in” view of Professor Bank. protect the public against monopoly and urged a higher corporate tax on the great consolidators of the day: 1. The Regulatory View Professor Avi-Yonah makes a compelling case that the [I]f a company is organized for the purpose of con- primary policy objective underlying the 1909 corporate solidating a dozen other companies with a view to tax was to inhibit the creation of new monopolies and controlling the business in which those companies limit the development of existing monopolies, in two are engaged for the purpose of being able to direct ways. First, the tax required corporations to fi le income through a single board the management of the entire tax returns,turnns, pprovidingrov information to both the government fi eld of industry … it ought to be taxed at 10 or 15 per andd tthehe ppublicubliihic tthathaat had been previously hard to come by.79 cent on the net earnings, that it ought to be taxed so ThisTh is s info informationormaationnwn wwould allow the govgovernmentt to bbetter heavily that such cocompaniesm would become not only enforcenfoorce antitrustantitrust lawslawl and grant the publicpublic greatergreater visibilityisibility unfashionableunnfashi ble butb unprofiun rofi tabtablee as wewell.83 intonto thethe actionsactions ofoffl largelarrgeg corporations.porations. InI the wordswo ds offS Sena-a- torrC CumCummins,mmins,s thee waveav of corporateorporate consolidationnsolid tion in ththehe These Th ese Senators’ S ors’ statestatements,ments in PProfessorfessor AAvi-Yonah’sYonah vview, late 19th9thh and d early 20th centuries was “simply a prelude evidence Congress’s intent with the 1909 act to tax corpo- to industrial commercial slavery unless the Government rate retained earnings in order to limit corporate power. intervenes with its strong arm, and it can not intervene Professor Avi-Yonah notes that the reasons behind the unless it has the information necessary to enable it to act creation of the corporate tax explain how the tax came to intelligently and wisely.” 80 Th e idea here was simple: if exist but do not establish that the tax should in fact exist the government could see what corporations were up to, or that the tax serves a proper objective currently. Th us, in it could identify and curtail bad behavior. addition to laying out his views on the policy objectives Second, and more signifi cantly for our purposes, the underlying the corporate tax as expressed by Congress, Pro- corporate income tax limited the ability of corporations fessor Avi-Yonah also off ers a normative justifi cation for that to retain their earnings. Congress viewed these retained tax.84 Put simply, in Professor Avi-Yonah’s view, the corporate earnings as the source of corporate power, which could tax should exist because it restrains the ability of corporate be abused by creating monopolies and unfair trade prac- managers to wield power using other people’s money (i.e., tices. By limiting the ability of corporate managers to corporate retained earnings). Although a full articulation of retain earnings, the corporate tax was viewed as a check Professor Avi-Yonah’s position, which would bring into play on these abuses. philosophical approaches to power and modern events, is Both of these objectives are clear from the congressional beyond the scope of this article, it is interesting to note how record. Regarding the problem of retained earnings, Sena- the normative justifi cations for the corporate tax comple- tor Robert L. Owen of Oklahoma remarked that “[t]he ment the policy arguments put forth by Congress in 1909. most important need of the people of the United States of this generation requires the abatement of the gigantic 2. The Capital Lock-In View fortunes being piled up by successful monopoly … which Professor Bank, like Professor Avi-Yonah, writes that the have brought about a grossly inequitable distribution of corporate tax as we know it owes its existence to the prac- the proceeds of human labor.”81 Senator Elihu Root of tice of corporations retaining increasingly large portions

MARCH 2016 227 MODERN REITS AND THE CORPORATE TAX

of their earnings beginning in the late 19th century and provided for a single level of tax on corporate income, re- extending through today. Professor Bank parts ways with gardless of whether distributed; shareholders therefore had Professor Avi-Yonah, however, on the reason why Congress no “normal” tax-related reasons to prefer corporations to wanted to tax those earnings. retain their earnings; whether distributed or not, corporate Professor Bank attributes the existence of the corporate income was subject to a one-percent tax. 93 tax to the “capital lock-in” feature of corporations and By contrast, the surtax provided a compelling reason politicians’ responses over time to that capital lock-in.85 for high-earning shareholders to prefer that corporations As Professor Bank uses the term, “capital lock-in” refers retain their earnings. Retained corporate income was to two complementary features of the corporate form, subject to one-percent tax; corporate income distributed both of which were critical to the development of late and subject to the surtax was subject to a total tax of 19th and early 20th century industrial capitalism: the in- seven-percent. Despite this incentive for tax deferral, ability of shareholders to withdraw their capital from the policymakers in 1913 did not fi nd it necessary to either corporation and the resulting ability of managers to retain force corporations to distribute their earnings or to sub- corporate earnings to fund corporate-level expenditures.86 ject high earners to tax on their share of a corporation’s Th e benefi ts and drawbacks of capital lock-in depend on retained earnings, perhaps because of the relatively small one’s perspective. For corporate managers, capital lock-in is diff erence between corporate and surtax rates in 1913.94 generally positive, as it enables corporate managers to pur- Th at view, according to Professor Bank, changed over sue their objectives without having to return to the capital time for three reasons. First, individual “normal” and sur- markets to raise new money and explain themselves. 87 tax rates were raised substantially as a result of World War For government, capital lock-in is generally negative to I, but corporate rates were not comparably raised, which the extent it prevents the government from imposing an increased the benefi ts of deferring shareholder-level taxation immediate shareholder-level tax on corporate profi ts. For by having corporations retain their earnings.95 Second, for shareholders,holders,, cacapital lock-in is a mixed bag: on the one reasons unrelated to taxation, as corporations grew larger, hand,anddid, iitt preventsprevents corporationsco from having to wind up if corporate managers decided to retain a larger portion of mulmultipletiplee sharshareholdersreholder demandmand the return of theirr ccapitalpi at their earnings.96 Th ird ird, ttheh existence and growth of retained thehe ssameame titimeme (a “ru“run” on the corporacorporation);tion); oon tthehe othotherer earnearnings,ings, combinedbined withth theh disparityispari y in “normal”normal” ttaxx anand hand,andd, it iimposesmposes ana oppoopportunityunity cost oonn sharehshareholdersold rs whoho susurtaxx raterates betweentween shareholdersha holder and corpcorporations,rations ccame cannotnnnot u use re retainedetaineed corcocorporatete wealth to their ownwn ends.nds 88 to bee viewviewed by polipolicymakerscymakers as an unfunfair tax ddeferralfe In Professorfesso Bank’s view, while both the tax of the Rev- mechanism for individual shareholders with high incomes.97 enue Act of 1894 89 and the 1909 corporate tax were aimed Because Congress was still uncomfortable with the at taxing shareholders on their share of undistributed idea of taxing individual shareholders on their share corporate earnings, both regimes refl ected congressional of a corporation’s retained earnings, this development unease with taxing corporate earnings per se (i.e., rather spawned a contentious struggle between the government than as a substitute for taxing distributions to sharehold- and corporate managers over shareholder tax deferral and ers). Th us, in the early years of the corporate tax (and after retained earnings.98 Th e two sides in this struggle staked the passage of the Sixteenth Amendment and subsequent out relatively simple positions on retained earnings: Th e enactment of an individual income tax in 1913), 90 the government wanted more revenue from high earners in government generally collected tax from corporations order to do what it needed to do, and corporate managers and then allowed shareholders to exclude from their own wanted to retain as much of their corporations’ earnings incomes any dividends attributable to income that was as possible in order to do what they needed to do. 99 previously taxed at the corporate level.91 After a decades-long legislative struggle that lasted Th is exclusion, however, was only partial; as it is today, through the presidency of Harry S. Truman, the govern- the individual tax under the Revenue Act of 1913 was pro- ment and corporate managers reached what could best gressive. At that time, corporations were subject to income be described as a political settlement: Th e government tax at a rate of one percent and individuals were subject to would increase the corporate tax rate as a proxy for taxing two taxes—a “normal” income tax of one percent and a shareholders’ collective accessions to wealth, and managers “sur tax” of up to six percent imposed at graduating rates. 92 would keep their ability to retain earnings. In this sense, Individuals were entitled to exclude corporate dividends the corporate tax can be thought of as a rough-justice from income for purposes of calculating their “normal” tax shareholder-level anti-deferral regime, similar conceptu- liability but not for purposes of determining their surtax ally to the current regime that applies to passive foreign liability. Consequently, the 1913 corporate tax generally investment companies.100

228 TAXES The Tax Magazine® MARCH 2016 When it comes to the relationship between shareholders power that corporate managers wield as a result of having and corporate managers, the logical implication of Profes- control over vast amounts of retained earnings. Because the sor Bank’s account of the corporate tax is rather stark: Th e corporate tax represents an appreciable drag on the growth corporate tax can be seen as the amount of shareholder of retained earnings, it also represents an appreciable drag wealth that corporate managers are willing to surrender on the growth of the power of corporate managers, and to the government in order to have the power to deploy this drag becomes especially impactful when the eff ects what is left.101 Th e starkness of this view is refl ected in of the corporate tax compound over time. While the cor- discussions of the agency cost problem of retained earn- porate tax cannot be the sole instrument through which ings, many of which have been led by Professor Bank. corporations are regulated, it is to this day one of many Although a discussion of those problems is beyond the tools in the tool box, and one that we believe is as relevant scope of this article, the problem boils down to the fact today as it was in 1909. that, when it comes to corporate profi ts, corporate manag- Turning to Professor Bank’s view that the corporate tax ers and shareholders have confl icting interests, insofar as represents a kind of charge paid by managers to retain shareholders would like to receive as much in the way of corporate earnings, we note that some aspects of Professor dividends as possible and corporate managers would like Bank’s view—specifi cally his recounting of how corporate to retain as much in the way of earnings as possible.102 managers of the late 1930s and early 1940s used corporate funds to lobby against the undistributed profi ts tax—il- C. Either Way, the Corporate Tax lustrate the way in which corporate managers are willing Is About Retained Earnings to surrender a portion of shareholder wealth in order to retain control over the remainder of that wealth. Professors Avi-Yonah and Bank present compelling ar- If it seems as though we are endorsing both Professor guments in support of their positions. Th at said, when Avi-Yonah’s and Professor Bank’s views, it is because we we foundounnd twotwwo prominent law professors advocating fi nd both of their accounts compelling and, furthermore, competingmpetiinng vviewsiews oon the policy objectives underlying the think it likely that both Professor Avi-Yonah’s regulatory corporateorpporatte taxtax, x, weefoe foundfo ourselves ruminating rum overo er that view and Professoressor Bank’sBank capital lock-in view were correct ancientnciient SSwahiliwahili provpproverb—when—when elephelephantsants josjostle,e, it is tthehe duriduringng certaince periodsperi ofo time,ime, withwith the regulatoryregulatory viewview ata grassrass thatthhaat suffsuff ers. sosome poinpoint (probablyrobabl inn thehe late 1930s)930s) begbeginningnning tto yyield TheTh e bestestbe be wayw to o avoidvoivo gettingting crucrusheddisto is to takeake to ththehe to thehe capcapital lock-inock in view. view ThThat at said, s d ProfesProfessorr Avi-Yonah’s Avi-Yon trees, anddon on tthat score we were relieved to fi nd that we view that the normative power of the corporate tax lies in need not decide which position to adopt for purposes of its ability to reduce the power of corporate managers at this article. Th e crux of each scholar’s position is that the the societal level transcends time periods and would apply purpose of the corporate tax is to enable the government, with the same force today as it did in 1909. for one reason or another, to use its taxing power to relieve As discussed below, the point of primary relevance to the corporations of some portion of their retained earnings. REIT context is retained earnings. On that score, regard- In other words, regardless of which scholar one chooses less of which scholar’s view one accepts, the conclusion is to follow, one is led back to the same place—the policy the same: the corporate tax is all about the government objective underlying the corporate tax involves the gov- reducing retained corporate earnings. ernment’s desire to confi scate a portion of corporations’ retained earnings. Furthermore, the position taken by each IV. Historic Development scholar, although grounded in the events of the late 19th and early 20th centuries, resonates to this day. of REITs in Our Tax System With respect to Professor Avi-Yonah’s views on the role of the corporate tax in seeking to limit the power of cor- A. The Back-Story: Why REITs porate managers, we think that these policy objectives are Needed Tax Legislation in 1960 still relevant today. While a discussion of antitrust enforcement and the deleterious eff ects of monopolies and unfair Th e current debate on the proper taxation of REITs is trade practices is beyond the scope of this article, it does premised on the notion that REITs should be subject to bear mentioning that signifi cant sectors of our economy the corporate tax in the fi rst instance. As discussed in Part are dominated by a small number of companies, and while V, we think that premise is false. we might not face constant oppression by monopolists, we Th is Part IV focuses on the intellectual foundation do experience as a society some harmful eff ects from the underlying that false premise: the “corporate resemblance

MARCH 2016 229 MODERN REITS AND THE CORPORATE TAX

test.” Th is test was used to classify as a corporation any a real estate investment trust—and Massachusetts real unincorporated entity that looked too much like a corpo- estate investment trusts were used to pool money from ration and not enough like a noncorporation. Although a large number of investors in order to develop and own the test sounds silly and proved disastrous in practice, it real estate projects in Detroit, Chicago, Minneapolis, St. existed in one form or another for over seven decades until, Paul, Kansas City, Omaha, Milwaukee, San Francisco, after having been discredited intellectually, it was discarded Duluth, Denver and Seattle.107 by the government and replaced with the check-the-box Investment managers soon found that the investing regulations in 1997.103 public had an appetite for collective investment vehicles Although the corporate resemblance test and its un- and that this appetite extended to stocks and other se- derlying authorities never made sense from a tax policy curities.108 In trying to structure a collective investment perspective and have been dead for two decades, they vehicle for stocks and securities, managers ran into the somehow continue to provide the sole intellectual sup- same problem faced by sponsors of real estate investment port for the premise that, as a matter of tax policy, REITs trusts—under the law as it existed in the 19th century, should be subject to the corporate tax in the fi rst instance. one corporation could not own stock in another,109 and Given the enduring nature of what we can best describe as general partnerships were not appropriate vehicles for a conceptual weed, we feel compelled to explain in gory pooled investment due to issues around unlimited li- detail the history of the corporate resemblance test; how ability, governance and continuity of life. Th ese manag- disastrous that test proved for both the government and ers reached the same conclusion as their counterparts in taxpayers; the reasons why that test did not advance the the real estate industry—Massachusetts trusts were the policy objectives underlying the corporate tax; and, per- only viable vehicle for collective investment in stocks haps more importantly, the reasons why that test actually and securities. Th ese trusts were referred to in their early prevented those policy objectives from being fully realized. years as “mutual investment companies,” and the Mas- Seasonedasonned membersmmem of our profession, for whom the sachusetts trust mutual investment company evolved corporaterpporate resemblanceresembbla test may be an unfortunate but into today’s RIC.110 vividividdmed mememory,emorry, might mmigmigh wishish to focus exexclusivelyy onn Part IV.A.2(d),V.AA.2(d), wwhwhichich adaddresseses the tax popolicylicy shshortcomingsrt omings 2. REITsREITs andd the “CorporateCorp ate ResemblanceResembblanc offfh the thhe corporatecorporate resemblancereser emb ce test, and Part IV.A.3,IV.A. whichw ch TTest”t” DebacleDe cle addressesdrressessanu a numbernuumbbe of aspectsa ts of the Revenuevenue Actct ooff 19319366 (a)(a AA“Fe “Fearfulul Bungle” Bungle” Sets the t Stage for f aaDe Debacle.ba that are relevantreleva to the current policy debate on the proper Interestingly, although the corporate resemblance test is a taxation of REITs. Th ose who desire detail might wish to product of courts’ interpretation of the 1913 corporate tax, take a sip of coff ee before reading on. its immediate successors, and the related Treasury regulations, the history behind the corporate resemblance test 1. The Early Development of Collective begins in 1894, when Congress enacted what amounted Investment Vehicles to an income tax on individual corporate shareholders In the 19th and early 20th centuries, real estate spon- that was to be collected by the corporations in which sors and investors faced a conundrum that inhibited the those individuals owned stock. (Th at tax was struck down formation of widely held real estate investment vehicles: as unconstitutional in 1895.) 111 As it was drafting the Although corporations existed and shielded shareholders language for the Revenue Act of 1894, Congress became from liability for debts and obligations of the corpora- concerned that business entities that did not go by the tion, corporations, generally speaking, could not own name “corporation” but were otherwise similar to corpora- real estate as a matter of corporate law,104 and although tions might avoid the new tax.112 general partnerships could own real estate, the partners To address this concern, Congress included both “com- were personally liable for the debts of the partnership.105 panies” and “associations” as the types of entities that Th e need for a limited liability entity that could own would be brought into the corporate tax base under the real estate was fulfi lled by the State of Massachusetts’s 1894 act. State law generally did not defi ne “associations” recognition of a “business trust,” which was a creature of (although Senator George G. Vest of Kentucky mentioned contract law that provided for limited liability in its trust “building and loan associations” as an example), 113 and documents, as recognized in Attorney General v. Proprietors Congress did not defi ne the term. Th is left the scope of the of the Meetinghouse in 1854.106 corporate tax itself undefi ned and conceptually unclear, a Th e Massachusetts business trust soon became the na- result which prompted Senator William Chandler to reach tion’s fi rst trust for real estate investment—quite literally the following, remarkably prescient, conclusion:

230 TAXES The Tax Magazine® MARCH 2016 Th e clause [defi ning the scope of the tax] is a fearful Eventually, the legal community would reach a con- bungle, and it ought to have, if it passes, a special sensus that corporations were “natural entities.” In the title to it, and that is “[a] clause to increase the fees fi rst decade of the 1900s, however, the debate between of lawyers,” because there will be more litigation and the “natural” and “artifi cial” theories was at its height.119 more large fees in connection with this wonderful Th e debate involved aspects of philosophy, legal theory discovery, invention, contrivance, and construction and constitutional theory, and legislators held diff ering … than ever have been known before in connection views on the topic.120 with any tax law passed by this Government. [T]here never was a more loosely drawn, inaccurate, and, I was about to say, impotent taxation clause submitted to a legislative body …. 114 These facts lay the groundwork for four simple conclusions. First, in light Th e Supreme Court ruled that the 1894 tax violated the apportionment clause, which required that income taxes of the policy objectives underlying the be apportioned among the citizens of the various states corporate tax, REITs should never have based on population.115 Because income and wealth were been subject to the corporate tax. spread so unevenly, the tax could not satisfy that standard. With the 1894 tax a nullity, the problem of the scope of the “corporate” tax lay dormant until the lead-up to the 1909 corporate tax. Congress once again faced the As one might expect from a group of legislators facing question that led to the “fearful bungle” of 1894: Should a diffi cult philosophical, legal and constitutional question the corporate tax be limited to entities that are actually that went straight to the viability of the statute on which incorporatedporratedd ununder state law, or should the tax also apply they were working—they punted. Congress adopted a to ototherthher ententitiesiittiihes tthathah implicate the law’s policy objectives? provision applying the 1909 corporate tax to every “cor- In n worworkingrkinggthrog throthroughoug thiss question, ConCongress wasas walkingal poration, jointt stock companyco or association, organized a tigtightrope.ghtrope. Th e SSupremeupr Court had struckstruck downdown thethe 189418994 for profip t … underunde thehe lawsaws of the United States orr anany taxax oonn aapportionmentpportionmem nt clauseuse grounds, ground and theth SixteenthS te th statest … anand engagedngaged inn bbusiness,”usiness and left ththee terms ““jointj Amendmentmeendmment was mmerelyerelre a twinklewinkle in Presidentresiden TaTaft’st’s eyeye.e stockst k company” com y” and “association”associatio undefiundefin ned. 121 Congresss was careful to style the 1909 corporate tax as an We understand why Congress punted on the defi nition “excise tax” on the act of doing business, even though the of “corporation” in 1909. Th e public was demanding ac- tax was computed with reference to income. 116 Legislators tion against the monopolists and Congress felt compelled hoped that the “excise tax” language would avoid the ap- to enact legislation. In that environment, it would seem portionment clause problem. 117 completely reasonable for Congress to conclude that it Although they might have side-stepped the apportion- was better to have a provision that no one understood ment clause problem, legislators struggled with a related than to have no provision at all. Nonetheless, inaction constitutional question: Were corporations “natural en- has its consequences, and in this case, congressional inac- tities” under the law or were they “artifi cial entities”? tion on the defi nition of “corporation” in 1909 allowed Put diff erently, were corporations natural persons who the fearful bungle of 1894 to resurface, resulting in a possessed constitutional rights of their own accord, or seemingly uninterrupted, 80-year long string of court were they instead creatures of law, bereft of constitutional cases, legislative amendments, administrative regulations, rights and possessing only those rights granted to them rewritten regulations, amended regulations, withdrawn by legislatures? If corporations were natural persons with regulations, revenue rulings, amended revenue rulings and constitutional rights, then they might be able to challenge withdrawn revenue rulings that collectively represent one the 1909 corporate tax on the theory that it was unfair to of the saddest and perhaps most embarrassing debacles tax corporate persons without also taxing noncorporate ever produced by our tax system. persons. If corporations were artifi cial creatures of law, Although we are confi dent that this debacle would then they could be taxed diff erently than natural persons bring a wry smile to the face of the late Senator Chandler, or other entities. In legislators’ eyes, the answer to this it continues to create perception problems for the entire question went straight to the constitutionality of the cor- REIT industry and in fact forms the key premise of a tax porate tax, and the answer itself aff ected the defi nition of debate that has the potential to threaten the very existence the term “corporation.” 118 of the industry. While the entire episode could consume

MARCH 2016 231 MODERN REITS AND THE CORPORATE TAX

a book, this article will provide a brief sketch of how the Th e Court’s holding followed two lines of analysis, episode aff ected REITs. one a technical argument grounded in common law and (b) Entity Classifi cation in the Early Years. From the one policy-based. As a matter of common law, the Court perspective of the REIT industry, the trouble around the rejected the Bureau’s contention that the trustees and tax classifi cation of unincorporated entities began almost benefi ciaries should be grouped together as associates as soon as the 1909 corporate tax was enacted. To put it engaged in a joint business venture. Th ere was a crucial bluntly, despite the fact that Congress and the Taft admin- distinction between benefi ciaries and trustees, in that the istration pushed for the enactment of the corporate tax to trustees, not the benefi ciaries, had control over the trust, address the accumulation of corporate retained earnings, and the Court could “perceive no ground for grouping the Treasury and the Bureau of Internal Revenue set about the two—benefi ciaries and trustees—together in order to attempting to subject to the corporate tax seemingly every turn them into an association by uniting their contrasted type of business entity other than sole proprietorships functions and powers although they are in no proper and certain general partnerships, with scant reference to sense associated.” Treating REITs as corporations would, retained earnings. in the words of the Court, “be an unnatural perversion For example, almost immediately after the enactment of of a well-known institution of the law.”132 the 1909 corporate tax, the Bureau went after the Cush- On policy grounds, one of the more interesting aspects ing Real Estate Trust, which was “formed for the purpose of the Crocker decision was that it represented one of the of purchasing, improving, holding, and selling lands and few instances we have found in which the Court consid- buildings in Boston,” and attempted to subject it to tax ered the policy objectives underlying the corporate tax in as a corporation.122 Th is led to Eliot v. Freeman , where the analyzing whether an unincorporated entity should be Supreme Court held that the Cushing REIT could not subject to that tax. With regard to the leased mills, the be subjected to the corporate tax because, like other Mas- Court noted: sachusettssettts bubusinessusin trusts, it was a creature of common law andd thusthus notnot “organized“orgag … under the laws of the United Th e function of the trustees is not to manage the mills Statestatees or r any y states,”state es,”es, as requiredequired by the 1909 AcAct.123 [that were beingeing leleasedse to the corporation], but sim- PriorP rior ttoo tthehe enenactmentactma of the 1939 Code, eeachch succesucces-s- plyy to ccollectct the rentsnt andan incomeincome of suchuch propertyproperty siveve revenuerevenue act—inact—i— n 11913,,124 1916, 1255 1917, 1266 1918,91 127 as may be inn theirthei hands,ha ds, withwi a large discretiond scretion ini 192121128 —essentially——ess entiaal y constitutedcco uted a ccompleteplete rewritingwr ing of thee application app ion of it, i butbut with a recognitionrecogn n that tha theth the tax code,code and Treasury issued regulations pursuant to receipt holders are entitled to it subject to the exer- most of these acts. Th is process led to constant revisions of cise of the powers confi ded to the trustees.In fact, the statutory and regulatory language, often without explana- whole income, less taxes and similar expenses, has been tion, with predictably unpredictable results. paid over in due proportion to the holders of the receipts. For example, the Revenue Act of 1913 (the “1913 Act”) Th ere can be little doubt that, in Massachusetts, this amended the corporate tax to bring within its scope ev- arrangement would be held to create a trust, and ery “corporation, joint stock company or association … nothing more.133 organized in the United States … no matter how created or organized.” 129 Although this amendment undercut With regard to the dividends received from the REIT’s the Court’s reasoning in Eliot , the 1913 Act remained corporate subsidiary, the Court noted: ambiguous with respect to the taxation of Massachusetts business trusts, as it was unclear if the trusts fell within We presume that the taxation of corporations and the defi nition of “association” under the Act. joint-stock companies upon dividends of corpora- Th e Supreme Court fi rst addressed this question in tions that themselves pay the income tax was for the Crocker v. Malley. 130 Th is case involved a trust that owned a purpose of discouraging combinations of the kind now in number of mills that were leased to a corporate subsidiary disfavor [ i.e., monopolies], by which a corporation holds of the trust. Th e Bureau sought to tax the trust both on controlling interests in other corporations which, in their the dividends from the stock and the rent from the mill; to turn, may control. Th ere is nothing of that sort here. 134 put it in modern terms, the Bureau sought to tax the trust both in its role as a regulated investment company (RIC) Put simply, the Court viewed the trust as a conduit and REIT. Th e Court held for the taxpayer, concluding entity for collective investment, and not as an entity that that the REIT did “not fall under any familiar conception retained its earnings or operated in a way that created of a joint-stock association.”131 concerns around monopoly or retained earnings. Because

232 TAXES The Tax Magazine® MARCH 2016 the trust was not the type of entity that implicated the be described as a game of regulatory “whack-a-mole,” and policy objectives underlying the corporate tax, the Court the game was as ugly and frustrating for the participants refused to classify the trust as an association that was as it is for all of us. 146 Commentators of the period noted subject to that tax.135 that “harassed district courts have referred to the [defi ni- Interestingly, Treasury refl ected this view when it issued tion of association after Hecht ] as a ‘troublesome subject’ Reg. 45, Article 1502 under the Revenue Act of 1918 and a ‘vexed question,’”147 and that a Bureau of Internal (published in 1919, after Crocker was decided), which Revenue attorney had, in 1935, “expressed the unoffi cial provided in part that: opinion that the decisions ‘determining what constitutes an association within the meaning of the statute, bewilder Where … the interest of each benefi ciary in the in- rather than enlighten.’”148 come of trust property, as received, belongs to him Th is brings us to the seminal 1935 decision of the Su- as his separate, individual property, and the trustee is preme Court in T.A. Morrissey , 149 which concerned the required to make prompt distribution of it and is not application of the 1934 entity classifi cation regulations responsible for the operation of the property from on the tax classifi cation of trusts. Although Morrissey is which it is derived, the trustee and the cestuis que undoubtedly infl uential—it remained quoted in entity- trust do not constitute and association.136 classifi cation Treasury Regulations until 1997150 —we view Morrissey not as a product of careful judicial analysis but as Additionally, following Crocker ’s common law rationale, a judicial surrender to the Treasury’s endless amendments these regulations provided that a trust would be subject to our entity classifi cation system. to the corporate tax if the benefi ciaries “have a voice in Th e Morrissey case involved a REIT that engaged in the the conduct of the business of the trust.”137 Th e clarity of construction and operation of golf courses and the devel- this “control test” rule enabled the lower courts to hold, opment of land for sale. In holding that the REIT was an in everyery case of wwhich we are aware, that a REIT was not association taxable as a corporation, the court articulated subjectbject toto thethe corporatecorp tax, as long as the benefi ciaries fi ve characteristics of corporate status that, if found in a didid not eexercexercisecise conc control over the trust.1381 business trust, indicatedindica ed that the trust should be treated ((c)c) EEntityntity ClassifiClassifis cationn from the 11920s920s to ththee GreGreatat as a taxabtaxable association:socia n: (i)) the aabilitybili y of thehe trust tto holhold DepDepression.pression. WWhaWhateverhatevver clarityity Crocker providedrovided wwas shshort-rt- titleti too proproperty;ty; (ii) survivalurv val of tthee trust beybeyondond the dedeath lived.edd.dIn In Hec Hechtcht v. v MMalleMalleyall , thee SupremSupreme Court held that a ofo itss benefi ben ciariesaries (“continuity (“con inuity of life”); (iii)) centcentralizedal REIT ththathat hl hheld offi ce property in Boston was a taxable management by trustees, who act similarly to corporate association on the grounds that the trustees were “associ- directors; (iv) freely transferable ownership interests (“free ated together in much the same manner as the directors transferability”); and (v) limited liability. 151 Th is fi ve-factor in a corporation for the purpose of carrying on business corporate resemblance test was reinforced by three other enterprises.”139 cases in the Court’s 1935 term: Swanson ,152 Helvering v. Th e statement in the Hecht opinion that a trust which Combs ,153 and Helvering v. Coleman-Gilbert Associates.154 operates “in much the same manner” as a corporation can As these characteristics were found in most Massachusetts be taxed as a corporation eventually led to the debacle business trusts, the passthrough taxation that those trusts that we all know as the corporate resemblance test.140 had enjoyed was eff ectively at an end. Th e Treasury reacted to this expansive criterion for taxa- Returning to our view of Morrissey as a judicial surrender tion almost immediately after Hecht was decided, with to a relentless administrative process, perhaps the most the Bureau attempting to tax trusts as corporations. Th e important feature of the decision lies not in its articula- government won some cases and lost some cases, and tion of a corporate resemblance test—the Court essentially seemed to amend the regulations regardless of whether adopted factors already present in Treasury regulations it won or lost. When it won, the government seemed to promulgated after Hecht 155—but the extreme deference it amend the regulations to include judicial theories it had gave to Treasury in defi ning the term “association.”156 Th e not previously advanced, and when it lost, the government Court’s reasoning was straightforward enough: Because seemed to amend the regulations to include theories that the Revenue Act of 1918 stated, without further defi ni- might have helped it win.141 Th e end result—regulations tion, that the term “corporation” includes “associations,” issued in 1926,142 1928,143 1932 144 and 1934145 attempting the Court felt that Congress had eff ectively delegated the to distinguish between a narrow set of trusts that would defi nition of “association” to Treasury.157 continue to be taxed as trusts and a broadly defi ned set In our view, this interpretation of the 1918 Act cannot of trusts that would be taxed as corporations—can best fully explain the level of deference given by the Court to

MARCH 2016 233 MODERN REITS AND THE CORPORATE TAX

the Treasury. For example, key words used to defi ne the Th us, throughout the early 20th century, the legislative scope of a “corporate” tax were not defi ned in the 1909 history underlying the various corporate tax acts indicates tax, nor were they defi ned in any of the revenue acts that a congressional policy aimed at corporate retained earn- followed, yet the courts took it upon themselves to inter- ings. Th e various regulatory iterations of the corporate pret those words, sometimes taking into account the policy resemblance test simply ignore that policy focus. In fact, objectives underlying the corporate tax (most notably in throughout the history of the corporate resemblance test, Crocker). Deference to the Treasury was not the dispositive the regulations completely ignored the distinction between judicial position on the tax classifi cation of unincorporated the question of whether an entity could be taxed and the entities until Morrissey , hence our view of Morrissey as a question of whether an entity should be taxed. Instead, the judicial surrender to a relentless administrative process. regulations simply adopted the position that every entity Although we are not huge fans of surrender, we note that which could be taxed must be taxed. Th us, under the corpo- in this instance surrender provided signifi cant benefi ts—as rate resemblance test, every entity that theoretically could far as we can tell, Morrissey was the last signifi cant entity be taxed was subject to tax as a corporation regardless of classifi cation case decided by the Supreme Court. whether the entity was able or likely to retain its earnings (d) Th e Policy Problem with the Corporate Resem- and thereby implicate the policy objectives underlying blance Test. From a tax policy perspective, the corporate the corporate tax. Th e regulations were simply divorced resemblance test posed two huge problems. First, the from the policy objectives underlying the corporate tax. test was completely divorced from the policy objectives More importantly, the corporate resemblance test, by underlying the corporate tax. Second, by classifying RICs classifying collective investment vehicles such as RICs and and REITs as corporations for tax purposes, the test ac- REITs as corporations, actually prevented the policy objec- tually prevented those policy objectives from being fully tives underlying the corporate tax from being fully realized. achieved. When it enacted the corporate tax in 1909, Congress was Th e kekeyey too ununderstanding the fi rst problem is that the heavily focused on retained earnings. 160 Refl ecting that corporaterpporate resemblanceresembbla test merely recites the attributes focus, Congress allowed a corporation to deduct interest reliedelieed up uponpon by schs scholarss and policympolicymakers too validateali paid to lenders,s, whichwhich hash been justifi ed on the grounds thehe “natural“natural entientity”ty”t theoryy of the corcorporation,poration wwhichhich in that debt servicece ppaymentsme s inhibinhibitit the growgrowthth of reretainedaine turnurnn is usedused toto justifyjustifffy thet treatmentreatment oof a corporationcorpora on ass a eaearnings.ngs.161 Fromom theth perspectivepe spectiv of corporatecorporate tax policy,o naturaltuural ppersopersonon wiwithit rigrights andnd proteprotectionsons ununderer thehe lalaww wwhennaR a REIT owns ppropertyroperty ththat it leases to a corcorporatepo in generalal .158 Th e natural entity theory says little about tenant, it is performing the same basic function as a lender, which rights a corporation possesses, and nothing about insofar as the payment of rent prevents the accumulation rules should apply to corporations or how those rules of retained earnings by the corporate tenant. By prevent- should be applied. ing REITs from performing this function, the corporate In the context of tax policy, the attributes of “corporate- resemblance test may have actually stymied the policy ness” underlying the natural entity theory contributed to the objectives underlying the corporate tax. notion that corporations could be treated as entities separate Th is result was not inevitable. If Treasury had wanted from their shareholders, meaning that corporations could be to adopt a corporate resemblance test for administrative taxed. But these attributes, in and of themselves, provided convenience while remaining true to the policy objectives no guidance on whether corporations or other entities that underlying the corporate tax, it could have adopted a shared some or all of these attributes should be taxed. In or- single factor test: whether the entity’s charter documents der to determine whether an entity that theoretically could provided for a centralized management team that pos- be taxed separately from its owners in fact should be taxed, sessed the power to retain earnings and to deploy those Congress itself needed a policy objective for the imposition retained earnings without further input from owners. If of the tax. In this case, depending on whether one adopts the managers of an unincorporated entity were required the regulatory view or the capital lock-in view, Congress by the entity’s charter documents to distribute earnings enacted the corporate tax either to limit the accumulation on a regular basis, the entity did not implicate the policy of retained earnings that could be used to pursue monopo- objectives underlying the corporate tax and should never listic or unfair trade practices or to impose an indirect tax have been classifi ed as a corporation. on shareholders’ accession to wealth. Regardless of which (e) Th e Corporate Resemblance Test Debacle: From view one follows, the existence of retained earnings, or at Morrissey to Check-the-Box. After Morrissey , the cor- the very least the existence of the ability to retain earnings, porate resemblance test morphed from a policy problem is the sine qua non of corporate taxability.159 plaguing the REIT industry into a debacle that aff ected

234 TAXES The Tax Magazine® MARCH 2016 American business more generally. Th e IRS’s general ap- tried to establish a pension plan. Th e establishment of a proach was to uniformly expand the application of the pension plan thus became a “super noncorporate factor” corporate resemblance test (without regard to the policies in determining whether the corporate resemblance test underlying the corporate tax) but, where this expansion was satisfi ed. At some point, someone inside the IRS produced results the IRS did not like, create incoherent began to grasp the utter ridiculousness of that position exceptions to the test. and issued Rev. Rul. 57-546, 166 which “modifi ed” Rev. For example, the IRS decided to go after doctors, who, Rul. 56-23 and directed the IRS to apply the corporate by the 1930s, had begun banding together into larger resemblance test to a professional service entity even if the medical practices. Th e fi rst doctor to enjoy some atten- entity established a pension plan. tion from the IRS was Dr. Pelton, who had participated Th e Kintner case and the process that produced Rev. in a medical clinic that was organized in trust form to Rul. 56-23 and Rev. Rul. 57-546 led the IRS to reevaluate provide limited liability.162 Th e Seventh Circuit classifi ed its entity classifi cation regulations, and the end result was the medical practice as a corporation for tax purposes in former Reg. §301.7701-2 , nicknamed, appropriately, the a two paragraph opinion that relied on Morrissey . Th is is “Kintner Regulations.”167 Under this iteration of the cor- an astounding example of just how divorced the corporate porate resemblance test, an unincorporated entity would resemblance test was from the policy objectives underlying be subject to tax as a corporation if it possessed a prepon- the corporate tax. derance of the following six factors: (i) associates; (ii) an Policy disconnects notwithstanding, things seemed to objective to carry on a business and distribute profi ts; (iii) be going well for the IRS and poorly for taxpaying physi- continuity of life; (iv) centralized management; (v) limited cians until a clever doctor by the name of Arthur Kintner liability; and (vi) free transferability of interests. Because fi gured out how to obtain an above-the-line tax deduction any multi-member entity that was engaged in commerce for every dollar that he saved toward retirement and, in would satisfy the fi rst two requirements, an unincorpo- addition,ionn, taxtax-deferredx-de growth of all funds held in the re- rated entity would be subject to tax as a corporation if it tirementemment accaccount.ount.t 163 Th e strategy was amazinglyy simple: possessed at least two of the four remaining characteristics. Dr. Kint KKintnertner aand hhis medicalcal partners cacaused theirir memedical Returning too ourur debacle,deba a taxpayer might have reason- practiceracctice to becomebecomem classifified ed as as a acorporation corporation uunderder tthehe ably thoughtthou that,hat, whenen thehe IRSRS issued Rev. Rul. 57-5465 -546, corporateorpporate resresemblanceemblanblb nce test and the PeltonPe ton case.se OnceO ce thatat it hadd movedmo past its preoccupationp eo up tion with doctorsdoctor withw wass done,donee, the e medmedicaldi allp ppracticece establestablishedd a taxtax-deductibledeductible ppensionsion pplans and had had learnedearned too live with w h the resultses qualifi edd penpensioni plan for the shareholder/employees and produced by the corporate resemblance test it had cham- voila —the tax-deductible, tax-deferred bank account was pioned in one form or another for at least three decades. born, courtesy of the corporate resemblance test. Th at taxpayer would have been sadly mistaken, as the IRS Th e IRS’s reaction demonstrated the growing fi asco inserted into the new regulations a special rule designed of the corporate resemblance test—after having issued a to prevent professional services fi rms from being classifi ed set of anti-taxpayer regulations and prevailing against a as corporations for tax purposes. Th e special rule provided similarly situated taxpayer on those same regulations, the that a general partnership organized under the Uniform IRS tried to challenge its own regulations as being unfair Partnership Act—essentially all state law partnerships— to the government. 164 Not surprisingly, the courts held could not be classifi ed as a corporation for tax purposes the IRS to the regime it had created and classifi ed Dr. even if it had a preponderance of the other corporate Kintner’s medical practice as a corporation. Dr. Kintner factors.168 Because state laws at the time required medical got his tax-favored savings account, and the IRS got a practices to be formed as general partnerships, the IRS black eye in the process. thought that this new rule would forever solve the problem Th e IRS’s response to Kintner was Rev. Rul. 56-23, 165 of doctors with pension plans. Unfortunately for the IRS, in which the IRS stated that a group of professionals the battle over the tax classifi cation of medical practices who created a “corporation” within the meaning of the was only beginning: soon after the new regulations were corporate resemblance test and proceeded to establish a issued, states began allowing doctors to form their own pension plan for themselves would instead be treated as professional corporations, and the practice of doctors with having formed a partnership for tax purposes, which could pension plans was back in vogue. not take advantage of the pension strategy. Basically, the When states amended their corporate statutes to permit corporate resemblance test would continue to apply to all doctors to conduct their medical practices through state entities, including professional service entities, unless, in law corporations,169 they seemed to have used the corpo- the case of a professional services entity only, the entity rate resemblance test to paint the IRS into a corner, insofar

MARCH 2016 235 MODERN REITS AND THE CORPORATE TAX

as state law professional corporations would certainly after which the proposed amendments were withdrawn seem to resemble corporations for tax purposes. In fact, without comment. Although the offi cial reason for the we would have thought it impossible to imagine a situa- abrupt withdrawal has never been made public, the unof- tion in which a state law corporation does not resemble fi cial view is that the Department of Housing and Urban a corporation. Development (“HUD”) arranged for the scuttling of the Th e IRS’s imagination during the 1960s was far better proposed regulations because the regulations would have than ours—in 1965, the IRS issued proposed amendments destroyed HUD’s low income housing program, which to the Kintner Regulations in order to make sure that a was for the most part carried on through privately owned medical practice, whether or not formed as a professional limited partnerships.176 corporation under state law, could not be classifi ed as a Th is brings us to the last chapter in the story: the growth corporation for tax purposes.170 Generally speaking, the of the state law limited liability company (LLC). Although amendments made it almost impossible for a state law these entities are now ubiquitous throughout the American medical services corporation to satisfy the defi nitions of business landscape, they were at one time exotic. Surpris- “centralized management” and “limited liability,” which ingly enough for something that was considered exotic, the would have prevented the corporation from possessing a LLC originated in Wyoming, in 1977.177 Th e Wyoming preponderance of the corporate factors.171 LLC statute was set up in a way that allowed the entity At this point, the debacle became almost surreal: the IRS to be taxed as either a corporation or a partnership under expected courts to defer to its view that a narrow class of the Kintner Regulations. state law corporations did not resemble corporations and For whatever reason, over the years following Kintner, pursued a number of taxpayers who were brave enough the IRS did not amend the one thing it should have rewrit- to disagree. Th e courts refused to accept the IRS’s argu- ten in toto : its playbook for dealing with developments in ment that a corporation did not resemble a corporation the world of unincorporated business entities. As evidence and invainvalidatedalidaated the amendments on the grounds that of that nonamendment, the IRS responded to the devel- theyeyy werewere “arbitrary““aarbitrar and discriminatory.” 172 Unlike its opments in Wyomingg by proposing amendments to the purportedurpporteed susurrenderurrennde in Rev. Rul. 57-54657-5 , the IRS’sIR s sur- Kintner Regulationslations thath would have classifi ed state law renderendder tthishis titimeme wasw genuine;ne; it issued Rev.R RulRul. 7070-101-101 ,173 73 LLCLLCss as corporations c oratio ifif noo memberemmber possessedpossessed unlimitedunl mite whicwhichh chh permittedpermitted professionalprofe nal corporationscorpor tions to be treatedre ed lliabilityi ity fofor thee obligobligationstions of ththe entity. BBecausecause tthisis ap- as cocorporationsorporatioons forfo or taxax purposes.os pproachach apappliedd only toos stateate law LLCs anand not to oother Professionalf sional service corporations were not the only in- entities such as state law trusts, limited partnerships, or stance in which the IRS regretted the results produced by joint stock companies, those latter entities could continue the Kintner Regulations. Once business began to pick up, to structure their way into and out of corporate status at the real estate industry fi gured out pretty quickly that state will. Th ese amendments were withdrawn in 1983, and law limited partnerships that were classifi ed as partnerships LLCs received little attention until the IRS issued Rev. for tax purposes could provide private investors with both Rul. 88-76 , 178 in which it ruled that a Wyoming LLC an investment product that was very similar to the pre- could be taxed as a either a corporation or a partnership Morrissey REITs and signifi cant tax benefi ts in the form of under the Kintner Regulations. accelerated depreciation deductions fueled by leverage. 174 By 1995, the IRS had been pushing the corporate Th e IRS, seeing something it did not like, attempted resemblance test in one form or another for over seven to classify these early real estate limited partnerships as decades with little, if any, positive tax policy results to corporations for tax purposes, which would have ended the show for it. Th is ought not be surprising, as the corporate investor-level tax benefi ts. Th is time, it was the Tax Court resemblance test was devoid of intellectual underpinnings that delivered the IRS its black eye, issuing its opinion in and was inconsistent with the policy objectives underlying Larson175 that a state law limited partnership that did not the corporate tax itself. In any event, the eff ort to enforce exhibit a preponderance of the corporate factors had to a fundamentally fl awed regulatory approach produced a be classifi ed as a partnership for tax purposes under the seemingly endless stream of court cases involving untold Kintner Regulations. costs for both the IRS and taxpayers; triggered tremen- Just as it did after the decision in Kintner , the IRS dous criticism from both the tax bar and the courts; and responded to the decision in Larson by issuing proposed damaged the image and reputation of Treasury and the amendments to the Kintner Regulations that would have IRS, which fl ip-fl opped and reversed course on multiple classifi ed real estate limited partnerships as corporations issues, drew an apparent rebuke from another executive for tax purposes. Th is strategy lasted all of two days, branch agency and lost high-profi le cases after attempting

236 TAXES The Tax Magazine® MARCH 2016 to rewrite the regulations in rifl e-shot fashion. Th ankfully, by investing through RICs, would be forced to acquire after the corporate resemblance test had been thoroughly shares directly in the market, if at all. In other words, if the discredited as a proper means to defi ne the scope of the Morrissey decision were allowed to stand, small individual corporate tax, the test was discarded in 1997 in favor of investors would be incentivized to eschew professionally the current check-the-box regime,179 which, except in the managed diversifi ed collective investment vehicles in favor case of a limited category of entities that are classifi ed as of nondiversifi ed direct investment in individual securities. per se corporations, allows all other entities to choose their It did not take long for Congress to act. Th e Morrissey entity classifi cation simply by checking a box on a form. decision was issued in December of 1935, and by the Although the check-the-box regulations were promulgated fall of 1936, the Morrissey decision had been legislatively six decades too late for the REIT industry, we’re quite reversed with respect to RICs. Th e Revenue Act of 1936 sure that the late Senator Chandler would approve of the (the “1936 RIC Legislation”), among other things, profi nal result. vided RICs the ability to deduct distributions paid to their owners, meaning that RICs would not be subject to tax 3. The Immediate Fallout from Morrissey: on income distributed to owners. 182 The Revenue Act of 1936 Th ere are several interesting aspects of the 1936 RIC Because most REITs and RICs were operating in Massa- Legislation that are relevant to the modern policy discus- chusetts Trust form in the early 20th century, and because sion on REITs. Morrissey applied equally to all Massachusetts Trusts re- First, when Congress defi ned the types of entities that gardless of their asset classes, the eff ect of Morrissey was to could qualify for taxation as a RIC, it adopted what subject all REITs and RICs to the corporate tax. amounts to an ad hoc description of the pre- Morrissey RIC By the time Morrissey was decided in 1935, the Great operating model. 183 Th is indicates that Congress was not Depression was in full swing, and the losses in the real enacting a new regime but simply confi rming the institu- estatee secsectorctor wwere staggering.180 Many real estate companies tion’s view that, given the policy objectives underlying the likelykellflly ffeltelhlt tthathaat ttheyhheey had incurred enough tax losses to last corporate tax, RICs are not the type of entity that should foror thet foforese foreseeableeeablle f futuree and that real estate valuesal s were ever have beenn subjectsubje t to the corporate tax. Th is view is unliunlikelyikely to recoverrecovere anya timeme soon. AlthoughAlthough iti isis not en-en- supportedsupported by the Senateat testimonyte mony of ArthurArthur KeKent,t, ththe tirelyrelly cclear,lleear, iitt seeseemsmsm liklikely thathat the MMorrisseyrris ddecisionci on hadad Bureau’sB au’s AActingg ChiChief CCounsel,un l, who,ho, in resresponseonse to SeSena- littletlee imm immediatemediiate p practicalpracticcti impactmpact on thee REIT sector.sec or 18118 torto Couzen’sCouz questionquestionre regardinggardin why investment inv tment truststr Although h ugh tththe RIC industry sustained heavy losses dur- should not be subject to the corporate tax, replied: ing the 1929 stock market crash, the losses were spread unevenly and many RICs were still earning signifi cant I am not certain that Congress actually intended to income from interest and dividends. Other RICs were able include them [i.e., investment trusts], or that this situ- to raise new money after the 1929 crash and were making ation was considered when the association defi nition new loans and investments through the 1930s. For RICs, was written into the Act. As a matter of fact, until the outcome in Morrissey was potentially devastating, as comparatively recently they made their returns as the imposition of two levels of tax would dilute invest- trusts and were taxed upon that basis, and as a result ment returns to the point at which investors would be of these recent court decisions [i.e., Morrissey, Swanson better off purchasing individual securities directly rather v. Commissioner , Helvering v. Combs , and Helvering than through RICs. v. Coleman-Gilbert Assoc. 184], they have been swept Th e Morrissey decision put Congress in a diffi cult posi- into the association group and are now being taxed as tion. Congress had punted on the defi nition of “corpora- corporations. 185 tion,” and the result was now a potential disaster for a very important sector of the U.S. economy. Th e powerful Second, the 1936 RIC Legislation contained two pro- investment management industry was up in arms over the visions indicating a congressional aversion to imposing potential destruction of their business model, which was the corporate tax on income and gains from collective still important for the formation of new capital. More investment. In particular, the 1936 RIC Legislation al- importantly, the savings of small investors were now at risk lowed a RIC to deduct the amount of all distributions of being eroded through the imposition of the corporate paid to shareholders, which meant that RICs were exempt tax on the RICs in which they had invested. Worse yet, if from the corporate tax not only on dividend income but Morrissey were allowed to stand, small investors, who had also on interest and capital gains as well. 186 Reinforcing been able to spread risk and achieve diversifi cation only this theme, the 1936 RIC Legislation contained an asset

MARCH 2016 237 MODERN REITS AND THE CORPORATE TAX

diversifi cation test designed to protect investors. Th is test at least 90 percent of their profi ts and ratcheted up to 27 prohibited a RIC from investing more than fi ve percent percent for corporations that distributed 40 percent or of its assets in the securities of a single issuer. 187 less of their profi ts. 191 Although it may appear regulatory Th ird, when it enacted the 1936 RIC Legislation, Con- at fi rst blush, this rule was actually designed to prevent gress faced an interesting choice. On the one hand, it could corporations from “hoarding cash” in the form of retained rewrite the rules on trust taxation in a way that ensured earnings.192 Th e idea was that economic conditions might RICs would continue to retain their status as trusts for improve if corporations were incentivized to distribute tax purposes. While intellectually satisfying and consistent their earnings to shareholders. Although the idea that with the policy objectives underlying the corporate tax, corporate cash hoarding contributed to the Great Depres- the process to implement this approach would likely have sion was ultimately discredited, Professor Bank’s work on been laborious and lengthy, and it is entirely possible that the capital lock-in theory illustrates how the undistributed the enabling legislation might not have been available for profi ts tax was one of the many battles waged between inclusion in the Revenue Act of 1936. On the other hand, government and corporate managers over the control of Congress could simply grant RICs the ability to deduct retained earnings. distributions made to its owners. From an intellectual In sum, when viewed in the context of the modern perspective, this approach was unsatisfying because it gave debate on REITs, the 1936 RIC Legislation represents the impression that RICs should have been subject to tax a remarkable piece of the tax policy picture. First, the as corporations in the fi rst instance, a position that was structure of the statute, the rapidity with which the statute inconsistent with both the policy objectives underlying the was adopted and the testimony given in support of the corporate tax and the Senate testimony of Acting Chief statue all support the view that the 1936 RIC Legislation Counsel Kent. Still, providing RICs with a deduction was a congressional rebuke of the corporate resemblance for dividends paid to its owners seemingly required less test advanced by Treasury and upheld by Morrissey , as it signififi cancantnt legislativeleggisl drafting and minimized the risk that applied to collective investment vehicles such as RICs. thee RIC lillegislationegisslliatioon would not be available for inclusion Second, the fact that the 1936 RIC Legislation exempted innthn ththehe RRevenRevenuenue AAct of 1936. CongresCongress chose tthe llatter all types of RIC-levelC-level investmentnv income from the corpo- approach,pprroach, which,wwhich,h asa discussedussed in PartPa t IV.B below,be ow, hashas rate tax, rratherr than simplym y dividdividendsends receivereceiveded from otheother hadadd a trtremendousemennddous imimpactmpa on how we thinkhink aboutab u REITs.RE Ts. cocorporations,oratio when combinedc m ned withw h the investorinve tor protectionpro ec Fi Finally,inallyy, and d perperhapsrhapsps mmost importaimportantly,y whewhen it eenactednact d obobjectivesctives of thehe legisllegislation,tion indicindicatee a congcongressionalsional popolicy the Revenueenue AAct of 1936, Congress included two new in favor of collective investment.193 Simply put, the 1936 rules that emphasize that the policy objectives underlying RIC Legislation provides clear evidence that Congress the corporate tax remained top-of-mind in 1936 and il- favored the act of collective investment by small inves- lustrate how the regulatory view of the corporate tax and tors and did not believe it appropriate to punish that act the capital lock-in view of the corporate tax can co-exist through the imposition of the corporate tax. Th ird, the with one another. 10-percent asset concentration limits imposed on RICs, Th e fi rst rule prohibited RICs from owning more than combined with the undistributed profi ts tax imposed on 10 percent of the stock or securities of any one corpora- regular corporations, indicate that Congress in 1936 was tion.188 Th is rule was designed to prevent RICs from being just as concerned with corporate retained earnings as it used by fi nanciers to engage in monopolistic behavior. Th is was in 1909. concern makes complete sense in light of both the history that led to the adoption of the corporate tax as well as the B. 1960 and the Revival of the REIT corporate tax provisions in eff ect as of 1936.189 Th is provision also supports the view that the regulatory view of the As discussed above, many real estate developers and spon- corporate tax was alive through the Great Depression.190 sors were wiped out by the Great Depression, and their Th e second rule, which illustrates the vitality of the collective views as of 1935 on the potential for American capital lock-in theory, was contained in Section 14(b) of real estate development were so bleak that they apparently the Revenue Act of 1936 and was designed to discour- saw no need to follow the RIC industry into Congress for age corporations from retaining their earnings. Th e rule, relief from the Morrissey decision. Th at lack of optimism referred to as the undistributed profi ts tax, imposed an ad- would leave the real estate industry scrambling for capital ditional tax at graduated rates on the undistributed profi ts once the allies won World War II and the troops came of every corporation. Th e undistributed profi ts tax rate home and got back to work.194 began at seven percent for corporations that distributed In the early years after the war, real estate developers and

238 TAXES The Tax Magazine® MARCH 2016 sponsors raised money for projects through syndicated with the amount of capital that they needed. limited partnerships. 195 In a typical structure, a sponsor Th is dynamic is what led the real estate industry to do would own the general partner interest in the partnership what the RIC industry did in 1935: to ask Congress to and the partnership would issue limited partner interests to reverse the Supreme Court’s decision in Morrissey and al- investors in exchange for cash that the partnership would low the industry to raise funds from small public investors use to fund its real estate business. Th ese entities provided in a way that made economic sense for all parties. Th e investors with the yields they were seeking as well as a industry asked Congress to revive the old REIT. number of tax benefi ts owing to the tax law’s treatment of depreciation deductions attributable to leverage. 1. Reviving an Old Vehicle Yield-producing assets such as rental real estate typi- When Congress decided to revive the REIT vehicle by cally must be held in passthrough form, otherwise the enacting the 1960 REIT legislation, its stated policy objec- corporate-level tax would dilute the investment’s yield to tives refl ected the commercial events that led the real estate the point where the investment would no longer be at- industry to seek the revival of the REIT. Th us, Congress tractive at the price off ered by the developer or sponsor. indicated that it was acting to advance both populist and Limited partnerships could be classifi ed as either partner- capital markets policies. ships or corporations under the corporate resemblance On the populism front, the legislative history of the 1960 test. 196 As a threshold matter, the entity technically did REIT legislation bemoans the fact that private ownership not possess “limited liability” within the meaning of the of rental real estate was largely concentrated in the hands of corporate resemblance test because one partner—the wealthy investors who used the partnership form. Congress general partner—bore personal liability for all of the viewed the 1960 REIT legislation as leveling the playing partnership’s debts. Th us, in order to avoid corporate clas- fi eld between the “wealthy” and the “mom and pops” of sifi cation, the partnership needed to lack at least two of the world by providing the latter with a way to pool their the remainingemaaininng ccorporate characteristics. For that reason, money in order to acquire a diversifi ed and professionally mostosst lilimlimited-partnermiidted-partnt interests were nontransferable, and managed portfolio of real estate assets without being sub- thehe ppartnership partnnershhip was w requiredired to liquidateliquidat on a dateat certaince ject to two levelsels of tataxation.xa 198 Th e notion that collective inn ththehe nnot-too-distantot-too-distans future.ur investmentinvestmen vehicleshicles shouldou d be exemptexempt from corporate-levelcoorporate-leve WWithith ppassthroughasstthhroughu h taxtaxationon securedsecured, real estaestatee develop-ve p- taxta is a cocommonon ththememe inn our ttaxx law. IndIndeed,ed, it wwasas the ers anda ssponssponsorssors wwereree aable too raise sisignifificant cant amountsmounts of primaryp mary jjustifi cation fforor tthehe 1931936 Act’s exeexemptionption offm mu- capital ththroughhrough real estate limited partnerships. Th at being tual funds from the corporate tax,199 on which the 1960 said, capital—even private sector capital—became scarce REIT legislation was based. On the capital-markets front, during the 1950s, which is not surprising given the num- the legislative history cites the need of real estate promot- ber of massive capital-intensive projects being undertaken ers to better access the public capital markets in order to at the time, including the rebuilding of Europe and Japan, advance large commercial real estate projects.200 the Korean War, the Cold War arms build-up, and the In thinking about whether REITs should have been sub- build-out of American infrastructure (e.g., the interstate ject to the corporate tax in the fi rst place, it is interesting to highway system and the air transit system).197 note that the REIT created by the 1960 REIT legislation When capital becomes scarce, the returns demanded was a somewhat limited version of the 1930s-era REIT by equity investors begin to rise. In the real estate sector, and a more or less ad hoc description of the mid-to-late when equity investors demand more of a return, those 19th-century REIT. 201 Th e basic organizational require- demands result in lower property values and returns for ments imposed on REITs at that time—i.e., that a REIT developers and sponsors. must be organized in trust form, must be managed by Th us, by the mid-1950s, two things were true. First, its trustees, must be an entity that would otherwise be income-producing real estate investments were available subject to tax as a corporation and must have at least 100 only to private investors who had the fi nancial means shareholders—more or less describe the pre-Morrissey to either acquire their own real estate or participate in Massachusetts real estate investment trust. Th e income syndicated limited partnerships. Because C corporations test, asset test and distribution requirements were also a could not hold real estate in a way that made economic basic sketch of the manner in which REITs had operated sense for stockholders, small public investors were locked since the 19th century. Viewed that way, the 1960 REIT out of the rental real estate sector altogether. Second, the legislation, similar to the 1936 RIC Legislation, revived syndicated limited partnership capital market was not an investment vehicle that, like the RICs of 1935,202 oper- capable of providing real estate developers and sponsors ated in a way that did not implicate the policy objectives

MARCH 2016 239 MODERN REITS AND THE CORPORATE TAX

underlying the corporate tax. received and retained by the independent contractor. 209 In Although the 1960 REIT legislation was intended to other words, if some tenants wanted specialized services, create a useful vehicle for the collective investment in real the REIT would have to fi nd an independent contrac- estate, it was immediately apparent to real estate profes- tor to provide those services and then arrange for the sionals that the REIT of 1960, while well suited for a independent contractor to bill the tenant separately for 19th-century real estate operating model, was too limited those services. Th is meant REITs had very limited ability for the mid-20th century. For example, under the 1960 to share economically in any income attributable to the REIT legislation, a REIT generally could not provide provisions of services, but also were required to go through any services (even customary services), unless it hired an the cumbersome process of fi nding and negotiating with independent contractor to do so. 203 TRSs did not yet ex- third parties to provide those services, a task that could ist, so the REIT had no ability, as REITs have today, to not be done quickly or easily every time the market created furnish services through a wholly owned subsidiary at the tenant demand for a new service. REITs simply could not cost of a corporate tax on that subsidiary’s income. Other compete in the marketplace with these kinds of restric- restrictions, too, applied in 1960 that do not apply now, 204 tions, which undercut the policy objectives of the 1960 but those diff erences are less relevant to this article than REIT legislation.210 the diff erences relating to tenant services.205 Many com- Th e fi rst major modernizing amendment to the tenant- mentators writing shortly after the adoption of the 1960 services provisions of Code Sec. 856 came in 1976, when REIT legislation noted that, if these limitations were not Congress allowed REITs to treat as qualifying income all removed, many real estate sponsors would likely eschew charges for customary services, whether bundled in the the REIT vehicle in favor of syndicated limited partner- monthly rent or separately stated.211 Although, under the ships, in a sense undercutting the very policies that led to 1976 amendments, the services still had to be furnished by the enactment of the legislation.206 an independent contractor rather than the REIT itself,212 a As discdiscussedcusseed below, the limitations of the 1960 REIT REIT at least could share economically in the income from legislation,gisslliatioon, aandndhd ttheheh manner in which they undercut the these services without having to bundle the charge into the policiesolicies underlyingundeerlyinng that legislation, led to the adoptiona op monthly rent. Under theh 1976 amendments, a REIT that off rurulesules tthathat enenhancedhanc thehe ability of a REIT to operaoperatete hiredd an independenti pend cocontractortracto to provide, for exexample,mple inn a momoderndern bbusinessusinei ss cclimateate while rremainingmaining trtruee tto its customarycu mary trash-collectionh-coll ti n or popool-cleaningl-cleaning services cocould originalginalg objecobjectivectiveeo off providingpropr ngaveh a vehiclee for the th collectiveco lective separatelyse rately bill the REIREIT’sT’s tenants foror those servicesvices (whichwh investmentent in real estate assets. presumably would generally refl ect a mark-up over the actual fees paid by the REIT to the contractor for the services). 2. Modernizing the REIT Vehicle As noted above, though, the 1976 amendments were Under the 1960 REIT legislation, a REIT could not still overly restrictive by requiring even customary services provide any services to its tenants—even customary to be provided by an independent contractor. Congress services—unless it hired an independent contractor 207 to fi nally addressed this problem in 1986 by amending Code do so, and even then, income attributable to the services Sec. 856 to allow REITs themselves to furnish (and treat would be qualifying REIT income only if both (i) the as qualifying the income from) customary services.213 After services were customary, and (ii) the charge for the services 1986, independent contractors would be needed only for were not separately stated and instead were bundled into noncustomary services. the monthly rental amount. 208 In other words, income Although the 1986 amendments were helpful to the attributable to the provision of services would be qualify- REIT industry, the inability to control (and meaningfully ing REIT income only if all of the following requirements share economically in) the provision of noncustomary were satisfi ed: (i) the service was customary; (ii) the service tenant services still put REITs at a signifi cant competi- was furnished by an independent contractor; and (iii) tive disadvantage. Th us, in 1999, in what may have been the charge for the service was built into the monthly rent the single most important amendment to the REIT rules received by the REIT rather than being separately stated. since their original enactment in 1960, Congress cre- All other income received by a REIT for services—in- ated the TRS and, in doing so, allowed REITs to furnish cluding any customary services that either bore a separate almost any tenant services they wished, 214 as long as, in charge or were furnished the REIT or its affi liates—was the case of noncustomary services, they did so through a nonqualifying income. tax-paying corporate subsidiary. With the creation of the Th e practical eff ect of these rules was that substantially TRS, Congress fi nally struck a reasonable balance between all income for services had to be separately stated and the original conception of the REIT as a real estate rental

240 TAXES The Tax Magazine® MARCH 2016 vehicle (rather than a service provider) and the need of corporate resemblance test—and discuss how that false REITs to compete with other real estate rental vehicles in premise became entrenched in our collective thinking. the real world. We conclude that, as a matter of logic, this premise can no longer be founded upon the corporate resemblance test V. Challenging the Premise and, if the premise is to continue, it must fi nd another foundation. Th is brings us to the next part of the analysis, That REITs Should Be Subject where we examine whether REITs should have been sub- to the Corporate Tax ject to the corporate tax in the fi rst instance, taking into account the policy objectives underlying the corporate tax. Th e Code classifi es REITs as corporations for tax purposes. After concluding that REITs should not have been subject In fact, an entity cannot elect REIT status unless it is to the corporate tax in the fi rst instance, we analyze the already classifi ed as a corporation for tax purposes. modern developments in the REIT space and conclude Th e fact that the Code treats REITs as corporations for that these developments do not undercut the view that tax purposes is nothing more than a rule. More precisely, REITs should not be subject to the corporate tax. Our it is nothing more than a rule which claims as its founda- ultimate conclusion is that, if we are to determine the tion another rule—the corporate resemblance test—which scope of the corporate tax in light of its underlying policy itself resulted from the historical development of both the objectives, REITs should never have been, and should not corporate tax and the view of the corporation as a natural be, subject to that tax. entity under the law. More than a century ago, Justice Holmes urged the A. The Corporate Resemblance Test as a members of our profession to practice with a number Wellspring of an Incorrect Premise of key principles in mind, two of which are particularly relevantant herehere.. FiFirst, Justice Holmes reminded us that his- Th e key events that helped create the false premise that toryryy iinn aandnd ooffi iitselftselfe does not possess normative ppower. In REITs should be subject to the corporate tax in the fi rst othertheer wowords, ords, histohistory,ory standingnding alone, cacan only tellell uss whatw instance can bee stated ququite simply: Th e congressional punt happhappenedpeneed andannd cacannotnnon tell us whether whatw happenedhappened wwasas on tthehe defid nitiontion of “c“corporation”poration” allowed the BBureau,ureau right.ghht. Second,Second, JJusticeustiu ce HHolmesmes admonishedadmo ished uus to under-un er- anand laterater the IRS, tot atattemptmpt to drag into the corcorporatepo standndn the e origins origgins aandddp purposesp ses of a rule r beforebefor we relyely on on tatax base a numbermber of unin uunincorporatedcorpo ed entitentities that ddidd not it or applyly it iin practice. To paraphrase a passage from his retain their earnings. Th is process began in earnest with Path of the Law speech: It is not good enough for us to the Supreme Court’s decision in Hecht , which embold- rely on tradition to justify our legal conclusions; and one ened the government and spawned a series of new and of the worst mistakes we can make as lawyers is to blindly more aggressive Treasury regulations, which spawned the accept and apply a rule which rests on legal foundations corporate resemblance test described in Morrissey , which that no longer exist. 215 spawned the Kintner Regulations. Th e Kintner Regula- In the context of the current debate on the proper tions were widely viewed as poorly conceived and, after taxation of REITs, Justice Holmes reminds us that the nearly a half century of pain infl icted on both taxpayers fact that a rule exists and has existed for a long time can- and the government, the same government that created not, standing alone, tell us whether the rule reaches the the Kintner Regulations discarded them. correct result or rests on good authority. In this case, the At this point, the Kintner Regulations and the corpo- entire debate on the proper taxation of REITs rests on the rate resemblance test are usually mentioned only by the premise that REITs should be subject to the corporate most seasoned members of our profession as evidence of tax in the fi rst instance. Proponents of that position do how long they have been practicing. Few of those people, not off er any normative justifi cation for that premise and if any, ever mention the Morrissey decision. It is almost instead rest the entire debate on a statutory rule that, as as if an entire profession agreed to collectively forget an Justice Holmes would tell us, has no normative power, unfortunate foray into ridiculousness. In that sense, the might not reach the correct result and might not be based Hecht-Morrissey- Kintner line of authorities, the Kintner on good authority. Regulations and the entire concept of the corporate resem- In this Part V, we analyze the question of REIT taxation blance test would seem to be the tax profession’s equivalent in light of the advice off ered by Justice Holmes. First, we of the big hair and bell bottom jeans fads of the 1970s. examine the origins of the false premise that REITs should At a deeper level, however, those authorities still infl u- be subject to the corporate tax in the fi rst instance—the ence our collective thinking on the topic of REIT taxation.

MARCH 2016 241 MODERN REITS AND THE CORPORATE TAX

Intellectually speaking, our profession fi nds itself in a “new regime” for RICs as it partially overruled Morrissey rather bizarre situation. Despite the fact that the entire and confi rmed that, as applied to collective investment line of authority underlying the premise that REITs vehicles such as RICs, the corporate resemblance test and should be subject to the corporate tax in the fi rst instance Morrissey reached the wrong result. By overruling Mor- has been both discredited intellectually and discarded by rissey with respect to RICs but leaving REITs within the the government, our profession continues to rely on that corporate tax system, Congress created a legal distinction premise, and indirectly on those discredited and discarded between two vehicles that ought never have been treated authorities, as the intellectual starting point for a tax policy diff erently, and this distinction has colored our collective debate that has the potential to pose an existential threat thinking ever since. to an industry that is critical to the U.S. economy. If we Th e Treasury Department made its own unique con- continue down this path, we will certainly run afoul of tributions to this state of aff airs. Th e most enlightening Justice Holmes’ admonition against allowing a rule to example of Treasury’s hostility to REITs comes from the persist out of “blind imitation of the past.” Treasury’s reaction to REIT legislation proposed in 1956. Fortunately, tax lawyers as a group are not known for Th e 1956 proposal, which was substantially identical to intellectual blindness. To the contrary, we pride ourselves the 1960 REIT legislation, was vetoed by President Eisen- on our reputation as the deep thinkers of the bar, a repu- hower, apparently at the behest of his Treasury Secretary, tation that was earned through the eff orts of those who who viewed the legislation as an inappropriate narrowing came before us. It is this reputation for deep thinking and of the corporate tax. 216 According to prominent authors the related opportunities for intellectual challenge that at- in the REIT space, “[w]hen the then Secretary of the tracted many of us to the profession in the fi rst place. Tax Treasury fi rst viewed the proposed REIT legislation, he lawyers by nature enjoy, and in fact thrive on, intellectual is reported to have said: ‘If they [REITs] can do it, why puzzles. It is in that spirit that we ask two questions: How can’t GM—GM can be said to be only in the business of did we getgeet suckedsuccked into relying on discredited and discarded investing in automobiles and passing on the income to authoritiesthhiihorities ttoo fframeramem a tax policy debate that mayy aff ect the its shareholders.’” 217 futureutuure of facrf a criticalcrriticaal industry,in try, and how dod we gett ourselveso rs If the Treasuryry SecrSecretaryta was trying to create the starkest backackk on track?track? possiblepossible examplee ple of thee intellectuali tel tual disconnectdisconnecct betweenbetw en hishi AlAlthoughllhthough tthehe truttruee aanswerer to the fi rst questionque tio iis ul- department’sd rtme view ono thet properp pe taxation of REITREITsTs and timatelymaately unkunknowable,knowwa le,e baseddonco on conversationsrsation wwithth oourur hish department’sdepart t’s view on the polpolicyy objectobjectivess undunderlyingrly colleagueses in theth profession, we think the answer lies partly the corporate tax itself, he could not have picked a better in how Congress handled the 1936 RIC Legislation, partly example than the comparison between REITs and GM. in how the Treasury Department reacted to REITs during In the quote, the Treasury Secretary suggests that GM the period leading up to and following the enactment of would suff er an unfair result if REITs were exempted from the 1960 REIT legislation, and partly in how we as tax the corporate tax while other C corporations were not. In lawyers have been trained to think about the Code and framing his department’s objections to the 1956 REIT tax policy issues. Proposal in that way, the Treasury Secretary simultaneously Focusing fi rst on Congress’ handling of the 1936 RIC highlighted the pernicious eff ect of the negative infer- Legislation, it seems that part of the reason why so many ence created by the 1936 RIC Legislation and provided people are willing to accept without question the general an example of why the policy objectives underlying the rule that REITs should be subject to the corporate tax corporate tax were well founded. in the fi rst instance is that REITs look a lot like RICs First, the Treasury Secretary’s quote obviously assumes and that, because the 1936 RIC Legislation was enacted without any further thought that REITs are diff erent from so quickly after Morrissey was decided, RICs were never RICs, and that REITs should be subject to the corporate actually subjected to the corporate tax. In other words, in tax while RICs should not. It would not surprise us if that a world where we are rarely required to research a Code assumption is attributable to the legacy of Morrissey and provision beyond the 1939 Code at the earliest, it is easy the unfortunate negative inference created by the 1936 to accept both the proposition that RICs are “naturally” RIC Legislation. exempt from the corporate tax and the negative infer- Second, and perhaps more importantly, the quote, ence produced by that proposition—that REITs should by focusing on GM, unwittingly demonstrates why the “naturally” be subject to the corporate tax. We think this original policies underlying the corporate tax, whichever outcome is unfortunate because, by enacting the 1936 is adopted, were well founded and why REITs do not RIC Legislation, Congress did not so much create a implicate those policies. GM’s stature in this country after

242 TAXES The Tax Magazine® MARCH 2016 World War II cannot be overstated. At that time, GM instance and a corresponding “narrowly construed excep- was in its heyday, having just earned a massive amount tion” for entities that satisfy the requirements of Code of money and developed tremendous connections inside Secs. 856 through 859 . Although this statutory structure the government following its eff orts to keep our military is certainly part of the reason why so many people are equipped during the war. In an age when American indus- willing to base a tax policy debate on the premise that try was coming into its own, GM was the largest industrial REITs should be subject to the corporate tax in the fi rst producer of the time.218 instance, the statutory structure alone cannot fully explain While GM produced great products and made enor- this premise for one simple reason: RICs and REITs are mous contributions to our country, GM’s level of infl uence governed by the same statutory structure, and yet most of in society and its operating style from the 1930s through us seem to view RICs as entities that should “naturally” the 1960s serve to validate the policy objectives underlying fall outside the corporate tax. If we were truly basing our the corporate tax. For example, insofar as the corporate tax exists to curb the power of corporate managers or reduce retained earnings, it is striking to note that GM’s wealth and earning power provided its managers so much infl u- Why, then, would anybody choose a ence over our government that Charles Erwin Wilson, REIT over a nontaxpaying partnership? then CEO of GM, was appointed Secretary of Defense to The answer is largely explained by the President Eisenhower.219 Second, insofar as the corporate tax was designed to limit the ability of corporate manag- ability of a REIT (but not a partnership) ers to use retained earnings to pursue monopolistic and to distribute its income in the form of other unfair trade practices, it is downright astounding that the Treasury Secretary’s quote came just seven years corporate dividends. after GMGM’sMs crcriminalrimi conviction in the National City Lines antitrusttitrust conspiracyconspiraca 220 and only fi ve years after a federal appealsppeeals ccourtt uphupheldhel thatat conviction.22122 premises on the mannermann in which statutory structure Th e ideaidea tthathat thet Secretarytary of the TTreasuryreasury wwoulduld uusese creatcreateses gegenerall rulrules andnd narrownarrowlyly construeconstruedd excepexceptions,tions GMM as anan exampleexamplepl of the type of eentitytity thathat wwouldul be ththen our collectivec ctive underlyingu de lying viewsv ws on RICsRICs and REITsRE treatedatted unfaiunfairly u rly iffR REITREITsEI werere exemexempteddfrom from the corpcorpo-o cocouldd not bothhbeco be correct.rec rate tax iillustratesllustr t three key points. First, Treasury failed to Th is brings us to the topic of our use of intellectual use the 20-year period following the Morrissey decision to presumptions. Whether we acknowledge it or not, many reacquaint itself with the policy objectives underlying the of us often think our way through a tax policy issue by corporate tax. Second, as the use of GM in the example setting up a presumption—a “base case,” if you will—and indicates, those objectives were as relevant in 1956 as they then testing whether or not the presumption (or base case) were in 1909. Th ird, because Treasury had lost touch with should apply to a given set of facts. We use these intel- the policy objectives underlying the corporate tax, it never lectual presumptions or base cases to create intellectual grasped the manner in which REITs could help advance starting points, which ultimately develop into our views those policy objectives, as described in Part VI.B below. on tax policy. Th e events outlined above, when combined Th is brings us to the topic of how we as lawyers are with the statutory structure of Subchapter M, created in trained to think. When we think about an issue or in- our minds a presumption of nontaxation for RICs and a terpret a statute, we often think in terms of general rules presumption of taxation for REITs. and their narrowly construed exceptions, and we seem- Th ese two presumptions, taken together, have the ingly allow our judgment to be infl uenced by intellectual eff ect of skewing the debate against the REIT industry presumptions, some of which might not be acknowledged in a truly insidious way. Th at is because, as lawyers, consciously. We think that one or both of these mental once we have formed a presumption in our minds, we processes may have played a role in our collective reliance are trained to impose the burden of proof on the party on dead authorities to support the premise of a modern seeking to overcome the presumption. Th us, many of tax policy debate. the participants in the current tax policy debate on Turning fi rst to general rules and their narrowly con- the proper taxation of REITs seem to be starting from strued exceptions, the statutory structure governing REITs the positions that the presumption of nontaxation for would certainly seem to create both a “general rule” that RICs is virtually insurmountable but that the REIT REITs should be subject to the corporate tax in the fi rst industry bears a heavy burden of proving to the rest of

MARCH 2016 243 MODERN REITS AND THE CORPORATE TAX

the world why it should not be subject to the corporate that test—including the Kintner Regulations, Hecht and tax. Given the history described above and the policy Morrissey —died for good reasons. Th ose authorities should objectives underlying the corporate tax, this starting stay dead, and we should stop relying on them to frame point is inappropriate. our current debate on the proper taxation of REITs. In thinking about how harmful these two presumptions In order to move forward with a policy debate that is have been to the REIT industry, it is important to note that both intellectually honest and productive, we need to base they are not a phenomenon of the current policy debate, the debate on a valid premise. In order to fi gure out what nor are they applied solely by the REIT critics. To the that premise ought to be, we think we should return to contrary, the notions of presumptive nontaxation for RICs fi rst principles and ask two simple questions: Based on and presumptive taxation for REITs seem to run through- the policy objectives underlying the corporate tax, should out our entire profession. We have been unable to locate REITs have been subject to that tax in the fi rst instance? in post-1960 tax literature any debate on the question of If not, do recent developments change the conclusion? whether RICs should be subject to the corporate tax, even Parts V.B and V.C address those questions. in the obvious case where a RIC holds indebtedness of a C corporation and the C corporation receives a deduction B. Starting from the Right Place: for interest paid to the RIC, which is an arrangement that REITs Should Never Have Been Subject allows income to move from a customer of a C corporation to a shareholder of a RIC without any imposition of to the Corporate Tax corporate tax. In addition, we have been unable to locate We think that one of the best ways to fi gure out what any post-1960 tax literature arguing that, based on fi rst premise should underlie a policy debate on the proper principles underlying the corporate tax, REITs should taxation of REITs is to analyze how Congress would have not have been subject to that tax in the fi rst instance.222 treated REITs in 1909 had they thought about the issue At thiss poipointint iin the history of our tax system, the view of REIT classifi cation in the fi rst place.223 As discussed thatat a RIRICIC sshouldhldh ouldd bbe excluded from the corporate tax base below, we believe that, because REITs did not implicate the innthn thethhe fi fir rrst in instancenstannce seemsms practically ssacrosanctct andnd the policy objectivesves undunderlyingrl the corporate tax and indeed viewieww tthathaat a RREITEIT shshould be included iinn the cocorporatep rate ttaxax helphelpeded fufurtherr those tho policypo icy objectives,ob ectives, CongressCongress wouldwoul baseasee in thethhfie fi rrstst ininstancestas nce seemsms beyond reproach.eproach AAlthoughho gh nnot have thoughtght ththatt RREITsEITs wwerere subject to that tatax in we agreea e with h the e fifirst rst view asasama a matterrofco of corporatepo ate tax tax ththe fifirst rst instance. i nce We thithinknk the modernodern ddebateate ououghtgh to policy, we think thi that, in the minds of most people, those start from that premise. two views derive not from an in-depth analysis of fi rst Given the state of the record, it is not possible to state principles but from a combination of the timing of the with certainty exactly how each and every REIT operated 1936 RIC legislation, the fact that REITs were not given between the early 19th century and the mid-1930s; the similar relief in 1936, the Treasury Department’s treat- available technology and media resources simply could not ment of the REIT industry in the early years, and the accommodate a contemporaneous account of all aspects way in which these events have infl uenced our collective of business life during that time. Th at said, we do have thinking in ways that we might not fully appreciate. One signifi cant evidence, in the form of court opinions and has to seriously consider whether the recent debate on the secondary authorities written either contemporaneously or proper taxation of REITs would have been conducted with shortly after that period, to give us a solid enough founda- the same level of vitriol, or indeed if it would have been tion to conclude that should not have been subject to the conducted at all, had REITs been included in the Revenue corporate tax in the fi rst instance. 224 Act of 1936 as a collective investment vehicle that ought First, we know that REITs were vehicles for the collective never have been subject to the corporate tax. investment in real estate development and ownership. REITs Turning now to our second question—how do we get were created by sponsors in order to develop and sell, develop ourselves back on track?—we think it is time to correct and rent or buy and rent diff erent types of commercial real the record. If we are to have a debate on the proper taxa- estate properties. Th is is important because our tax system tion of REITs, we ought not base that debate on a line of has historically favored vehicles that existed for the collective authorities comprising a doctrine—the corporate resem- investment in income producing assets, as evidenced by the blance test—that has been discredited intellectually (for rapid enactment of the 1936 RIC Legislation. good reason) and discarded by the government (also for We also know that REITs raised money from a wide variety good reason). Th e corporate resemblance test and every of investors and that one of the benefi ts of REIT equity was authority that at any time helped to provide validity to periodic distributions of cash fl ow. In other words, we know

244 TAXES The Tax Magazine® MARCH 2016 that REITs were designed to pursue real estate ventures in Professor Borden has addressed the fi rst concern, con- a way that produced a cash fl owing security for investors, cluding that C-to-REIT conversions and REIT spin-off s which means that REITs did not retain their earnings. do not aff ect overall tax receipts nearly to the extent that Th ird, insofar as one subscribes to the regulatory view some of the REIT critics seem to believe. Most C corpo- of the corporate tax, we know that real estate investment rations have relatively low dividend payout ratios—on did not have the same tendency toward monopoly that average, just 25 percent—while REITs must distribute 90 plagued other businesses, such as the railroads, oil produc- percent of their taxable income, and in practice, often dis- tion and commodities. In fact, competition in the real tribute more than 100 percent.227 Consequently, because estate space was the historical norm, with the company REITs do not off er deferral to their shareholders (income towns of the late 19th and early 20th centuries being is distributed rather than sheltered in corporate solution), exceptions to the rule.225 Th is makes sense given the dif- increased revenue from increased taxes on distributions ferences between developing real estate for rental or sale, to shareholders mitigates entity-level tax reductions.228 on the one hand, and manufacturing and selling goods or Depending on various assumptions regarding dividend providing services, on the other. Th e latter can tend toward payout ratios and eff ective tax rates on shareholders, the monopoly in a way that the former cannot.226 overall eff ect may be as low as seven percent. Additionally, Th ese three features of the early REITs—their use as col- if a C corporation converts to or spins off a REIT, it must lective investment vehicles, their propensity to distribute make a “purging” distribution of the REIT’s share of the earnings and the lack of monopoly risk—all show that C corporation’s historical earnings and profi ts.229 Th ese the REITs of the 19th and early 20th centuries simply did purging distributions are often very signifi cant,230 and the not implicate any of the policy objectives underlying the up-front tax on them further reduces any aggregate tax corporate tax. Instead, similar to RICs, REITs operated advantages of REIT spinoff s. 231 in a way that was consistent with nontaxation. Neither Professor Borden’s analysis validates what many REIT entityy shshouldhouldd hahave ever been subject to the corporate tax. practitioners intuited but had not undertaken the eff ort to FiFinally, illinallyy, REREITsEITs actuallyaca helped advance the policy objec- prove out: because the revenue eff ects of the entity-level tax tivesivesvess undunderlyingderlying thet corporateorate tax. Th at is, by holdingol ng real benefi ts enjoyeded by RREITsEI are off set by higher taxes paid estatestatte aandnnd ccharginghargingn ttenantsts rent, a REIREITT that lleasedas d spaspacece by REITR shareholders,ehold C-to-REITC to-RE T conversionsconversions and REIT too corporatecorporate tenantstenanta s could co d prevent thet e accumulationaccumu io of spin-offsp off s may not mmateriallyte ally rereduceuce overaloverall tax rerevenuesen earningsrnnings in thet he same saame wayw ass a lender lende chargesharges interestnte est for for and,an in certain ce instances,instanc sm may actually actu ly increase increa tax revenues. reven the use of momoney. Th e fact that the original corporate tax Th is Part addresses the second concern of the REIT allowed a deduction for interest payments, which has been critics—that the development of TRS structures, nontra- justifi ed as reducing the accumulation of retained earn- ditional REITs, C-to-REIT conversions and REIT spin-off s ings by corporations, combined with the swift legislative represent an inappropriate use of the REIT vehicle. In our reversal of Morrissey as it relates to RICs, all support the view, these types of developments should only be viewed as conclusion that REITs should not have been subject to problematic from a tax policy perspective if one of the fol- the corporate tax. lowing is true: (i) REITs are failing to advance the populist and capital markets policy objectives underlying the 1960 C. Recent Developments Do Not Change REIT legislation; (ii) REITs are acting in a way that would the Conclusion That REITs Should Not Be run afoul of the policy objectives underlying the corporate tax by facilitating the accumulation of retained earnings; Subject to the Corporate Tax or (iii) REITs are hindering some other, more important False premises, intellectual presumptions and powerful policy goal of Congress. As discussed below, the modern words seem to have created a visceral aversion to REITs developments in the REIT space do not produce the fi rst among certain members of the media, academic, political two outcomes, and we have yet to encounter an argument and practitioner communities—we call them the REIT that REITs are producing the third. Th erefore, the modern critics, for lack of a better term—and this group seems to developments do not alter our conclusion that REITs should view REITs’ use of TRS structures, the development of not be subject to the corporate tax in the fi rst instance. nontraditional REIT assets and the movement of assets from C corporation form to REIT form, whether by way of 1. The Use of TRS Entities C-to-REIT conversion or REIT spin-off , as a drain on and the “Operating REIT” Debate the fi sc and an inappropriate extension or use of the Th e debate around the use of TRS entities essentially fo- REIT vehicle. cuses on two topics: (i) a REIT’s ability to own 100 percent

MARCH 2016 245 MODERN REITS AND THE CORPORATE TAX

of the stock of a TRS; and (ii) the ability of that TRS to present those shareholders with a choice among three earn income that does not qualify under the REIT income undesirable alternatives: (i) allow their entity to earn tests and to provide noncustomary services to tenants of the profi ts associated with the services at the cost of the REIT. 232 relinquishing its REIT status, (ii) maintain REIT status (a) TRSs Th at Earn Non-REIT Income. REITs have at the cost of retaining an independent contractor who been able to own non-REIT operating companies in one will necessarily capture those profi ts and who might form or another since the 1960 REIT legislation. At that not provide the same level of service that the REIT time, the 10-percent asset test limited a REIT’s ability could provide on its own, or (iii) forgo investing in the to own more than 10 percent of the voting power of a C types of properties that require noncustomary tenant corporation but did not limit the ownership of low vot- services. If REIT investors were forced to make such a ing stock that accounted for more than 10 percent of the choice, the populist/capital markets policies underlying value of the corporation.233 Th us, subject to the 75-per- the 1960 REIT legislation would be frustrated without cent and fi ve-percent asset tests, a REIT was permitted to advancing in any way the policy objectives underlying own low voting stock in a C corporation that represented the corporate tax. substantially all of the economics of the corporation. Such Viewed from this perspective, the fact that REITs are a C corporation could engage in any activity other than allowed to use TRSs to provide tenant services helps REITs providing services to tenants of the REIT. Many REITs carry out the policy objectives underlying the 1960 REIT used this structure to engage in non-REIT activities prior legislation without running afoul of the policy objectives to the adoption of the TRS Legislation in 1999. After underlying the corporate tax. In fact, since most real prop- that, REITs generally pursued all non-REIT qualifying erty in this country is owned in either partnership form activities through the TRS structure. or REIT form, the use of the REIT/TRS structure may It is hard to see why a REIT’s ownership of a TRS that actually result in more corporate tax being paid than the earns nonnon-REITn-REEIT income is problematic. A REIT that earns likely alternatives. Given the limits on the size of TRSs,235 non-REITon-REIIT income iinncomem through a C corporation subsidiary which in turn limits a TRS’s retained earnings, this does iss actingacctingg exactlyexa ctly likelik a RIC. To the extentex thee REITEI is not pose a corporateporate taxax policy problem. behavingehaaving exactlyexactly likelik a RIC, and non-REITnon-REIT incomeincome is (c) ) ConConcludingding Th oughtsug ts on tthehe UUsese of TRTRSs.RSs. AltAlthoughhough beingeinng taxedtaxed atat thethhee TRSTRRS level,l, this aspectaspe of the debatedeb e doeses ththe unlim unlimited and unchecked ch k ususe of TRSs could ppresentre nott presentpreseent a tax ppolicyolicylic issueue that iis uniquenique to RREITsITs as tatax policy problems,oblems ththe key llimitationsmitation onaRon a REIT’sE compareded to RRICs. Given that none of the REIT critics ability to deploy TRS entities— i.e., the 25-percent are suggesting that RICs should be prevented from own- (beginning in 2018, 20-percent) size limit on TRSs and ing C corporations that earn non-RIC income (indeed, other non-real estate assets, the fact that dividends and that is the raison d’etre for every equity-focused RIC), as non-real-estate interest paid by a TRS to a REIT do not well as the fact that TRSs pay corporate-level tax on their qualify for the 75-percent income test, the application income, 234 we view this aspect of the operating REIT of Code Sec. 163(j) and the 100-percent penalty tax on debate as a nonissue. non-arm’s-length arrangements between a REIT and its (b) TRSs Th at Provide Tenant Services. When it comes TRS—strike a decent balance between, on the one hand, to REIT critics’ concerns over the use of TRS structures, a a REITs’ need for fl exibility and, on the other hand, the signifi cant focus seems to be on whether a REIT should be policy objectives of both the corporate tax itself and the allowed to provide noncustomary tenant services through a 1960 REIT legislation. And the use of TRSs should not be wholly owned TRS. In our view, because it is theoretically viewed as reducing the corporate tax base, as TRS income possible for a REIT to rely on independent contractors to is necessarily subject to the corporate tax. perform all tenant services, the real question is whether a Although the TRS legislation balances REIT fl exibility REIT should be forced to rely on independent contractors with the policy objectives underlying the corporate tax, it to provide tenant services in order to maintain REIT status. might be possible to modify the TRS rules in a way that Property owners compete with one another for tenants further advances those policy objectives. For example, in and therefore must either respond to tenants’ demands order to further limit a TRS’s retained earnings without for services or risk losing their tenants to other property subverting the populist/capital markets objectives under- owners who are willing to satisfy those demands. If the lying the 1960 REIT legislation, the TRS rules could be shareholders of a REIT are best served by investing in amended to require TRSs to distribute all of their taxable properties that require tenant services in order to com- income to the REIT, which dividend would then be sub- pete in the market place, then eliminating TRSs would ject to the REIT distribution requirement.236 But even as

246 TAXES The Tax Magazine® MARCH 2016 the rules are drafted today, we do not see how REITs’ use Th is is nothing more than an example of the familiar of TRSs could off end tax policy. legal problem of having to apply an old law to new facts— the same problem the Supreme Court faces when, for 2. The Development of Nontraditional example, it is asked whether the term “search” under the Real Estate Fourth Amendment includes placing GPS on a suspect’s One assertion made by some REIT critics as evidence that car 244 or viewing the suspect’s home through a thermal the REIT rules need to be scaled back is that the IRS has imaging device.245 Even though the drafters of the Fourth somehow “expanded” or “broadened” 237 the defi nition Amendment, if they had seen a GPS tracking unit or a of “real property”238 in order to help “create” new types thermal imaging device in action back in 1789, may have of REITs. As a threshold matter, this assertion is simply regarded those technologies as black magic,246 the Court incorrect. Furthermore, even if the IRS had “expanded” of course did not “change” or “expand” the defi nition of the defi nition of “real property,” the expansion would not “search” when it ruled that GPS tracking and thermal pose a policy problem for the reasons explained in Part imaging constituted a “search.” All it did was apply an old V.C.2 below. law to new facts. So, too, has the IRS when it has been First, the defi nition of “real property” has not changed asked to address new types of real property. 247 since that term was adopted in fi nal regulations issued in None of these developments create policy problems. 1962, and the IRS’s interpretation of that defi nition, as First, each of these developments enable REITs to carry expressed in private and published rulings, has remained out the populist and capital markets policy objectives un- consistent from then until now.239 Furthermore, even derlying the 1960 REIT legislation. Th ese developments though the IRS has issued proposed regulations that provide small investors with access to yield producing would simplify the 1962 regulations and streamline and asset classes that they could not otherwise access and clarify the analytical process used to determine whether enable asset owners and sponsors to access the public or nott asassetsssets quaqqualify as real estate, the substantive require- capital markets. Second, none of these developments run mentsennts thatthat anan assetasses must satisfy in order to constitute afoul of the policy objectivesj underlying the corporate realeal estateestaate would w drd remainr n the same, anda the proposedp p tax, because REITsEITs dod notn accumulate their earnings and regulationseguulations oughtoughtt not no produceduce diff erenerentt results thanth n thosethose any TRST activitiesities are susubjectject to the corporacorporatete tax. Th ird,ird producedrodducedbd byy thethe historichish stor rulinguling policy,poli y, which wasw basedb ed becauseb use these th developmentsdevel m nts all involvenvolve rereall estate asassets on thet 19621 962 regulations.reguul tiono 240 thatth are leased le to large (typically(typically corporate)rporate tenants,enants theseth Insofarf rasn as new types of assets are being classifi ed as “real developments advance the policy objectives underlying property,” it is only because those assets are either the the corporate tax by limiting the accumulation of retained product of technological advances made since the 1960s earnings inside corporate tenants. Finally, we cannot see or changes in the regulatory or economic environment how curtailing these developments would advance any that make it possible for one person to own the asset and policy objective that Congress has articulated. another person to use the asset. For example, as a result of technological advances, the monstrous radio transmission 3. C-to-REIT Conversions and REIT Spin-Offs towers of the 1960s have given way to cell phone towers, 241 Th is Part goes to the heart of what really seems to concern and the pneumatic tube systems and telegraph centers the REIT critics: C-to-REIT conversions and REIT spin- of the 1930s have been replaced by fi ber-optic networks off transactions. Critics seem to advance two arguments and data centers. 242 Similarly, as a result of changes in when expressing concern over these transactions: fi rst, fi nance and regulation, a power producer need not own the transactions are tax-motivated schemes that do not the transmission and distribution system that connects its advance real business objectives and therefore run afoul electricity plants to the power grid.243 of corporate tax policy; second, regardless of the existence In none of these situations did the IRS classify as real or nonexistence of real business objectives for the trans- estate an asset that would have been classifi ed as non-real action, the transaction results in materially decreased tax estate in 1960 had the asset existed on a stand-alone basis revenues for the government. Because Professor Borden in 1960. Th us, if one were to ask why the list of real estate has ably addressed the second argument, we will focus on assets today is diff erent than the list of real estate assets circa the fi rst argument. 1960, the clearest explanation is that technological and other Transactions are typically prompted by a variety of factors, developments since that time have either created real estate some of which are relevant to our tax policy debate and some assets that did not exist in 1960 or created opportunities for of which are not. When it comes to C-to-REIT conversions alternate forms of asset ownership that did not exist in 1960. and REIT spin-off transactions, we think that capital markets

MARCH 2016 247 MODERN REITS AND THE CORPORATE TAX

developments248 and the trend toward specialization help have owned real estate are now encouraged to dispose of explain much of the activity. In addition, in situations where that real estate and turn to third-party property owners a C corporation is converting into or spinning off a non- to fulfi ll their real estate needs. traditional REIT, the technological, regulatory and fi nance Second, as discrete business functions or business units developments described above also drive transactions. As become more narrowly focused, tenants’ real estate needs discussed below, we do not believe that either factor presents tend to become more narrowly focused as well. Th is means tax policy concerns that undercut the conclusion that REITs that property owners need to develop real estate that is should not be subject to the corporate tax. especially suited to the needs of tenants who are searching (a) Capital Markets Factors. Over the years, the capital for narrowly tailored properties. markets have become comfortable with two ideas that have Th ird, as property owners develop properties that are fostered growth in the REIT space. Th e fi rst idea is that more specialized, those properties become suitable for use some businesses can operate most effi ciently on a “capital- by a more narrow class of tenants. As property owners light” basis by renting rather than owning critical parts of become more focused on accommodating the demands of their value chains. Th e second idea, a corollary to the fi rst, an increasingly narrow type of tenant, the property own- is that other businesses can function profi tably by owning ers themselves, by necessity, start to become specialized critical parts of value chains and charging rent (or some providers of property. type of rent-like fee) for their use. Th is means that some On a stand-alone basis, the fi rst development can lead companies that would otherwise own the real estate in to REIT spin-off s as conglomerates or vertically integrated which they do business will choose to rent instead. When businesses narrow their focus to their non-real estate busi- this happens, it creates opportunities for other investors to ness operations. acquire that real estate. Th ese two ideas, when combined Th e second development can lead to C-to-REIT con- with one another, can explain many C-to-REIT conver- versions in situations where a company that at one time sions andd REITREEIT spin-off s. operated multiple business lines narrows its focus so that OtherOhOther rerelevantlevant cacapital markets factors are the enhanced its primary business is real estate and any ancillary busi- emphasismpphasiis thatth hat investors innve s place, especiallyespec recently,ce ly on nesses can fi t insidenside a TRS.T yield-generatingieldd-generating securitiessecs 24924 combinedcombined with thehe chang-chang- EachEach of thesee cascases involvenv lv businessesu ine ses changinghannging tthee waway ingng fi nanancialncial metmetricsrics ununderr which pupubliclic C cocorporationsrp at ns thatth theyhey ooperateate in oorderde too enhaenhancece effi ciencyciency and profipro ts. noww operate.ope erate. In a aw worldorldrl whereere investors inves are willing w ing to pay pay Th at’st’s what wh businessesusinesse arear supposupposeddtodo to do. a premiumium for fo securities that pay a predictable yield, and (c) Policy Implications of C-to-REIT Conversions and where capital markets fi nancial metrics are punishing many REIT Spin-Off s. Th e developments described above are all non-real estate companies that own the real estate in which driven by business concerns and do not change the manner they conduct business, many C corporations that would in which REITs operate. In our view, to the extent these in prior times have chosen to accumulate their earnings developments are fostering growth in the REIT space, and operate in C corporation form are pressured to either they are advancing the policy objectives underlying the dispose of their real estate assets, through a spin-off or 1960 REIT legislation by providing small investors with sale-leaseback transaction, or convert to REIT status, even access to yield-producing asset classes that they could not though the costs of doing so can be quite large and the loss otherwise access and enabling asset owners and sponsors of fl exibility can restrain management in signifi cant ways. to access the public capital markets. More importantly, (b) Specialization of the Firm and the Separation these developments are advancing the policy objectives of Asset Ownership and Usage. American businesses underlying the corporate tax, as they are both acceler- have been trending toward specialization for at least 40 ating the distribution of C corporation E&P through years. Th at trend toward specialization—a term that we a “purging” dividend, which is a prerequisite for every use colloquially to refer to a process in which a business C-to-REIT conversion and REIT spin-off , and prevent- focuses on performing fewer and fewer functions at higher ing the accumulation of retained earnings by corporate and higher levels of quality—is playing out in the REIT tenants of the REIT, which must pay rent to the REIT, space in three ways that are relevant to the current tax which in turn is distributed to shareholders. In addition, policy debate. any TRS income would remain subject to the corporate First, as conglomerates and vertically integrated compa- tax, as would any built-in gain recognized by the REIT nies become more unwieldy from a management perspec- during the fi ve-year period following the conversion.250 tive and less attractive from a cost-of-capital or capital- Finally, we have not identifi ed any other congressional markets perspective, businesses that, in prior times, would objective that would be advanced if these developments

248 TAXES The Tax Magazine® MARCH 2016 were to be curtailed (or, in the case of REIT spin-off s, any property owners, which may be direct competitors of objective to support their recent curtailment as noted in the new REITs but could not achieve the tax and nontax the introductory endnote to this article). benefi ts of being a REIT. Insofar as Professor Avi-Yonah’s “regulatory” view of corporate tax policy is correct, this D. Concluding Thoughts on REITs, result would frustrate that policy by hindering the antidote the Corporate Tax and Modern to monopoly—competition. In our view, the recent developments are a successful Developments on the REIT Space example of the tax law remaining true to its underlying Aside from the impact of false premises and strong words, policy objectives—i.e., the objectives underlying both a good portion of the debate around the tax policy implica- the 1960 REIT legislation and the corporate tax—while tions of the REIT industry seems to stem from diff ering adapting to changing times. We simply do not see a tax levels of comfort and discomfort that debate participants policy problem here. have with progress and change. Some participants seem to be comfortable with the idea that REITs can remain true to VI. Policy Recommendations the policy objectives underlying the 1960 REIT legislation and the corporate tax while at the same time adapting their for Rationalizing Our System of asset bases and approaches to tenant relationships in a way Collective Investment Vehicles that responds to developments in technology, regulation, fi nance and the capital markets; other participants seem to Although the REIT critics might not have realized it, the think that if a particular asset class or operating style did debate they spawned is, at its heart, a debate about collec- not exist in 1960, then it is verboten for REITs. tive investment vehicles, what role they should play in our Th e fact that the REIT industry has grown dramatically tax system and what set of tax rules should govern them. and thathat REIREITsITs have changed in size, asset-class exposure Th e debate really involves four questions, each of which is andd opeoperatingrating stylestyley over the years cannot, in and of itself, explored below. First, should collective investment vehicles createreaateatate a ttax ppolicy ypy pproblem.m. Th ese typestype of developmentselo m be subject to thehe corpcorporateor tax? Second, if not, what types shouldhouuld oonlynly bbee viewedviewv as problematicproblemati if one of the fofol-ol- of inincomecome shoulduld collectivec ct e investmentinvestment vehicles vehic es be alloweda owe lowingowiing tthingshings are trutrue:ue: (i) REITs are fafailingling to aadvancedv nc thehe to receive?ceive Th ird, whatw at operatingperati g model sshouldhould tthehe tax populistpulist and capicapitalita mammarketss policy oobjectivesectives underlyingund rlying sysystemem adopt ad for collective collective investment inve ment vehicles? ve cles? Fourth, Fou the 1960600RE REITEIT legislation; (ii) REITs are acting in a way what other tax law changes should be adopted and what that would run afoul of the policy objectives underlying other issues should be considered in order to enable the the corporate tax by becoming, or allowing others to be- collective investment system to function properly? come, monopolists that excessively accumulate retained earnings; or (iii) REITs are hindering some other, more A. Collective Investment Vehicles Should important policy goal of Congress. Not Be Subject to the Corporate Tax Each of the recent developments described above enables REITs to carry out the policy objectives underlying the A threshold question in any tax policy debate is rev- 1960 REIT legislation by providing small investors with enue—or, more precisely, whether the debate is going to exposure to asset classes in which they would otherwise be be all or mostly about revenue. We have not considered unable to invest and by enabling asset owners and spon- revenue in this article for three reasons. First, depending sors to access the public capital markets. Because REITs on one’s perspective, the corporate tax is either a regulatory must still distribute their earnings on an annual basis and tax designed to combat monopoly and curb managerial may not end a tax year with C corporation E&P, REITs power or the outcome of a political settlement between the are not running afoul of the policy objectives underlying government and managers in which corporations pay tax the corporate tax. Indeed, the REITs described above, as the price of having the power to retain their earnings. through their collections of rent and rent-like fees from Viewing the corporate tax through either lens, revenue other corporations, actively advance those policy objectives ought to be relevant only to the extent necessary either by limiting the accumulation of retained earnings inside to achieve the regulatory policy objectives underlying those corporations. that tax or to impose the proper upfront charge for the Finally, if recent C-to-REIT Conversions and REIT fl exibility of retaining earnings. Because REITs do not Spin-Off s were to be curtailed, newly formed REITs would operate in a way that implicates either goal, revenue ought have a competitive advantage over older C corporation to be irrelevant to an analysis of the proper taxation of

MARCH 2016 249 MODERN REITS AND THE CORPORATE TAX

REITs. In other words, if the corporate tax rate is too low, returns and companies can be expected to enjoy a lower or if the corporate tax base is too narrow, to achieve the cost of capital because both groups are able to transact policy objectives underlying that tax, then the corporate with each other without having to go through the bank- tax rate or corporate tax base should be adjusted. Neither ing system. Without collective investment vehicles to of those issues, however, should be relevant in any way unite savers and companies, savers would have to deposit to the proper taxation of an entity, such as REIT, which funds in a bank, and the bank would then lend funds to does not implicate those policy objectives. companies. Th at transaction would provide the bank with Second, Professor Borden’s work covered the question of a profi t that reduces the return of the savers, increases the REITs’ impact on tax revenues in a thorough and impres- cost of capital of the companies or both. Assuming that the sive fashion, as discussed above. Th ird, debates that are collective investment vehicle is not subject to the corporate driven by revenue always seem to devolve into a battle of tax, the profi t that would otherwise go to the bank can be the lobbyists. Because the government possesses both the split between savers and companies. pen and the gun, it can take money from whomever it Finally, and perhaps most importantly, the act of col- wants, and it suffi ces to say that most people believe that lective investment, at its heart, helps achieve socially the government should take whatever money it needs from desirable goals that should be encouraged, or at least not someone else. Given that lobbying is not our forte, our discouraged through the imposition of an entity-level tax. analysis of the proper taxation of collective investment ve- As is refl ected in the populist objectives of the RIC and hicle is framed in terms of traditional corporate tax policy. REIT legislation,251 the act of collective investment is the As discussed below, we believe that collective investment primary, and perhaps the only, way that small investors vehicles, as they currently exist and as they would exist if can save their money in a manner that earns a reasonable our policy recommendations were adopted, should not return without exposing them to levels of risk that would be subject to the corporate tax. ordinarily be unwise for an investor to assume. A small In lightlighht of thet policy objectives underlying the corporate investor that has only a small amount of savings to invest, tax,x, ttherehere iiss nnoo rreasoneae for collective investment vehicles say $1000, will have a diffi cult time managing its risk if toobo bbe subject subbjectttott to thatthat tax.. Th roughout their history,st y, col- it must invest in asseassetss directly. For this investor, it may lectiveectiive investmentinvestmentn vvehicless have functfunctionedoned bby aacquiringquiring be ddiffiiffi cultcu too dirdirectlyy buyuy enenoughough diff erentereent stostocksks tto assetsssetts or fi nancialnancial instrumentsinnstr ents that generateg nerate returnsretu s suchch achieveac ve a reasonableonable levelev l of diversifidi rsifi cation,catio , and buyingbuy as rerent,ent,ent iinterest,ntereest,est ddidividendsidende andnd capitcapital gainsains aanddh haveve ddis-s a diversifiversifi ed portfolioortfolio of real estate es e would beedow downrightnr tributedd their cash fl ow to investors on a regular basis. By impossible. Without collective investment, our investor distributing their earnings, collective investment vehicles has a diffi cult choice: either purchase an ultra-safe invest- have not implicated the policy objectives underlying the ment such as a U.S. treasury bond (which, while safe, corporate tax. will generate a low return), or gamble on a nondiversifi ed In addition, to the extent that a collective investment portfolio of directly held assets (which puts the investor vehicle owns an asset or fi nancial instrument that func- at signifi cant risk of losing a large portion of his savings tions economically as a claim on the income of a corpora- in the event of a downturn in the few areas in which he tion—for example, through rent or interest paid by the has invested). But collective investment gives the inves- corporation to the collective investment vehicle—the tor a third option: buy, with thousands of other similarly collective investment vehicle is engaging in activity that situated investors, a very tiny share of a diversifi ed and limits the growth of the corporation’s retained earnings professionally managed portfolio of assets that can earn, and is therefore advancing one of the policy objectives over the long haul, a reasonable return while being able underlying the corporate tax. to absorb market volatility along the way. Because collective investment vehicles distribute Th is strategy works well when the only thing cutting their earnings on a regular basis and limit the ability into the investors return is a small fee paid to the profes- of corporations to retain their own earnings, collective sional asset manager. But when an additional 35 percent investment vehicles mesh nicely with both the regulatory of the investor’s return is diverted from the investor to view and the capital lock-in view, both of which focus the government in order to pay corporate-level tax, the on retained earnings. investor very well may determine that the risk-spreading Moreover, collective investment vehicles, by defi nition, benefi ts of collective investment are not worth the cost of help create a bridge between investors seeking to deploy a corporate-level tax. In that case, the investor is left with capital and companies that need capital. By providing its original choice between, on the one hand, very safe but that type of bridge, savers can be expected to earn higher low-yielding investments and, on the other hand, very

250 TAXES The Tax Magazine® MARCH 2016 risky but (potentially) higher-yielding investments. Th ose But these terms are useless as criteria for distinguishing who anticipate needing more than the returns generated between activities that should be subject to the corporate tax by the safest investments in order to save for expected or and activities that should not, except in the broadest sense. unexpected life events—such as the acquisition of a home, Like many other terms in the 1960 REIT legislation, the the education of one’s children, and one’s retirement—may term “passive” did not originate in 1960. At the time of opt for the higher-risk approach. We would expect that the 1936 RIC Legislation, “passive” investment was to be most would agree that it is socially and economically un- distinguished from “active” investment based on the degree desirable for small investors to use modest savings to make to which an investment trust had the power to control its high-risk investments. Fortunately, collective investment portfolio companies through the ownership of voting shares. vehicles can give these investors a safer alternative with Th e 1936 RIC Legislation’s requirement that an investment which to achieve their goals. Th e imposition of a corpo- trust not own more than 10 percent of its portfolio company rate tax, however, would signifi cantly impede the ability was aimed precisely at curtailing this sort of “active” control, of collective investment vehicles to do so. Indeed, this is which Congress worried could lead to monopoly.254 one of the main premises underlying subchapter M. 252 A RIC’s ability to control its portfolio companies has Collective investment vehicles are thus benefi cial for everything to do with the stake it holds; it has little to a number of diff erent reasons. Th ey do not operate in a do with the nature of its activities with respect to those way that implicates the policy objectives underlying the companies. Suppose there are four corporations in the corporate tax and, indeed, often times affi rmatively help United States engaged in business X and a RIC acquires advance those objectives. Collective investment also helps 100 percent of the stock of all four corporations. Th e RIC develop our capital markets, which necessarily helps both would then be in a position to vote its shares in favor of savers and businesses, and can foster socially desirable goals the same directors for all four companies.255 associated with saving money for future needs without Th e RIC in this example could simply collect and dis- bearingng uunreunreasonableaso levels of risk. Th ese types of activi- tribute to its investors the dividends received from those tieses shouldshouuldld notnot bebe punished or discouraged through the corporations, without taking any further action. In modern impositionmposition oofacof a ccorporateorp e ttax. parlance, the RIC wouldwo ld be considered a “passive” investor in securitiessecuriti becauseecaus thehe RICRIC simplyimply purchasedpur hased and votedvote B. WhaW Whathat T Typeype ofo I Incomeome Sh Shouldul theth stockock ofo fourur corpcorporations,ra ons, cocollectedected and distributedistribu ed the Collectivellecll ctitive InvestmentIIn estt tV Vehicles h EEarn incomein me earned ea on that stostockck and tookok no fufurtherher actaction.on In 1936 parlance, however, the RIC would be considered an and How Should They Earn It? “active” participant in the market because, by virtue of its 1. Moving Beyond the Words “Active” ownership of every corporation in a line of business, the RIC sat atop a monopoly. Th e fact that the RIC did nothing other and “Passive” than vote its shares and collect and distribute dividends was Before discussing the types of income that collective irrelevant to the classifi cation of the RIC as “active.” investment vehicles should be allowed to earn, we want Once we move beyond a discussion of monopoly power, to focus on what types of activities collective investment the “active/passive” distinction has nothing to do with vehicles should be allowed to pursue in order to earn that the policy objectives underlying the corporate tax. Th e income. Th at, in turn, requires us to focus on the one corporate tax was enacted to enable the government to aspect of the REIT critic argument that we have alluded reach corporate retained earnings. Entities either retain to but have not yet addressed—the distinction between their earnings or they do not, and the concepts of “active” “passive” and “active” income. and “passive” have nothing to do with the existence or In expressing their concern about the role of modern absence of retained earnings. REITs in the tax system, some REIT critics advance the idea Moving from etymology to current usage, the words that “investment entities” must remain “passive” in nature “active” and “passive,” as they have come to be used in the in order to be exempt from the corporate tax, while “oper- modern debate, are often times more than useless—they ating entities” are “active” in nature and therefore must be are downright dangerous. Th at is because, although these subject to the corporate tax.253 A number of recent articles words have no real meaning in the tax policy sense, they seem to suggest that REITs are no longer “passive” because, have the ability to conjure up enough of a mental image through the use of TRS structures or other developments, that many participants in the debate come away thinking they have become “active.” Th ese articles advance both as- that they know what these words mean when, in reality, sertions without defi ning the terms “passive” and “active.” each participant is likely to have a diff erent image in

MARCH 2016 251 MODERN REITS AND THE CORPORATE TAX

mind. In the end, it is highly doubtful that anyone using through its agents, negotiate the terms of debt instruments the words “passive” and “active” to distinguish between directly with borrowers or their agents and engage in other those entities which should and should not be taxed could activities that are typically viewed as a “loan origination craft legal defi nitions of those terms without relying on a business” in tax parlance. 256 Th is type of activity is viewed facts-and-circumstances approach. In that respect, distin- by the IRS as a trade or business,257 and it would not be guishing between “active” and “passive” income, as those a stretch to say that certain RICs are part of the so-called terms are used in the modern debate, is much the same shadow banking system. as distinguishing between art and pornography. Th e tax Perhaps, the best example of RICs that are “doing system cannot function in a rational way if it has to rely things” are business development companies (BDCs) that on these types of distinctions to draw the line between operate in RIC form (“BDC RICs”). A BDC RIC is basi- entities that operate within and without the corporate tax. cally a commercial lender that engages in lending transac- To illustrate the uselessness and dangerousness of the tions directly with customers and relies on the commercial active/passive distinction, consider the classic example debt markets rather than traditional retail depositors in of a supposedly “passive” entity—the RIC. Many com- order to fund itself. A BDC RIC, almost by defi nition, is mentators will look at a modern REIT, observe a TRS a type of bank, and banks are certainly “doing things.”258 with employees who are “doing things” (e.g., managing None of this is meant as a criticism of the RIC vehicle. properties, providing services, etc.) and advance an anti- On the contrary, these are simply facts in the RIC space, REIT argument along the following lines: “Because REITs and it is helpful to bear that in mind whenever a com- are doing things with their own employees, the REITs are mentator calls out RICs as the “passive” counterpoint to active, unlike RICs, which by defi nition are passive. Th at those “active” REITs that need to be reined in. is why REITs should be subject to the corporate tax while In reality, the idea that we can defi ne a real estate com- RICs should remain exempt.” pany as “active” or “passive” depending on whether it has Th ose wordwordsds ccreate images in readers’ minds and actu- “employees” or whether it “does things” has proved diffi cult allyy soundsounndd plausibleppllausib until one realizes that RICs have since the early 1960s. For example, in Rev. Rul. 67-353, the alwayslwaays “done “donee thithings”ing in order to makmake moneyy andnd are IRS ruled that REIT trusteesru could “contract for the con- “doingdoiing tthings”hings” rirightghtg now in order to makem mmoney.n y. WiWithth structionstruction of ann offi ce buildingbu ding on land ownedowned by ththee trustrust theheh excexceptioneption ooff inindexnde funds,unds, whiwhichh are ddesignedsi ne to withoutw out adverselyad ely aff ectingtin [the trust’s]tr st’s] qualifi cation aas a real holdldddast a staticsttatic baskbasketke of ssecuritiesities thathat changeshanges only as ththehe estatees e inveinvestmentnt trusttrust,””no notwithstandingtwithst ding ththe ruleule thathat RREIT securitiesti s comprising com the underlying index are changed, trustees could “not directly manage or operate the trust’s RICs generally do not consist of static pools of securities. property.”259 We are not sure what Congress had in mind It is diffi cult for a mutual fund manager to justify its fee when it described REITs as passive entities, but from our structure if all it does is keep an eye on a pool of securities perspective, constructing a building certainly seems active. that never changes. Sometimes, rather than directly comparing RICs and RIC managers exist in order to develop and implement REITs, the REIT critics compare diff erent types of REITs investment strategies, and they cause the RICs that they and conclude based on the comparison that some of the manage to buy and sell securities and do other things in modern REITs are abusive. Th is occurred recently in the furtherance of those strategies. Th us many, if not most, case of data center REITs, which were alleged by some nonindex fund RICs are engaged in the trade or business REIT critics to have crossed the line from “passive” land- of trading in stocks and securities. Many RICs, acting lords to “active” electricity companies.260 through their external managers, will also investigate As described above, data centers are buildings that securities for potential investment, actively monitor the provide a specialized function—they are tailored to house companies in which they invest, engage with the directors the computer servers on which every major modern busi- and chief offi cers of the companies in which they invest, ness relies. In order for a computer server to carry out its and occasionally push directors to take action advocated function, at least four things need to be true—the server by the RIC. Th e fact that a RIC might do these things needs to be located indoors (they do poorly in the rain); through an external manager acting as agent of the RIC is the server needs to be plugged into an outlet; the room irrelevant to the conclusion that, for tax and commercial needs to be kept cool so that the server will not overheat; purposes, the RIC is out there in the world “doing things.” and the server needs to be connected to the internet so Th e activity level of debt-focused RICs provides an that employees who work in other locations can access the even better example of the extent to which RICs are “do- data located on the server. Not surprisingly, data centers ing things.” A bond fund functioning in RIC form may, require electricity and Internet connectivity—or, more

252 TAXES The Tax Magazine® MARCH 2016 precisely, lots and lots of electricity and extremely good of suffi cient electricity to Tenant should cause either REIT internet connectivity. to trip over some imaginary line into the world of the In addition to highlighting the aversion to change and “active” electricity business. Th is outcome makes no sense specialization exhibited by many REIT critics, the ques- from either a technical perspective or a policy perspective. tion of whether data centers are really electricity companies It is no surprise that policy makers and commentators goes to the heart of why the active/passive distinction is so alike have struggled with the passive/active distinction, es- dangerous. For example, assume that: (i) REIT 1 owns a pecially as it is used to distinguish between interest, which 50-story offi ce tower on the water front, next to the train seems to be “passive” in all cases, and rent, which some station and the expressway ramps, smack in the middle people view as “passive” and others view as being either of the nicest and most desirable part of downtown; (ii) “active” or “passive” depending on the circumstances. In each fl oor has 10,000 square feet of leasable fl oor space, an economic sense, however, there is no meaningful dif- for a total of 500,000 square feet; and (iii) Tenant is a ference between what tax lawyers call interest and what we large investment advisor and broker dealer that needs call rent—one is a payment received by a money owner 400,000 square feet of space for offi ce/conference space for the use of money and the other is a payment received and 100,000 square feet for its computer servers. by a property owner for the use of property.261 Interest and In this situation, if Tenant were to lease all 50 fl oors rent are both paid and received in exchange for the use of of the building, using the upper 40 fl oors for offi ce/ capital, and it is diffi cult to create a meaningful distinc- conference space and the bottom 10 fl oors to house its tion between the two that makes sense from a tax policy computer servers, it is impossible to see how the provision perspective. From what we can tell, the only people who by REIT 1 of suffi cient electricity to fuel all of Tenant’s have gotten the rent/interest analysis correct are econo- needs would somehow result in REIT 1 stepping across mists, who generally use the term “rents” to describe to the “active/passive” line (wherever that happens to be) and all returns on capital, whether couched as rent, interests, morphingphinng fromfroom a commercial landlord into an electricity dividend or royalties for commercial purposes. company.mpany. WWee cacannotnnn imagine a court reaching that result. Returning to our profession,p we think that, beyond But, Buut, ofo course,cou urse, ththe Tenantnant in this exexample wowouldld not guarding againstnst the ccreation of monopolies, the very wantwannt to rent 10 fl oorsoo of high-end offiffi ce spacespa e inn orderorder notinotionon ththat businessusine entitiesnt ies sucsuchh as RICs or REITREITs coulcould too hhouseouse its ccomputers.ompup ters ThThe e high-end high-en offi ce sspacepa is toooo bbe classifiassifi ed inn a memeaningfulin ful waway from the taxax polipolicyy per- expensive,peensivve, andan nd Tenant Teenantnt wouldd rather seekek out dataata centcenterer spspectivetive aas “active”tive” or “pa“passive”sive” wwas never hhelpful,pful aandnd the space in amoa more effi cient location. At this point, specializa- notion, to the extent used outside the monopoly context, tion starts to play a role in two respects. First, if REIT 1 ought to be discarded once and for all. makes its money by leasing high-end offi ce space in the best parts of the towns in which it operates, its executives 2. A New Way to Think About Collective and business people have probably been focusing on Investment Vehicles that segment of the market for most of their careers and If the current policy debate around REITs makes one thing probably do not know much about data center proper- clear, it is that we need a new way to think about collective ties in more effi cient locations. Second, Tenant is likely investment. Th e REIT critics are not wrong for wanting to to be sophisticated enough to know that, in terms of cost police the line between the corporate tax system and what and expertise, REIT 1 is not the place to go for its data lies beyond its borders. Th e diffi culty with the REIT critics’ center needs. approach, however, is that they have been focusing too In the end, Tenant is going to want to rent 400,000 much on what a REIT does in order to earn income and square feet of high-end offi ce space from REIT 1 and not enough on the type of income the REIT is earning. 100,000 square feet of data center space from another Collective investment has always been about using saved landlord, very likely a REIT, much the same way as Ten- money to earn more money by letting someone else use ant might hire one law fi rm for its SEC regulatory work the saved money until it is needed to fund consumption. and another law fi rm for its employee benefi ts work. Th e concept of saving some money now so that you can From a tax policy perspective, Tenant is going to use the use it later is as old as commerce itself. Practically speaking, same amount of electricity whether it rents all 50 fl oors the only diff erence, aside from risk, between depositing of REIT 1’s waterfront offi ce building or, alternatively, money in a bank and depositing money in some form of the top 40 fl oors of REIT 1’s offi ce building and 100,000 collective investment is that, through the process of col- square feet of fl oor space in another REIT’s data center lective investment, small investors can team up with one building. We do not see why in either case the provision another and with large institutional investors in order to

MARCH 2016 253 MODERN REITS AND THE CORPORATE TAX

pursue a larger variety of investments that may off er greater First, what types of income should the vehicle be allowed and more diversifi ed returns. to earn? Second, how should the vehicles operate? Each Given that the act of participating in collective invest- of these questions is explored below. ment has been viewed by policy makers as something that ought to be encouraged, the income of vehicles for collec- 1. Income Classes for Collective Investment tive investment has historically been taxed only once, at the If the tax system is to have any role in simultaneously investor level. If collective investment is to be encouraged encouraging collective investment and discouraging the and diff erent types of collective investment activity are to accumulation of earnings inside corporations, the tax be taxed equally, then the process of identifying what is system needs to encourage the creation of private entities and what is not collective investment ought to focus on that can eff ectively impose their own type of tax on the the nature of the income being earned rather than on what corporate sector in the form of rent and interest, and these types of assets the entity owns or on how many things need entities should be allowed to sell their income producing to be done in order to earn the income. 262 In other words, assets at a gain, all without being subject to the corporate there is nothing inherent in the act of doing something tax. Th e interest component is easy enough to address that changes the nature of a return from the type of return conceptually, as RICs and REITs can already earn interest that a collective investment vehicle should be able to earn income without being subject to the corporate tax. Th e without paying a corporate tax into the type of return that signifi cant changes would take place in the rental and can only be earned through a C corporation. asset gains areas. All of this leads to four conclusions that form the basis of (a) Rental Assets. In terms of rental assets, we suggest our policy recommendations. First, to the extent that gov- that collective investment vehicles be allowed to own ernment views the practice of saving as benefi cial to society, and lease to unrelated third-party users any type of asset it follows that collective investment is a socially desirable that can be owned by a group of investors and leased to a activityty thatt ougought to be taxed only once, at the investor corporation in exchange for a rent-like payment. level.vellSl. SSecond,econdd,, so llolongon as collective investment vehicles oper- Th e two diffi cult questions here concern the type of atete iinnawn a wway ththathat doesd not off end the policpolicies underlyinger n the assets that thee entity cocould own and lease and the type corporateorpporate taxtax—— ii.e.,.e., bby distributingributing all ooff their eearningsrn ngs anandnd of seservicesrvice the entityenti wouldwo ld be ableable to provideprovide diredirectly,tly, aas operatingperrating in wwayay thatthath t doesdo not foster economicallyec nomica ly harmfular ful opopposedsed tot throughrough a TRS.T S behaviorhaaviorr such hhasth as thethhe creationcreare of monopoly mono ypowe power or giveive rise rise In termterms of tangibltangible asassets,ets ththe entityntity wwouldld be ablebl to to inappropriateropriit infl uence on government behavior—the own and lease any type of building, plant, machinery or vehicles themselves ought not be subject to the corporate equipment; any type of transportation asset that a corpora- tax. Th ird, growth in the number and variety of collective tion needs to use in order to function; and any privately investment vehicles can advance the policy objectives un- owned infrastructure asset that a corporation needs to use derlying the corporate tax by encouraging corporations to in order to pursue its own business. own fewer assets and pay rent for the assets that they use, Given the increasingly critical role of intellectual prop- a process that would inhibit the accumulation of retained erty in our economy, we do not think it makes sense to earnings. Finally, if we are to draw a workable line between prohibit collective investment vehicles from owning intan- collective investment vehicles that ought not be subject to gible assets. Th at said, intangible assets present uniquely the corporate tax and those entities that should be subject complex questions in this context, and there are two basic to tax, then we need to focus on the nature of the income models we could use to deal with them—the simple model earned by the collective investment vehicles (e.g., rent, inter- and the complex model. est, dividends and capital gains) and the distribution of that Under the simple model, a collective investment vehicle income on a regular basis, rather than on words that defy would be allowed to own and license to third parties any defi nition, such as active or passive, or the actions that the type of intangible asset for which no further development collective investment vehicle needs to take in order to earn work is necessary, and the entity would not be allowed the income in the fi rst place. to develop or improve intangible assets, either directly or through a “TRS.” Under this model, the entity could own C. Picking the Right Model assets such as fi xed patents; copyrights on items such as for Collective Investment Vehicles books, music and movies; and other business-related intan- gibles that are capable of being owned by one person and Once we decide to expand collective investment vehicles licensed by another. Th is model would be consistent with to include additional asset classes, two new questions arise. the idea of a collective investment vehicle earning money

254 TAXES The Tax Magazine® MARCH 2016 by allowing a corporation to use its capital in exchange securities, we need to be careful that the policy objective for rent, which advances the policy objectives underlying of expanding collective investment does not subvert the both collective investment and the corporate tax. policy objective of discouraging retained earnings and Under the complex model, the entity would be able to subjecting to the corporate tax those businesses that tend own, license and develop its own intangible assets, mean- toward monopoly. ing that the entity would be able to do R&D work for its Th e 100-percent tax on prohibited transactions, as own account and license the fruits of that R&D to third discussed above, can play a role in balancing those objec- parties. Th e main danger with this model is that develop- tives, but that tax is just part of the picture. Th e other ing intangible assets (e.g., software) for licensing to third part, we believe, lies in tweaking the TRS rules for the new parties is the type of business that tends toward monopoly, businesses that will be able to operate in a new collective which can bring the collective investment vehicle concept investment vehicle regime. into direct confl ict with the policy objectives underlying the corporate tax. If the complex model is to be pursued, then at a minimum the Code would need to adopt the REITs are thus often a good way to safeguards outlined below. invest in real estate, but in many In the end, we prefer the simple model because it is more consistent with the use of a collective investment cases a partnership or a C corporation vehicle as an entity that provides fi nancing in exchange will be a better investment vehicle. for a usage fee, which is what collective investment is supposed to be about. (b) Sale Assets. Th e concept of collective investment First, in order to ensure that a collective investment vevehicles selling assets raises two policy concerns, both hicle is not retaining earnings, we would require the “TRS” of whichhichh cann be addressed by existing provisions of the to distribute all of its taxable income and excess earnings to REITEIIT regime.regime. the collective investment vehicle. Th is rule would apply to Th The e fi rrst fir po policyolicyycoy coconcernn is that, if colcollective investmentnv tm all “TRSs,” bothth foreforeigngn and domestic, and in the case of vehiclesehiicles are ppermittedermittm to sell assets to customcustomerser in tthehe a forforeigneign “TRS,”S,” tthe TRTRS-levelS-level distribution requirrequirementmen ordinaryrdidinary cocourseurse ofofb bus bbusiness,s, they wowouldld be abablee to ccom-m- wwouldd appapply evenven wherewh re thehe income income earned by the foreignfore petetee unf unfairlyfairlyy wit withth manmamanufacturerscturers wwho are ooperatingera ing inn “T“TRS”RS” is not includaincludableble in the incomecome oof thehe cocollectiveec C corporationoratio form. Th e second policy concern is that investment vehicle under Subpart F. Th e requirement to manufacturing businesses by their nature are scalable and distribute earnings at all levels of the collective investment tend toward monopoly, which implicates the policy objec- vehicle structure would help ensure that the policy objectives underlying the regulatory view of the corporate tax. tives underlying the corporate tax are not subverted by the Both of these concerns could be addressed through expansion of the collective investment vehicle concept. existing REIT provisions by imposing the 100-percent Second, we would apply the existing related party rent prohibited transactions tax on any sale by a collective and Code Sec. 163(j) limitations to the new vehicles and investment vehicle of inventory or assets held for sale to would expand the 100-percent tax on non-arm’s-length customers in the ordinary course of a trade or business. transactions to encompass any Code Sec. 482 adjustment In the case of assets that are produced or manufactured by between an expanded collective investment vehicle and the collective investment vehicle or one of its TRSs, the its TRS. 100-percent tax could be applied regardless of whether the Th is brings us to one of the more contentious issues property is sold at the collective investment vehicle level of the current debate—the provision of services. In our or the TRS level. Th is provision would likely prevent a view, any services provided to a user of an asset, whether collective investment vehicle from manufacturing or pro- tangible or intangible, should be provided through a TRS ducing assets either directly or through a TRS, and that of the collective investment vehicle or through an inde- is fi ne with us. To the extent the corporate tax is aimed pendent contractor from which the collective investment at discouraging monopolistic businesses, we think that it vehicle does not derive any income. Th e reasoning here makes sense as a policy matter to lock out of the collective is that, if collective investment vehicles were allowed to investment vehicle space manufacturing businesses that own and lease any non-real estate asset and simultane- tend toward monopoly. ously “bundle” assets and services, they might be able to (c) Additional Safeguards. If we are to expand the role compete unfairly with taxable providers of similar services. of collective investment vehicles beyond real estate and Requiring a “TRS” to provide all user services and policing

MARCH 2016 255 MODERN REITS AND THE CORPORATE TAX

that requirement with a 100-percent penalty tax on any sponsor can create a virtually unlimited variety of “regular” Code Sec. 482 adjustment in favor of the “TRS” would interests, which allows for the intricate slicing and dicing go a long way toward addressing concerns around the tax of mortgage cash fl ows in ways that are not achievable in system providing an unfair advantage to one entity over the grantor trust vehicle. Beyond that, the activities of a another. Th is is the same theory underlying the TRS rules REMIC are almost as limited as those of a grantor trust, and the regime for “unrelated business taxable income” and most folks view REMICs as “set-and-forget” vehicles (UBTI), and we think that theory applies with equal force that are only suitable for holding a static pool of securities. here. Th ese rules, when coupled with the TRS-level earn- Master limited partnerships (MLPs) are entities that ings distribution requirement and the other safeguards are organized as state law limited partnerships or limited described above, would also help ensure that an expanded liability companies. Because MLP units are traded on collective investment vehicle concept does not run afoul some type of stock exchange, MLPs are subject to tax as of the policy objectives underlying the corporate tax. corporations unless they satisfy a 90-percent passive in- Although these requirements are stricter than those ap- come test. Th e income test itself represents a smattering plicable to REITs, we think they are necessary to ensure of items, some of which make sense based on the existing that collective investment vehicles are earning returns in treatment of other entities (e.g., income that would qualify respect of rent and interest and that they are acting in a for a REIT or RIC is generally qualifying income for an way that does not run afoul of, and in fact helps advance, MLP), while others make sense only in the context of the policy objectives underlying the corporate tax. broader policy objectives ( e.g., promotion of fi nancing for natural resource activities). 2. Choosing the Best Operating Model (b) Expanding Subchapter M. Anyone who works in Expanding the REIT concept to additional asset classes is a Subchapter M acknowledges that this is a Tylenol-intensive quixotic venture to say the least, and if an expansion were practice area. Th e sheer number of technical requirements to requirequirre a bbranbrand new tax infrastructure, the entire ven- and unexpected results produced by those requirements turere wouldwouuldld likely likklkely collapsecoc under its own weight. Th erefore, can be either mind-bogglingg or mind-numbing, depend- we thinkt k that tiftht if ththehe REITT concept is to expand,, iit shouldh ing on the day.y. do ssoo throughthrouggh anan existinge g collective investmentnvestm n vehiclevehiccle ThThat at beingbe said,aid, ffor a vvarietyriety of reasons, frofromm an ininvestorvesto underndddher tthehe CCode.ooddThe. Th isis PaPart reviewseviews the existingxisting vvehicleseh es andnd anand capitcapital marketsarkets perspective,er pective expandinexpanding the universeuniv concludesnccludees ththat, hat,hat if f thehee REITR T concept concep isstobe to be expanded,expanded of collectiveollecti investmentvestmennt vvehicleshicles by expandexpandingg SubcSubchapterha the bestt way tot do that is by amended Subchapter M, as M is probably the easiest and best way to carry out our the other collective investment vehicles are too narrow policy recommendations. First, Subchapter M entities for the task at hand. provide signifi cant fl exibility in terms of capital structure, (a) Existing Operating Models for Collective Invest- corporate governance and marketability, as they can be ment. Next to REITs, the oldest collective investment vehicle organized as corporations, limited partnerships, limited is probably the grantor trust. A grantor trust can hold a va- liability companies and business trusts, and can have a riety of assets, but is often used to hold debt instruments in wide variety of share classes. order that the interest payments on those instruments may Second, the Subchapter M entities provide a level of op- qualify for the portfolio interest exemption. Th e benefi ciaries erational fl exibility and investor friendliness that the other of a grantor trust often share in distributions on a pro rata current collective investment vehicles cannot come close to basis, and the ability to create multiple classes of ownership matching. For example, because they can organize as state is extremely limited. In the end, the grantor trust is a plain law business entities, Subchapter M entities can buy, sell and vanilla, “set-and-forget” type of vehicle and is useful only for operate a variety of assets, which is something that grantor the widespread ownership and disposition of a static pool of trusts and REMICs cannot do. Second, because Subchapter securities or income-producing fi nancial instruments and the M entities are treated as corporations for most tax purposes, distribution of the proceeds attributable to the ownership they can take advantage of the Subchapter C infrastructure and disposition of those securities or instruments. for purposes of carrying out acquisitions, dispositions and Real estate mortgage investment conduits (REMICs) can consolidations of other entities. Although we have spent be thought of as more useful versions of the grantor trust, most of this article arguing that the Subchapter M entities but only in the real estate mortgage space. REMICs are ought never have been subject to the corporate tax in the vehicles that own mortgages on real property. REMICs are fi rst instance, we now have 80 years of rule-making and allowed to issue “regular” interests that are automatically judicial doctrines behind us and, from an administrative classifi ed as debt instruments for tax purposes. A REMIC perspective, we ought not reinvent an entirely new regime

256 TAXES The Tax Magazine® MARCH 2016 when we can rely on a regime that has already been devel- foreign governments is more political than tax policy, and oped. Finally, the Subchapter M entities pay out dividend leave the question to the politicians; in any event, in our income and report on Form 1099, which makes them more experience, the level of sovereign investment is not big tax effi cient for foreign and tax-exempt investors and easier enough to move the net tax receipts needle for a country to deal with for individual investors. of this size in any meaningful way. On pension funds, the bottom line is that the income that moves from a REIT to a D. Ancillary Policy Issues pension fund will eventually be taxed at ordinary rates when the money moves from the pension fund to the pension 1. What Other Changes Need to Be Made in benefi ciary. Th is issue is therefore one of timing, and, given Order to Ensure the Success of Collective the social policy objectives underlying the tax treatment of Investment Vehicles? pensions, combined with the struggles that pension funds already face in satisfying future commitments, we think the Although expanding Subchapter M sounds simple, such better view is to defer the taxation of the income until the an expansion would create a ripple eff ect of questions pension fund makes distributions to benefi ciaries. throughout the Code, some of which are addressed here. First, and perhaps most importantly, if one of the reasons 2. Shareholder-Level Changes behind the expansion of Subchapter M is the desire to Th e expansion of the REIT operating model to new as- encourage corporations to rent rather than own their asset classes can be expected to have ripple eff ects at the sets, then we need to reassess those provisions of the Code shareholder level. Th e fi rst one that comes to mind is the that encourage corporations to buy assets. For example, if dividend withholding tax on non-U.S. investors. REIT we want to encourage Subchapter M vehicles to acquire dividends are generally subject to 30-percent withholding, equipment and rent that equipment to corporate users, it which may be reduced to 15 percent under a treaty. By makeses senseseense to t eliminateel the bonus depreciation provisions contrast, C corporation dividends, although subject to thatatt wowoulduuldld ootherwisetherwiw encourage corporations to buy that a nominal 30-percent withholding rate, are eligible for equipment.quiipmeent. In n addition,add ditditi too the extent the corporateat taxax was more generouss reducreductions,io and in certain cases outright desigdesignedgned to iinhibitnnhibit tthe accumulationumulation ooff retaineretainedd eearnings,arninggs, exemexemptions,mptio undernder ourr taxx treatyaty network. it wouldwooulddld alsoalso makemakek senseen too revisit otherot er noncashnoncash deduc-de c- As discdiscussedd abovabove, oourr recommendationso mendations are ppolicy-ol tions,ns,nns in includingncludding ththee ddedeductiontion for accruedcrued butut unpaunpaidd bbasedd and not revenuerevenue-basedbased (iei.e., althoughthough ourr recomrecommen-mm originall issue discountd on corporate debt. dations could reduce revenue in certain cases, we are not To the extent that Subchapter M is expanded to al- trying to achieve that result and would be completely happy low Subchapter M entities to earn the types of income if revenue remained the same or increased). With that in currently being earned by MLPs, then investors in those mind, we would suggest that our treaties be amended where MLPs may suff er economically as their investor-friendly possible to impose on non-U.S. shareholders of a collective Subchapter M counterparts begin to come on line and investment vehicle the same withholding tax burdens to compete for capital and assets. On that score, it would which they would be subject if that entity were taxed as a be appropriate to modify the MLP rules in order to en- REIT. Where it is not possible to amend treaties, we sug- able MLPs to adapt to an expanded Subchapter M world. gest that the enabling legislation impose that increased tax Among other things, the MLP rules would be changed so on the collective investment vehicle itself and permit that that: (i) MLPs could convert into Subchapter M entities on vehicle, through its charter documents, to off set the entity- a tax-deferred basis, including tax deferral for MLP inves- level tax against the distributions otherwise payable to the tors who have “negative tax capital” in their MLP units; relevant non-U.S. shareholder. Th is mechanism already (ii) MLPs could report net income and distributions on exists in the mortgage REIT space, and many mortgage Form 1099 in order to relieve U.S. individual, tax exempt REIT charters already include the enabling language. and non-U.S. investors from state fi ling obligations, UBTI and ECI, respectively; and (iii) MLP distributions could be 3. What About Subchapter M Entities treated the same as RIC distributions for purposes of Code That Do Business with Noncorporate Tenants Sec. 1441 withholding, including pursuant to treaties. and Borrowers? It might also be appropriate to focus on whether investors such as pension funds and foreign governments should be To this point, this article has focused on REITs that allowed to receive dividends from Subchapter M entities interact primarily with corporate tenants, as those without paying Federal income tax. We think the issue of REITs have been the focus of the recent policy debate.

MARCH 2016 257 MODERN REITS AND THE CORPORATE TAX

Notwithstanding that focus, we think that REITs which tax (on top of the 35-percent corporate income tax) on focus on noncorporate tenants and borrowers should retained after-tax earnings. continue to be taxed under Subchapter M in light of If this law were to go into eff ect, Corporation X could the policies underlying the 1960 REIT legislation and become a takeover target for a large foreign corporation. For the historic treatment of collective investment vehicles example, if a U.K. competitor corporation were to acquire described above. Although these entities might not Corporation X in a noninversion transaction (so that U.K. inhibit the accumulation of retained earnings, they do competitor is still treated as a foreign corporation for U.S. serve ancillary social and economic objectives, includ- tax purposes), it could cause Corporation X to move the ing the provision of fi nance to the residential mortgage $10 billion from Luxembourg to Corporation X and from market and the provision of rental real estate to indi- Corporation X to the U.K. parent on a tax-free basis. Th at viduals. Because REITs that focus on noncorporate is because, although the distribution of the $10 billion tenants and borrowers advance multiple favorable policy from the Luxembourg CFC to Corporation X would be objectives, and we are unable to articulate any policy includable in Corporation X’s gross income, the off setting objective that would be advanced if these entities were dividends paid deduction would wipe out that income. If eliminated, we think they should continue to function the U.K. parent is entitled to the 0-percent dividend rate as they currently do. under the U.S.-U.K. income tax treaty, then the $10 billion would have escaped U.S. tax and landed in the hands of a 4. Should We Provide All Corporations with non-U.S. corporation. In that situation, unless U.K. law a Dividends Paid Deduction or Otherwise were to impose its own disincentives to the movement of Incentivize the Distribution of Earnings? earnings from the U.S. to the U.K. or to the retention of those earnings at the U.K. parent level, the change in U.S. One obvious question underlying our analysis is this: If law would have simply shifted the managerial power and the corporateorpooratee tax is all about limiting the accumulation of agency cost issues associated with the $10 billion of exist- retainedtaiidined earearnings,nniings, tthen why do we not simply encourage ing retained earnings, plusp 100 percent of all net earnings allll corporationsco orpooratioons to odo distributedi ute their earnings,earnin eitherer throughro from the futurere operationsoperati of Corporation X, from the a divdividendsvidennds ppaidaid dedddeductionn coupled wiwithh a punpunitivetive tax oon manmanagersagers of CorporationCorpo io X to thethe managersmanagers of theth U.K.U.K retainedetaiined earearningsnings orr ththroughgh an outroutrightght prohprohibitionib o on pparent.nt. Alternatively,A atively evenev n if CorporationCo poration X were too pull retainedaiined earnearnings?ningss? WhiWhWhile theseese mecmechanismsnisms wwouldoul woworkk ththe $10 billion b n upstream upstream from the th LuxembourgLuxemb urg CFC CFC and diff erently,ttly ththeyh would each advance the policy objectives distribute that money to its own historic shareholders, the underlying the corporate tax. U.K. parent, in the absence of some type of U.K. legal Th ere are experts in business and fi nance who would disincentive, could still benefi t from acquiring Corporation argue that retained earnings help foster innovation and X, as post-acquisition non-U.S. earnings could move from increase economic growth and that corporations’ abil- the U.S. to the U.K. parent and rest at the U.K. parent level ity to retain earnings should not be undercut. Although without any U.S. income or withholding tax. an analysis of those arguments is beyond the scope of In an environment where barriers to the movement of this article, we would like to make one simple point: capital are reduced by treaties and laws that encourage any negative eff ects of retained earnings aside, we do cross-border fi nance, a U.S. law change that simply shifts not think it makes sense to adopt rules to encourage $10 billion of retained earnings from a U.S. corporation or require all corporations to distribute their earnings to its non-U.S. parent does not accomplish anything posi- before we have analyzed the consequences of those dis- tive from the U.S. policy perspective and may potentially tributions and, if necessary, amended our laws and treaty make us all worse off by turning large sectors of corporate network to ensure that those eff ects do not create other America into takeover bait for non-U.S. competitors. unforeseen problems. Th is is not to say that we should never consider moving One possible consequence could arise from the ex- toward a world where corporations are discouraged from istence of multinational entities (MNEs). To illustrate retaining their earnings. Rather, if we are to consider do- the potential of MNEs to create harmful eff ects, assume ing that, we need to study and address the consequences that: (i) Corporation X is a publicly traded U.S. technol- of tax treaties and trade agreements. In the end, it may ogy company that has $10 billion of untaxed retained well be a system that discourages corporations from re- earnings in a Luxembourg CFC; and (ii) Congress passes taining their earnings is akin to pacifi sm—it works great a law that allows Corporation X to claim the dividends in theory, but only works in practice if everyone adopts paid deduction and subjects Corporation X to an excise it at the same time.

258 TAXES The Tax Magazine® MARCH 2016 VII. Conclusion investment vehicles that were impossible to construct due to the Morrissey decision and the corporate resemblance Although this article is excruciatingly long, the two main test. Th e third observation is an outgrowth of the second: points are incredibly simple. First, if we are going to have From the perspective of sound tax policy, which requires a tax policy debate that has the potential to pose an exis- that similar activities be taxed in the same way, the real tential threat to the REIT industry, which among other problem with the REIT regime is that it is too narrow and things is vital to the U.S. economy, we ought to use the excludes a number of economically similar asset classes correct premises to frame the debate. Second, the most that would be appropriate and suitable for inclusion in a recent tax policy debate on the proper taxation of REITs REIT-like collective investment vehicle. has been based on two fl awed premises—that REITs Th ese observations lead us to our policy recommenda- should be subject to the corporate tax in the fi rst instance tion—in order to advance the policy objectives underlying and that recent trends in the REIT space create a mate- the corporate tax and our traditional treatment of collec- rial drain on the fi sc. We have left the second premise to tive investment vehicles, as well as to create a coherent Professor Borden, who did a far better job than we ever system for the taxation of collective investment vehicles, could of addressing its faults. the REIT regime should be expanded (to the extent Th is leaves us to debunk the fi rst premise. On that score, described in Part VI above, and taking into account the the simple fact of the matter is that REITs, both histori- relevant limitations and precautions) to include any asset cally and currently, distribute their earnings and operate that can be owned by one entity and leased to another or in a way that discourages corporations from retaining their owned by one entity and fi nanced by another. own earnings. Th ese facts lay the groundwork for four REITs are simple vehicles, and talking about them in the simple conclusions. First, in light of the policy objectives context of corporate tax policy should not be as diffi cult underlying the corporate tax, REITs should never have as it has been these past few years. We think the diffi culty been subjectsubbjectt to the corporate tax. Second, in light of results primarily from a combination of adverse intellectual thoseosse policypoolilicy objectives,objbjeect when combined with the policy presumptions which frame our thought process as it relates objectivesbjeectivees underlyingun nderlyin thee 1960 REIT legislation,on REITsR to REITs and meaninglessmeanin le but powerful words such as “ac- shouldhouuld continuecontinue to not bee subject to the corporatecorpo ate tatax.ax. tive” and “passive.”sive. Th i is combicombinationnation has ccreatedreated a falsfalse ThirTh ird,rdd, rrecentecent ddevelopmentsevelov lopm s in the RREITIT spacspace rrepresentre nt ppremiseise ffor thee tax policyoli y debatdebate on the pproperoper tataxationxa a regulatoryeggulattory regimregimem anand a regulatedegulated industrydustry relyrelyingng oonn oof REITs,REITs andditisno it is nottp possibleossible to have a productiveoduct ve tax long-standingt nding llegal principles to respond to developments policy debate when we are starting from the wrong place in technology, fi nance and the capital markets. Fourth, intellectually. the tax system should encourage the growth of REITs, as It is time to reset the debate and remove from our minds payments made by corporations to REITs limit the abil- the ideas that REITs should have been subject to the ity of corporations to retain earnings and thus advance corporate tax in the fi rst instance and that words such as simultaneously the policy objectives of both the corporate “active” and “passive” can help us think about which activi- tax and the 1960 REIT legislation. ties REITs should and should not be allowed to pursue. Th ese four conclusions lead us to three observations. If our profession wants to debate whether REITs should First, it ought to be evident at this point that a combina- be included in the corporate tax base due to concerns tion of events—including the Supreme Court’s decision around tax revenue or some perceived change in the policy in Morrissey , Congress’ immediate but partial repeal of objectives of the corporate tax that is fi ne with us. Our Morrissey with respect to RICs and the development of views on corporate tax policy and the proper taxation of the now discredited and discarded corporate resemblance REITs are set out above, and we assume that others will test—have done signifi cant damage to the REIT industry express diff erent views. All we ask is that the debate be by skewing the policy debate against REITs. Second, those framed in terms of whether REITs, which should never events may have done their worst damage by preventing have been subject to the corporate tax, should now be the creation and development of other types of collective brought within that tax. ENDNOTES

* The authors thank Brad Borden, Jim Sowell, Rich- As this article was going to press, Congress 355(h)(1) (which prevents REITs from engaging ard Nugent, Barney Phillips, Jonathan Zanger and enacted the Protecting Americans from Tax in tax-free spin-offs) and Code Sec. 856(c)(8) the participants of the 68th Annual Federal Tax Hikes (PATH) Act of 2015 (Division Q of P.L. (which generally prevents C-to-REIT conversions Conference at the University of Chicago for their 114-113). Among other amendments effected by if the converting corporation had spun off, or useful comments. All errors are the authors’ own. the Act, Section 311 of the Act added Code Sec. had been spun off, from another C-corporation

MARCH 2016 259 MODERN REITS AND THE CORPORATE TAX

within the past 10 years). The portions of this REIT dividends do not qualify for the dividends effect of imposing a corporate-level tax on col- article dealing with REIT spin-offs and C-to-REIT received deduction). lective investment in the mutual fund context). conversions should be read as a critique of these 8 See, e.g. , UNITED STATES MODEL INCOME TAX TREATY 13 This was especially true for investors of modest new provisions. We view them as a product of a CONVENTION OF NOVEMBER 15, 2006 , art. 10.4 means in relatively low tax brackets, for whom debate that has been based on a false premise (providing that “Subparagraph a) of paragraph the benefi ts of shareholder-level tax deferral and conducted in a way that is inappropriately 2 [providing for reduced taxation on dividends] through the use of a corporation were minimal. skewed against REITs. This is what happens when shall not apply in the case of dividends paid by See Johnson, supra note 10, at 74–75. an institution loses sight of the policy objectives a U.S. Regulated Investment Company (RIC) or a 14 See H. Report. No. 2020, 86th Cong., 2d. Sess. underlying its legislation. U.S. Real Estate Investment Trust (REIT)” unless (1960), at 4 (citing the need to remove tax as 1 Oliver Wendell Holmes, The Path of the Law, 10 certain conditions are met). a consideration when investing in real estate HARV. L. REV. 457, 469 (1897). 9 Code Sec. 856(h)(3)(C) (treating certain divi- “because of the shortage of private capital 2 The House report to the REIT legislation states— dends from “pension-held REITs” as “unrelated and mortgage money for individual homes, … the equality of tax treatment be- business taxable income”). apartment houses, offi ce buildings, factories, tween the beneficiaries of real estate It is important to view these shareholder-level and hotels”). investment trusts and the shareholders drawbacks alongside the entity-level benefi ts 15 Id., at 3. of regulated investment companies is accorded REITs. If one were to compare taxes 16 By August 1961, REITs had raised $176 million in desirable since in both cases the meth- paid by a C corporation and taxes paid by a REIT, the public markets; by February 1963, that num- ods of investment constitute pooling one would think that the use of REITs drastically ber was approximately $300 million. See Cecil arrangements whereby small investors lowers overall tax receipts. But if one compares Kilpatrick, Taxation of Real Estate Investment can secure advantages normally available the aggregate tax liability of a C corporation Trusts and Their Shareholders , 39 TAXES 1042, only to those with larger resources. These and its shareholders with the aggregate tax 1044 (1961) and John MacDonald, Real Estate In- advantages include the spreading of the liability of a REIT and its shareholders, the vestment Trusts under the Internal Revenue Code risk of loss by the greater diversifi cation of picture is much different, and one realizes that of 1954: Proposals for Revision, 32 GEO. WASH. L. investment which can be secured through the impact of the REIT regime on the fi sc is far REV. 808, 808 (1963–1964). Following a stock the pooling arrangements … . less signifi cant than one might think. Professor market downturn in 1962, however, the market H.R. Rep. No. 86-2020, 1960-2 CB 731, 820. Bradley Borden has ably demonstrated this for REITs stalled and did not recover until the REIT 3 For example, equity REITs generally focus on the point. See Bradley T. Borden, Rethinking the regime was made more business-friendly. See E. acquisition, development, ownership and rental Tax-Revenue Effect of REIT Taxation , 17 FLA. T AX Norman Bailey, Real Estate Investment Trusts: An of real estate, while mortgage REITs generally Rev. 527, 530 (2015). Appraisal, 22 FIN. ANALYSTS J. 107 (1966). focuss on lendinlendingng to people and businesses that 10 See Simon Johnson, Reinvigorating the REIT’s Since 1972, the growth rate of the REIT in- acquire,cqquire, developdeveloop or ownowo real estate. Some eq- Neutrality and Capital Formation Purposes dustry has dwarfed that of the S&P 500 index: uituityty REITsREITs specializespecialize by focusingng on asseassets of a throughug a Modernized Tax Integration Model, 7 J. a 44,759-percent increase for REITs versus sspecifipeecifi c uuse,se, ssuchuch as offiffi cce buildings,ings, residential BUS. ENENTREPRENEURSHIPEP RSH & L. 61, 7766 (201(2013–2014)4) 11,708-percent,7 p for the S&P 500 indexindex. See BoBor- apapartments,artments, sshoppinghoppingn mmalls or, more recently, (“The(“T e newlyewly enactedenacted REITIT arrangementar angem [ofof deden, susupra nonotee 9, at 53534. dadatata cecentersnters oror prisons.prisonss Some may specialize 1960]960] wass viewedwed as tthee answerer for peoplele 17 SeeSe generally “Negativeegative InteInterestst Rates ini Europe:Eu evevenen fufurther,rther, for eexample,xax mple,ple by focusingcusing on a seekingsee ing a non-limitednon-limited partnershipar rship and a non-n- A GlanceG ance at Theireir Causes andd Implications,”Impli ati specifiecifi c segmsegmentente oof a particular market, such corporate business arrangement for pooled GLOBAL ECONOMIC PROSPECTS: A WORLD BANK as Class A apartments in urban locations or real estate investment. The REIT was heralded GROUP FLAGSHIP REPORT (June 2015), at 13. Class B/C apartments in suburban locations. In as the restoration of the small-investor real See also Martin A. Sullivan, REIT Conversions: terms of shareholder-level characteristics, a REIT estate trust as a tax conduit ….”); see also Jack Good for Wall Street. Not Good for America, THE can be classifi ed as publicly traded or privately E. Roberts, Public Ownership of Real Estate—Real TAX ANALYST BLOG (Sept. 15, 2014), available owned or by reference to the tax statuses of its Estate Trust Laws Provide New Impetus, 9 UCLA online at www.taxanalysts.com/taxcom/taxblog. shareholders (e.g., a “domestically controlled L. REV. 564, 564 (1962). nsf/Permalink/MSUN9NXQLG?OpenDocument REIT” or a “pension-held REIT”). See, e.g., Code 11 See Johnson, supra note 10, at 72. Johnson notes (“[I]n a market where investors are desperate for Sec. 897(h)(2), (4) (special rules under the the diffi culties faced by investors of modest yield, REITs have become extremely popular.”). Foreign Investment in Real Property Tax Act of means when investing in real estate through 18 See, e.g., Moody’s Investor Service, RATING METH- 1980 for “domestically controlled” REITs); Code partnerships. For reasons discussed below, the ODOLOGY: FINANCIAL STATEMENT ADJUSTMENTS IN Sec. 856(h)(3)(C) (special “unrelated business business requirements of these partnerships—in THE ANALYSIS OF NON-FINANCIAL CORPORATIONS, taxable income” rules for “pension-held REITs”). particular, certain sharing arrangements needed 9–11 (June 15, 2015). 4 Unless otherwise noted, references to the to aggregate a large amount of capital from 19 See, e.g., Justin Scheck, Cari Tuna and Ben Worth- “Code” are to the Internal Revenue Code of many small sources—made them particularly en, Companies More Prone to Go ‘Vertical’ , WALL 1986, as amended. susceptible to being classifi ed as corporations ST. J., Nov. 30, 2009, available online at www. 5 See Code Sec. 565 (defi ning the dividends-paid for tax purposes, which could result in an unten- wsj.com/articles/SB125954262100968855 (de- deduction), Code Sec. 61 (defi ning a corpora- able second level of tax. Partnerships composed scribing the trend over “the past half-century” tion’s taxable income) and Code Sec. 11 (subject- of smaller numbers of wealthy or institutional away from vertical integration). ing a corporation to tax on its taxable income). investors did not face comparable diffi culties. 20 While some of these C-to-REIT conversions and 6 Code Sec. 1(h)(11) (providing preferential See also John P. Carroll, Tax Policy for the Real REIT spin-offs have involved non-traditional RE- tax rates for so-called “qualified dividend Estate Investment Trusts , 28 TAX L. REV. 299, 301 ITs, many of them have involved traditional REIT income”); Code Sec. 857(c)(2) (providing that (noting that, after T.A. Morrissey, SCt, 36-1 USTC assets—land and buildings—that were subject to REIT dividends generally do not qualify for the ¶9020, 296 US 344, 56 SCt 289, “any vehicle triple net leases. preferential tax rates applicable to “qualifi ed for collective investment of funds in real estate 21 See Peter Boos, Runaway REIT Train? Impact of dividend income”). … would be taxed as a corporation); see also Recent IRS Rulings , 144 TAX NOTES 1289 (Sept. 15, 7 Code Sec. 243 (providing a dividends received Roberts, supra note 10, at 565. 2014); Sullivan, supra note 17; Martin Sullivan, deduction for most dividends received from 12 See Mark J. Roe, Political Elements in the Creation Economic Analysis: The Economic Ineffi ciency of domestic corporations and certain foreign cor- of a Mutual Fund Industry, 139 U. PA. L. REV. 1469, REIT Conversions, 144 TAX NOTES 1229 (Sept. 15, porations); Code Sec. 857(c)(1) (providing that 1479 (1990–1991) (discussing the “decimating” 2014); Martin A. Sullivan, REIT Conversions: Good

260 TAXES The Tax Magazine® MARCH 2016 for Wall Street. Not Good for America, THE TAX sions, it turns out another—potentially more income of the partnership from such unrelated ANALYST BLOG (Sept. 15, 2014), available online at important—tax avoidance technique is getting trade or business … .”). www.taxanalysts.com/taxcom/taxblog.nsf/Per- increased attention ….”). 33 Cf. Code Sec. 875(1) (“[A] nonresident alien indi- malink/MSUN9NXQLG?OpenDocument; Martin 25 See also, e.g., Jack Hough, Are REITs the Right vidual or foreign corporation shall be considered Sullivan, How Much Do Converted and Nontra- Choice? , BARRON’S , May 4, 2013, available online as being engaged in a trade or business within ditional REITs Cost the U.S. Treasury? THE TAX at www.barrons.com/articles/SB500014240527 the United States if the partnership of which ANALYST BLOG (Sept. 8, 2014), available online 48703591404578453020304813236 (noting such individual or corporation is a member is at www.taxanalysts.com/taxcom/taxblog.nsf/ that “to some, the string of REIT conversions so engaged ….”). Permalink/MSUN9NRFWQ?OpenDocument ; looks like a tax dodge,” but arguing that “the 34 See sources cited supra note 6. Martin Sullivan, The Revenue Costs of Non- tax savings for REIT conversions aren’t quite as 35 See sources cited supra note 7. Traditional REITs , THE TAX ANALYST BLOG (Sept. large as they appear”). 36 In the case of foreigners in treaty jurisdictions, 8, 2014); Anton Troianovski, Here’s a Way to 26 See, e.g. , Borden, supra note 9, at 530 (“The for example, the rate of withholding under Cut Business Taxes: Tech Firms Become Real comparison of REIT spinoffs to corporate inver- most treaties is higher on REIT dividends than Estate Trusts, WALL ST. J., Oct. 11, 2012, available sions borders on misplaced hysteria.”). C corporation dividends. See, e.g. , CONVENTION online at www.wsj.com/articles/SB10000872 27 See, generally, Borden, supra note 9. BETWEEN CANADA AND THE UNITED STATES WITH 396390444657804578048880778578720 28 See Code Sec. 561 (defi ning the deduction for RESPECT TO TAXES ON INCOME AND CAPITAL , art.11, (describing a “growing crop of companies who dividends paid); Code Sec. 857(b)(2)(B) (apply- paras. 2, 7, Aug. 16, 1984 (providing a five- are masquerading as real-estate companies” in ing the deduction to REITs). percent rate for certain C corporation dividends order to capture tax benefi ts); see also sources 29 See, e.g. , Boris I. Bittker & Lawrence Lokken, and a 15-percent rate for all other C corporation cited infra note 24. FEDERAL TAXATION OF INCOME, ESTATES, AND dividends; REIT dividends eligible only for the 22 This fi rst premise itself assumes as true a third GIFTS ¶ 91.10.1. Other corporations can, of higher 15-percent rate and even then only if and more fundamental premise—that the course, deduct interest on indebtedness, see certain requirements are satisfi ed); CONVENTION income of a corporation should generally be Code Sec. 163(a) , but the tax law limits how BETWEEN THE KINGDOM OF THE NETHERLANDS AND subject to an entity-level tax. A debate on the much debt an entity can take on before any THE UNITED STATES OF AMERICA FOR THE AVOIDANCE question of whether the corporate tax should new debt starts being treated as equity (and OF DOUBLE TAXATION AND THE PREVENTION OF FIS- exist at all could fi ll a book, and, for the reasons “interest” payments thereon start being treated CAL EVASION WITH RESPECT TO TAXES ON INCOME , described in Part III infra , we accept the premise as non-deductible dividends). See generally, art.11, paras. 2, 4, Dec. 31, 1993 (same). In the that it is appropriate to tax the income of corpo- e.g. , William T. Plumb, Jr., The Federal Income case of certain tax-exempt investors, dividends rations to the extent consistent with the policy Tax Signifi cance of Corporate Debt: A Critical paid by a “pension-held” REIT are treated in part justififi cationscattions undeuunderlying the enactment of the Analysis and a Proposal, 26 TAX L. REV . 369, 507- as UBTI. Code Sec. 856(h)(3)(C) . corporateorporatte tax tax.. 519 (1971) (exhaustively summarizing the law 37 Code Sec. 856(c)(4)(A). 23 See,Se e, e.g. , A.D. Pruitt,Pruitt, CongressCo Looks at REREIT Tax on thehe extent to which debt can be reclassifi ed 38 Code Co Sec. 856(c)(5)(B) (defi ning “real estate as- ExemptionExemptiioon, WALLWWAALL ST.ST. J.,J., Apr.A 23, 2013, available as equityqu y whewhen the isissuerer of tthee debdebt is toooo sesets” to include both “interests in reareal propertyropert onlineonline att www.wsj.com/articles/SB1000142412 www.wsj.com/ao SB1000142412 “th“thinlynly capitalized”)apital zed”) ; seese also Code Code Sec.Sec 163(d)d) anand interestsnt sts inn mmortgagesortga es oonn real prproperty”);perty” 7887323551004578441260298575162788732335510004578448 57516 . (limitationlim ta n ono thehe deductibilitydeduc bi off “investment“inve nt Reg.Re §1.856-3(b)(1)§1 6- b)(1) (same).(same). 24 Se See,e, e.e.g.g. , W. EEugeneuugene SeSeagogoo & Edwardrd J. SchneeSchnee, intinterest”);est” Code Code Sec. 163(e)(5)16 (e (limitation(limita on 393 For example, a REIT with $1000 of tottotall aassets REITT ConConversionsnversionso ResurrectR General Utilities, the deductibility of interest on “applicable high would fail the fi rst test if it owned more than 148 TAX NOTES , 1391, 1391 (2015) (“The ability yield discount obligations”); Code Sec. 163(j) $5 of the stock of any single issuer. to avoid the corporate-level tax following a (limitation on the deductibility of interest 40 For example, a REIT that owned 15 percent of C corporation’s conversion to a REIT still ex- paid by certain highly leveraged corporations the voting shares of a single issuer would fail this ists even though the Tax Reform Act of 1986 to non-taxpaying recipients); Code Sec. 163(l) test, as would a REIT that owned $15 of stock or contained provisions directed at repealing the (limitation on the deductibility of interest debt securities of an issuer, where the total value General Utilities doctrine.”); Nathaniel Popper, payable by a corporation in the form of equity of all stock and debt securities of that issuer was, Restyled as Real Estate Trusts, Varied Businesses of, or held by, the issuer or a related person); say, $100. Avoid Taxes, N.Y. TIMES, Apr. 21, 2013, available Code Sec. 279 (limitation on the deductibility 41 TRSs, which are discussed in more detail below, online at www.nytimes.com/2013/04/22/ of interest on certain corporate debt whose are subsidiaries. See infra Part II.B.3. business/restyled-as-real-estate-trusts-varied- proceeds are used to acquire stock or assets of 42 See H.R. Report. No. 86-2020, 1960-2 CB 731, businesses-avoid-taxes.html?_r=0; James Glanz, another corporation); Code Sec. 482 (permit- at 3 and 6 (1960) (describing the advantages of Landlords Double as Energy Brokers, N.Y. ting Treasury to reallocate items of income and investments in REITs as including “the spreading TIMES, May 13, 2013, available online at www. deduction between related parties to refl ect of the risk of loss by the greater diversifi cation nytimes.com/2013/05/14/technology/north- arm’s-length pricing). of investment which can be secured through jersey-data-center-industry-blurs-utility-real- 30 Code Sec. 7704(a) (treating “publicly traded the pooling arrangements,” and noting that estate-boundaries.html (“Real estate companies partnerships” as corporations). the 5-percent asset test is “designed to provide organized as investment trusts avoid corporate 31 Code Sec. 7704(c)(1) – (2) (providing an excep- diversifi cation”). taxes by paying out most of their income as tion for publicly traded partnerships that meet 43 The REIT rules do contain certain savings provi- dividends to investors …. ‘This is an incredible a 90-percent qualifying income test); Code Sec. sions that allow REITs to cure failures of the example of how tax avoidance has become a 7704(d)(1)(A) – (D) , (d)(3) – (4) (defi ning qualify- asset (and income) tests, including a provision major business strategy,’ said Ryan Alexander, ing income for this purpose to include most for de minimis asset test failures, but these, in president of Taxpayers for Common Sense, income that qualifi es under the REIT rules). the case of asset test failures, in all cases require a nonpartisan budget watchdog.”); Howard 32 Cf. Code Sec. 512(c)(1) (“If a trade or business the REIT to fi x the failure by getting itself back Gleckman, How REIT Spinoffs Will Further Erode regularly carried on by a partnership of which an into compliance with the rule. The $100 billion the Corporate Tax Base, FORBES , July 7, 2014, organization is a member is an unrelated trade REIT that did not fi x its $10,000 asset test issue available online at www.forbes.com/sites/ or business with respect to such organization, within the prescribed time limits would lose its beltway/2014/07/31/how-reit-spinoffs-will- such organization in computing its unrelated REIT status. further-erode-the-corporate-tax-base/ (“While business taxable income shall … include its 44 See text accompanying notes 189–191, infra. Congress has been obsessing about tax inver- share (whether or not distributed) of the gross 45 Code Sec. 856(c)(3).

MARCH 2016 261 MODERN REITS AND THE CORPORATE TAX

46 Code Sec. 856(c)(2). (2015) (noting early opposition to income taxes). A mighty power has been built up in this 47 See generally Code Sec. 856(d)(1)(B) , (2)(C) , (7) ; 61 See Camp, supra note 60, at 1696. country in recent years that seems to Paul W. Decker et al., Non-Customary Services 62 See Kornhauser, supra note 59, at 57. fairly stagger the methods of our gov- Furnished by Taxable REIT Subsidiaries, 148 TAX 63 See id. ; see also Gregory A. Mark, The Personifi ca- ernment to maintain the equal rights of NOTES 413 (2015). tion of the Business Corporation in American Law, all the people. Something appears to be 48 Code Sec. 856(d)(1)(B). 54 U. CHICAGO L. REV. 1441, 1444 (1987). wrong with business interests generally, 49 Code Sec. 856(d), (2)(C) , (7) . 64 See Mark, supra note 63, at 1457. and the people are passing through a 50 See infra Part VI.B.1. 65 Professor Kornhauser notes that these two fea- state of social unrest. The infl uence of 51 Code Sec. 856(l). tures were at the center of the notion of a “cor- fi nancial men has become so powerful 52 Code Sec. 856(l)(3). poration” in the 1909 act: “The premise of the and far reaching in self-interest that 53 For some of the more general limitations on 1909 law was the artifi ciality of the entity taxed. doubt is expressed whether its iron grip the use of intercompany debt to generate Thus, the interpretation of the law stressed on government and business can ever be interest deduction, see supra note 29. Of those those traits which evidenced that artifi ciality: destroyed. This mighty power has crip- limitations, Code Sec. 163(j) has specifi c rel- limited liability and centralized management.” pled or destroyed competition by placing evance to REITs and their TRSs. See Code Sec. Kornhauser, supra note 59, at 124. a limitation in the fi eld of production. It 163(j)(3) (defi ning “disqualifi ed interest” to See also Mark, supra note 63, at 1459 (“What fi xes the prices of fi nished products and include certain interest payable to recipients differences, then, remained to distinguish a raw materials and imposes its burdens that are not subject to U.S. tax on that inter- corporation from a partnership? In Taylor’s eyes upon the silent consuming public with- est, including specifi cally “any interest paid or [the author of the infl uential A TREATISE ON THE out restraint. The spirit of competition accrued … by a taxable REIT subsidiary … of a LAW OF PRIVATE CORPORATIONS HAVING CAPITAL seems to have almost vanished, being real estate investment trust to such trust”); see STOCK (1884)], there were but two. First, in a superseded by extortion. also Code Sec. 857(b)(7) (imposing a 100-per- partnership all partners were agents; in contrast, In fi nance this mighty power of infl uence cent penalty tax on interest paid by a TRS to a all shareholders were not agents of the corpo- is unlimited. The association of men en- REIT to the extent the interest exceeds arm’s- ration. Second, a shareholder could generally gaged in numerous channels of business length rates and on other non-arm’s-length remove himself from any liability resulting from regulates or controls credit. This power transactions between a REIT and its TRS). corporate action by selling his shares; partners manipulates the volume of money by 54 Code Sec. 856(c)(4)(B)(ii). retained liability for actions taken on behalf of infl ation or contraction required for the 55 This results simply from the fact that the REIT the partnership even after they had disposed constant transaction of business of the is not entitled to a dividends paid deduction for of their partnership shares. The two conditions entire country. Fabulous profi ts of busi- amountsountss that it retainedre rather than paying as were connected by a single vital thread: partners ness are made out of promotions and a dividenddividend.nd. often managed partnerships actively while most combination, by the acquisition of vast 56 Code Coode Sec.Sec. 857 857(a)(2)(a)(2). shareholderseh were passive investors in corpora-a- areas of the public domain and rapid 57 SeeS See Code CdCodee Sec.S1Sec. 13741 (imposing( iimp thishis built-in gains tions.”).” monopolization of the naturalal resresourcesrces taxtax on S ccorporation);orporation); RegReg. §1.337(d)-77(d)-7 (applying 66 Ste Stevenen A. Bank,B k, CorporateCorpor te MaManagers,nagers, Agencycy off ttimber,er, coaloa andnd iriron.n. IIndustriesdustries haveave Code Coode SeSec.c. 13713744 prinprinciplesciplec to RICs and REITs). CosCosts,s, andd ttheh Rise of DoDoublebl Taxationation , 44 WM.M. beenee closedos d andand businessbusin ss slackened slack ne 58 Se Seee HH.R..R. COCONF.NF. REP. NNO.O 848841, 99thth Cong., 22d & MARYARY L. REV. 167,167, 199 (2002)( 00 (notingnoting that t cor-or- ini compecompetingg localitilocalities to stifle ffaira Sess.,ss., VoVol.ol. II, 1198-20798-20 (1986), 1986-3 CB, Vol. porations could avoid “expensive and intrusive competition by this mighty power in 4, 198-207. external fi nancing sources” by “simply … dip[ing] illegal procedure of usurpation. Instead 59 See Reuven S. Avi-Yonah, Corporations, Society, into retained earnings”). of living under the lofty principles of a and the State: A Defense of the Corporate Tax, 90 67 Initially, these monopolies were formed under- mighty Constitution where the citizen VA. L. REV. 1193 (2004); Steven A. Bank, Entity neath “industrial trusts” and, later, by combin- is sovereign we are actually living under Theory as Myth in the Origins of the Corporate ing underneath a single holding corporation of a form of government where criminal Income Tax, 43 WM. & MARY L. REV. 447 (2001); the type with which we are all familiar. In the might is right. Steven A. Bank, A Capital Lock-In Theory of the initial stage of the consolidation process, one Newton J. Baker, Regulation of Industrial Corpo- Corporate Income Tax, 94 GEO. L. J. 889 (2006); corporation was not permitted to own stock in rations, 4 YALE L. J. 306, 306 (1912–1913). Marjorie Kornhauser, Corporate Regulation and another corporation; as a result, if two corpo- 69 See Kornhauser, supra note 59, at 57–62. the Origins of the Corporate Income Tax, 66 IND. rations were to combine to form one business, 70 As briefl y discussed in Part IV.A.2(a) below, the L. J. 53 (1990). the shareholders of each corporation had to popular shift in the view of the corporation 60 See Revenue Act of 1861, Ch. 45, 12 Stat. 292 contribute their shares to a trust in exchange existed alongside an analogous shift in the legal (Aug. 5, 1861), the income tax provisions of for trust certifi cates, as trusts were allowed community, which developed primarily from an which were repealed and replaced by Revenue to own corporate shares at that time. The end articulation of the legal rights of corporations. Act of 1862, Ch. 119, 12 Stat. 432. Tax rates were result was a single trust that owned 100 percent The dominant view of corporate rights prior to increased by Internal Revenue Act of 1864, 13 of the shares of multiple corporations, and the the late 19th century had been articulated in the Stat. 223. trustees of the trust would vote the shares in Dartmouth College v. Woodward , SCt, 17 US 518 Prior to 1862, government revenue came pri- each corporation. As the consolidation pro- (1819), in which Chief Justice Marshall held that marily from tariffs imposed on imported goods. cess continued, the states of New Jersey and Dartmouth College derived rights by virtue of See Bryan T. Camp,A History of Tax Regulation Delaware amended their corporation statutes, its contract with the state of New Hampshire, Prior to the Administrative Procedure Act, 63 to permit one corporation to own shares in through its charter. Under this “artifi cial” view of DUKE L. J. 1673, 1685 (2014) (citing BUREAU OF another. Because the corporate form was more the corporation, a corporation possessed those THE CENSUS, U.S. DEP’T OF COMMERCE, HISTORI- fl exible for aggregators than the trust form, the rights that were specially granted by the state. CAL STATISTICS OF THE UNITED STATES, 1789–1945, great industrial trusts quickly morphed into This view underwent various legal challenges at 295–98 ser. P 89–98 (1949) and noting that corporate holding company structures. and judicial modifi cations in the mid-19th cen- federal revenue prior to 1862 came roughly 85 68 This view of the monopolies was shared by the tury, and was dealt a major blow in the Railroad percent from tariffs and 15 percent from land popular and legal press alike. See, for example, Tax Cases, 13 F. 722 (C.C.D. Cal. 1882), appeal sales). See generally Joseph J. Thorndike, The this remarkable passage from the Yale Law dismissed as moot, San Mateo County v. South- Almost Income Tax of 1815, 148 TAX NOTES 624 Journal from 1912: ern Pac. R.R.Co., SCt, 116 US 138 (1885), in which

262 TAXES The Tax Magazine® MARCH 2016 the Circuit Court held that private corporations 77 Id. its subjective nature. A tax on undistributed earn- were entitled to equal protection of the laws 78 Id., at 1216. ings regardless of intent was not imposed until under the Fourteenth Amendment. This deci- 79 Although the New York Stock Exchange had a 1936. See Bank, supra note 66, at 170. See also sion was largely predicated on the notion that policy beginning in 1869 that required listed Bank, supra note 86, at 920 (“Given the relatively corporations derived their rights from the rights companies to publish annual fi nancial reports, small spread between the corporate rate and the of their incorporators—not state legislatures— the Exchange did not begin to enforce its policy top surtax rate, this provision did not appear to which view was thus generally compatible with until 1910 under pressure from the government. be worth the political expense that would come an “aggregate” ( i.e., partnership) view of the See Kornhauser, supra note 59, at 71. from eliminating deferral.”). corporation. Commentators realized, however, Professor Kornhauser seems to adopt the 95 For example, in 1913, the corporate rate was that this aggregate view made it diffi cult to view that the primary of objectives of the 1909 one percent while the top individual rate was justify the corporate privilege of limited liability, tax were increased publicity of corporate infor- seven percent; by 1917, the corporate rate had which partnerships did not enjoy at the time. By mation through tax returns and the taxing of risen to six percent but the top individual com- contrast, under a “real” or “natural” entity view retained earnings, although her work focuses bined rate had been raised to 67 percent to fund of the corporation, which developed in the late more on policymakers’ changing view on the the war effort. Act Sec. I(2) of War Revenue Act 19th century and eventually became the domi- nature of the corporate entity and the role of the of 1917, 40 S tat. 300. nant view, a corporation derives its legal rights publicity feature in helping to curb monopolistic 96 See Steven A. Bank, Tax, Corporate Governance, and privileges of its own accord, rather than from and trade restraining behavior. See, generally, and Norms , 61 WASH. & LEE L. REV. 1159, 1187–90 the state on the one hand or its incorporators on Kornhauser, supra note 59 at 69–82. (2004). the other. See, generally , Mark, supra note 63; 80 44 CONG. REC. 3965 (1909) (statement of Sen. Bank notes that, at the end of the 19 th see also Kornhauser, supra note 59, at 58. Cummins). century, “the notion that corporations would 71 See The Story of a Great Monopoly, ATLANTIC 81 44 CONG. REC. 3950 (1909) (statement of Sen. defer dividends to shield them from taxation MONTHLY, March 1881, available online at www. Owen). would have been considered quite foreign.” theatlantic.com/magazine/archive/1881/03/ 82 44 CONG. REC. 4003 (1909) (statement of Sen. See Steven A. Bank, Historical Perspective on the-story-of-a-great-monopoly/306019 (de- Root) (Emphasis added.). the Corporate Interest Deduction, 18 CHAPMAN scribing efforts to regulate Standard Oil and 83 44 CONG. REC. 4232 (1909) (statement of Sen. L. REV. 29, 33 (2014–2015). See also Steven A. the railroads, and noting that “the legislature Cummins). Bank, From Sword to Shield: The Transformation of Pennsylvania was besought to pass laws to 84 See generally Avi-Yonah, supra note 59, at 1231. of the Corporate Income Tax, 1861 to Present, at enforce the constitutional provision for equal 85 See generally Steven A. Bank, Entity Theory as 51, fi g. 2 (2010) (illustrating that the dividend rights on the railroads of the State, but the Myth in the Origins of the Corporate Income Tax , payout for public corporations between 1871 moneyney ofo the StandSStandard was more powerful than 43 WM. & MARY L. REV. 447 (2001). and 1895 was approximately 80 percent). thehee petit petitiontion of f busin businessne men.”) 86 See Steven A. Bank, A Capital Lock-In Theory 97 See Bank, supra note 86, at 920–922. 72 SeSeee Avi-Avi-Yonah,Yonah, supra a nonote 59, at 1215. of thee CorporateC Income Tax, 94 GEO. L. J. 88989 98 SeeSe Steven A. Bank, Is Double Taxation a Scape- 73 See SSee THE THE PENNSYLVANIAPENNSYLVANIAA RAILROAD,OAD, VOLUME 1: (2006).( 6) goatgo ffor Declining Dividends? EvidEvidencee from BUILDINGBUILDING AN EMPIEMPIRE,RE,R 11846–1917,917 459–460 87 See RoRoe, supras up note 1212, at 14914966 (not(noting that,at, HistoryHi ory, 56 TA TAX L. REV. 463, 466466 (2003(2003). (2012)(2012) ((describingdescribing thet U.S. Housese Commerce whenwh n ““managersna rs [were ppushed]sh … to ddistributete 99 SeeSe generally,generally Bank, supraupra noteote 96, att 1189–1 Commission’sCoommission’s larlargelygely ineffectiveneffecff subpoenasubpoenas oof mostmo t of ttheireir prprofiofi ts … [c]ompanies[c om nies that neededed 1201200. Pennsylvaniannsylvvania RailroaRRailroad executives in 1876). funds were dependent on capital markets to re- 100 Code Secs. 1291– 1297 . See also The Story of a Great Monopoly, supra plenish the moneys dividended out. When they 101 See generally, Bank, supra note 86, at 931. note 71: returned to the capital markets, bankers and 102 See also Boris I. Bittker, Martin J. McMahon & Just who the Standard Oil Company are, securities buyers would scrutinize the managers’ James J. Freeland, FEDERAL INCOME TAXATION OF exactly what their capital is, and what results and penalize them (in the form of higher INDIVIDUALS ¶ 2.05 (Emphasis added), noting are their relations to the railroads, no- capital costs) if the results were poor.”). that the disparate tax treatments of corpora- body knows except in part. Their offi cers 88 See Bank, supra note 86, at 944–945. tions and partnerships could be ameliorated refused to testify before the supreme 89 Act Sec. 73 of the Revenue Act of 1894, Ch. 349, through a partially integrated corporate tax, but court of Pennsylvania, the late New York 28 Stat. 570 (Aug. 27, 1894). The corporate tax that corporate managers might have reason to Railroad Investigating Committee, and a of the Revenue Act of 1894 was stuck down oppose such integration: committee of Congress. The New York by the Supreme Court as unconstitutional in Under this approach, a corporate-level committee found there was nothing to be Pollock v. Farmers Loan & Trust Co. , SCt, 157 US tax would be imposed, but the double learned from them, and was compelled 429, 15 SCt 673, reh’g granted, SCt, 158 US 601 taxation of dividends would be elimi- to confess its inability to ascertain as (1895), on the grounds that the 1894 Act’s taxes nated either by allowing a dividends-paid much as it desired to know “of this mys- on real and personal property were “direct taxes” deduction to the corporation or by allow- terious organization, whose business and which must be “apportioned among the several ing a credit to the shareholder for tax paid transactions are of such a character that States,” according to Article 1 Section 2 of the by the corporation. Corporations do not its members declined giving a history or Constitution. seem to be clamoring for partial integra- description, lest their testimony be used 90 Act Sec. II G(a) of the Revenue Act of 1913, Ch. tion, however, perhaps because offi cers of to convict them of crime.” 16, 38 Stat. 172. public corporations like to retain earnings 74 The Sherman Act of 1890, 26 S tat. 209, 15 USC 91 See Bank, supra note 86, at 917. in their corporations, and the current tax §§1–7. 92 Act Sec. II A(1)and (2) of the Revenue Act of 1913, system gives them a good reason to do so. 75 See Kornhauser, supra note 59 (noting that, in en- Ch. 16, 38 Stat. 172. 103 Reg. §301.7701-1 to §301.7701-7 (1996), T.D. forcing the Sherman Act, “[t]he executive branch, 93 Id. 8697, IRB 1997-2, 11. fi rst under President Roosevelt and then under 94 Professor Bank notes that a corporation could be 104 See William B. Dockser, Real Estate Investment Taft, accepted the view that large corporations taxed on its undistributed earnings beginning with Trusts: An Old Business Form Revitalized, 17 U. could legitimately dominate the market”). the 1913 Act, but that this tax only applied if earn- MIAMI L. REV. 115, 116 (“The business trust, as 76 See Avi-Yonah, supra note 59, at 1215 (noting ings were undistributed with the intent to avoid we now know it, had its origins in the middle that “[Roosevelt] was the fi rst President to at- a shareholder-level surtax. The tax was rarely eighteen hundreds, when Massachusetts law tempt to use the Sherman Antitrust Act”). imposed in practice due to diffi culties surrounding made it difficult to secure a charter for the

MARCH 2016 263 MODERN REITS AND THE CORPORATE TAX

development of real estate without an act of the Mr. VEST. That is the meaning of it. I [Corporate Excise Tax]. legislature (General Court).”). See also Su Han have not had any doubt about it. If I had Id., at 187. Although this rationale for the corpo- Chan, John Erickson, and Ko Wang, REAL ESTATE intended to use the word “partnerships,” rate tax was entertained by President Taft and INVESTMENT TRUSTS: STRUCTURE, PERFORMANCE, I should have said “partnerships.” For certain congressmen in the lead up to the 1909 AND INVESTMENT OPPORTUNITIES 14 (2002). instance, take building and loan associa- Act (though opposed by many others), it was Some early real estate investment vehicles tions. That is the way they style themselves. generally viewed as inadequate on the grounds were in fact organized as corporations, presum- They are not called “companies;” they are that most statutory benefi ts of the corporate ably pursuant to special legislative grants. See not called “corporations” eo nomine,but form derived from state (rather than federal) Lawrence M. Channing, Federal Taxation of the they are called “associations.” Two or more law. See Avi-Yonah, supra note 59, at 19–20. Income of Real Estate Investment Companies, 36 individuals associate themselves, and we 124 Revenue Act of 1913, Ch. 16, 38 Stat. 172. TAXES 502, 505 (1958). have a chapter in the Revised Statutes of 125 Revenue Act of 1916, Ch. 463, 39 Stat. 756. 105 Limited liability partnerships did not exist in the Missouri which provides for these associa- 126 War Revenue Act of 1917, 40 Stat. 300. United States until Texas passed the Registered tions. They are quasi corporations. 127 Revenue Act of 1918, 40 Stat. 1057. Limited Liability Partnership Act in 1991. See TEX. Mr. HALE. That is not a private business 128 Revenue Act of 1921, Ch. 136, 42 Stat. 227. CIV. STAT. ANN. art. 1528n, §11.07, art. 6132b, §15, partnership. 129 Act Sec. II G(a) of the Revenue Act of 1913, Ch. although limited liability companies subject to Mr. VEST. No; that is not a partnership. 16, 38 Stat. 172 (Emphasis added.). tax as partnerships emerged in the late 1970s. Mr. HOAR … I should like to ask my friend 130 Crocker v. Malley , SCt, 1 USTC ¶24, 249 US 223, See text accompanying infra note 177. from Missouri, who is a good lawyer 39 SCt 270 (1919). 106 Attorney General v. Proprietors of the Meeting- and does not want to draw a bill and be 131 Crocker v. Malley , SCt, 1 USTC ¶24, 249 US at 233 house, 69 MASS. 1 (1854), writ of error dismissed, responsible for an act that has doubt in (1919). 66 US 262 (1861). its meaning, whether it is not better to 132 Crocker v. Malley , SCt, 1 USTC ¶24, 249 US at 234 107 See H. Cecil Kilpatrick, Real Estate Investment make his meaning clear, and whether (1919). Trusts, 3 TAX REVISION COMPENDIUM OF PAPERS it is not, to say the least, a doubtful 133 Crocker v. Malley , SCt, 1 USTC ¶24, 249 US at 232 ON THE TAX BASE 1697, 1698; Chan et al, supra, question whether the clause “corpora- (1919) (Emphasis added.). note 104, at 15 ; Dudley J. Godfrey & Joseph M. tions, companies, or associations doing 134 Crocker v. Malley , SCt, 1 USTC ¶24, 249 US at 234 Bernstein, The Real Estate Investment—Past, business for profi t in the United States, (1919) (Emphasis added.). Present and Future, 1962 WIS. L. REV. 637 , 638 no matter how created or organized,” 135 As a practical matter, this argument from (1962); Kilpatrick, supra note 16, at 1044 ; see also does not include partnerships? I say on congressional intent was not an explicit crite- Channing, supra note 104, at 502 (“Early in the my responsibility as a lawyer that I think rion for taxation as a trust following Crocker ; centurytury theyt [i.e., i REITs] did yeoman service by it does. I should give that opinion as at instead, both the courts and the IRS adopted providingproovidingg capitcapitaltalfortal for ded development of the West.”). present advised to a client or to an offi cer the more easily administrable “control” test. 108 See See JohnJohnn MorMorley,ley, CollectiveC olle Branding andan the off tthe Government. I can not conceive ButBu the language quoted above indicates that OriginsOOrrigiiins ooffI IInvestmentnvestmentn Fund FuF Regulationula , 6 VA. L.. a mmorere apt descriptionscript of a partnershipartne theth Court viewed the lack of controltrol of the trustrus & BBUS.US. RREV.EV. 3341,41, 343488 (20(2011–2012).2). thanan “companiesco anies or associationsssocia ions doing d overov ititss subsidiarysi ary corporationsorpo tions as an inindicationdicatio 1099 Se Seee Avi-Avi-Yonah,Yonah, supra a nonote 59, at 1227. businessus ss for profi t.” If a papartnershiprship is not thatth such trutrustss were outsidoutside the scoscopee oof the 110 SeSee e MorMorley,ley, suprasu upra nnoteoteo 108,08 at 347.7. a companycompany oorr associassociationion off men doingd corporatecorporate tax as intended by CongresCongress. SeSeen in 111 Seee supraa nnoteotee 89. business for profi t, what in the world is it, this light, the technical control test in Crocker 112 See generally Patrick E. Hobbs, Entity Classifi ca- however established or organized. can be seen as a kind of proxy for the Court’s tion: The One Hundred Year Debate , 44 CATH. U. L. 26 CONG. REC. 6833-35 (1894) (Emphasis added.). policy-based considerations. In any case, those REV. 437, esp. 447–452 (1995). Hobbs quotes a 113 Id. considerations clearly indicate that the Court remarkable exchange between Senators Aldrich 114 26 CONG. REC. 6880 (1894) (statement of Sen. understood, correctly in our view, that one of (Rhode Island), Allison (Iowa), Hoar (Massachu- Chandler). the rationales underlying the corporate tax was setts), and Vest (Kentucky) that illustrates the 115 Pollock v. Farmers Loan & Trust Co. , SCt, 157 US to, in the language of the opinion, discourage diffi culty the Senate had in defi ning the scope 429, 15 SCt 673, reh’g granted, SCt, 158 US 601 certain corporate combinations. of a “corporate” tax. Senator Hoar noted that (1895). 136 Reg. 45, Article 1502 under the Revenue Act of the proposed language seemed to apply even to 116 Act Sec. 38 of the Tariff Act of 1909, Ch. 6, 36 1918 (Emphasis added.). partnerships: Stat. 11, 112-113. 137 See Reg. 62, Article 1504 under the Revenue Act Mr. ALDRICH. I should be glad to have 117 See Kornhauser, supra note 59, at 102–103. of 1921: the Senator from Missouri state whether 118 Id., at 60–61. Association distinguished from trust. the interpretation given to this bill by 119 Id., at 61. Where trustees hold real estate subject the Senator from Massachusetts in his 120 See generally Kornhauser, supra note 59 and to a lease and collect the rents, doing opinion is a correct one, because if the Mark, supra note 63. no business other than distributing the word “association” here includes partner- 121 Act Sec. 38 of the Tariff Act of 1909, Ch. 6, 36 income less taxes and similar expenses ships, as the Senator from Massachusetts Stat. 11, 112-118. to the holders of their receipt certifi cates, stated, as I understand- 122 Eliot v. Freeman , SCt, 220 US 178 (1911). who have no control except the right of Mr. HOAR. I did not say that. 123 In declining to extend the corporate tax to the real fi lling a vacancy among the trustees and Mr. ALDRICH. That is what I understood estate investment trust, the Court held that— of consenting to a modifi cation of the the Senator to say. Entertaining the view that it was the terms of the trust, no association exists Mr. HOAR. I said “companies.” intention of Congress to embrace within and the cestuis que trust are liable to tax Mr. ALLISON. I do not understand, and I the corporation tax statute only such as benefi ciaries of a trust the income of should be glad to have the Senator from corporations and joint stock associations which is to be distributed periodically, Missouri state, whether he understands as are organized under some statute or whether or not at regular intervals. But that this section and the subsequent sec- derive from that source some quality, or in such a trust if the trustees pursuant to tions regulating this subject are intended benefi t not existing at the common law, the terms thereof have a right to hold the to deal with anything but associated we are of opinion that the real estate income for future distribution, the net corporations? trusts … are not within the terms of the income is taxed to the trustees instead

264 TAXES The Tax Magazine® MARCH 2016 of the benefi ciaries …. If, however, the organization will be treated as an association if association was taxable regardless of that as- cestuis que trust have a voice in the the corporate characteristics are such that the sociation’s legal form. The IRS argued that, be- conduct of the business of the trust, organization more nearly resembles a corpora- cause doctors were prohibited by state law from whether through the right periodically tion than a partnership or trust. See Morrissey et organizing as corporations, Dr. Kintner’s practice to elect trustees or otherwise, the trust al. v Commissioner (1935) 296 US 344.”). was not an association for tax purposes. The is an association within the meaning of 151 Morrissey , SCt, 36-1 USTC ¶9020, 296 US at 359. court rejected this argument, noting that the the statute. See Thomas M. Hayes, Checkmate, the Treasury IRS had long held that an entity’s classifi cation 138 See, e.g., Chicago Title & Trust Co. v. Smietanka , Finally Surrenders: The Check-the-Box Treasury under state law was irrelevant to its treatment DC-IL, 275 Fed. 60, 1921 CT 080 (1921) (trust Regulations and Their Effect on Entity Classifi ca- under federal tax law. See Kintner, CA-9, 54-2 holding stock was an association where the ben- tion, 54 WASH. & LEE L. REV. 1147, 1152 (1997). USTC ¶9626, 216 F2d at 423 (“The Government’s efi ciaries had the power to instruct the trustees 152 Morrissey, SCt, 36-1 USTC ¶9020, 296 US 362 contention here goes counter … to the policy of the trust how to vote with respect to the (1935). of the Internal Revenue Department, which, at stock); Weeks v. Sibley , DC-TX, 1 USTC ¶37, 269 153 Morrissey , SCt, 36-1 USTC ¶9020, 296 US 365 all times, declines to be bound by State law.”). Fed. 155 (1920) (citing Crocker , and holding a (1935). See also Hobbs, supra note 112, at 484. (“The trust was not an association where benefi ciaries 154 Morrissey, SCt, 36-1 USTC ¶9020, 296 US 369 government’s reliance on local law was ironic lacked control of the trust); see also Henry Rott- (1935). because, as Judge Yankwich writing for the three- schaefer, Massachusetts Trust Under Federal Tax 155 See Reg. 86, Article 801-3, providing in relevant judge panel noted, the Service always refuses to Law, 25 COLUM. L. REV. 305, 309 (1925) (“these part: be ‘bound by State law.’ The court also declined to principles [of Crocker] have been followed by If a trust is an undertaking or arrange- follow the government’s reliance on state grounds the lower federal courts in every subsequent ment conducted for income or profi t, because the government’s regulations themselves income tax case, even when the trust involved the capital or property of the trust being undermined the government’s argument.”) was a so-called operating trust.”); see generally supplied by the benefi ciaries, and if the 165 Rev. Rul. 56-23, 1956-1 CB 598. Taubman, infra note 146, at 108. trustees or other designated persons 166 Rev. Rul. 57-546, 1957-2 CB 886. 139 Hecht , SCt, 265 US, at 147 (Emphasis added.). are, in effect, the managers of the un- 167 Reg. §301.7701-1 to §301.7701-11 (1960); T.D. 140 See Rottschaefer, supra note 138, at 309 (“The dertaking or arrangement, whether the 6503, 1960-2 CB 409. principles enunciated by the Supreme Court in beneficiaries do or do not appoint or 168 See former Reg. §301.7701-2(b)(3), -2(c)(4) , its opinion in the Hecht case constitute the fi rst control them, the benefi ciaries are to be -2(d)(1) (providing that partnerships whose defi nite pronouncement that the nature of its treated as voluntarily joining or cooper- charters conform to the Uniform Partnership Act activities is a decisive factor in fi xing the legal ating with each other in the trust, just as will generally lack continuity of life, centraliza- positiontion of a bbusinessusin trust for federal taxation, do members of an association, and the tion of management, and limited liability). or for an anyy othe otherer purp purpose.”).po under taking or arrangement is deemed 169 See Hobbs, supra note 112, at 489, citing ALA. 141 SeeSee ininfrafra Part IIV.A.2(e).V.A.2(e).( too bbe an association classifi ed by the Act CODECO §§10-4-380 to -406 (1975) (legislation 1422 Reg.Reg. 69,69, ArticleAilArticlee 15044 underun the Revenue Act of as a corporation.orpora on. approvedap in 1961); COLO. REV. STAT.AT. §§12-36-13436 13 11924.924. 156 See HoHobbs,s, supra ra note 112,2, at 478 (“The(“T deci-ci- (1969);(1 9) FLA. . STAT.S AT. ANNNN. §§621.0162 .01 to .15.1 (1969);(1969 143 Reg.Reg. 74, ArticleArticlee 1314 1314 underun the Revenueevenue Act of sionio [provided][p vid two signifisig fi cant contributionscontr ns IDAHOID O CODEE §§§30-130130-1301 ttoo --1315315 (196(1963);); MASS. 191928.28. to thehe entitye tity classific assifi catcationn debate.ate. FirFirst, afterer GEN.GEN LAWS ANANN. ch. 156A, §§1-17§ 17 (1965); (196 ; MINN. M 144 Reg.g. 77, ArticleArticlee 1314 under the Revenue Act of Morrissey the entity-classifi cation methodology STAT. ANN. §§319.01 to .961 (1963); MO. ANN. 1932. forever would be known as the ‘resemblance STAT. §§356.010 to .261 (1963); N.D. CENT. CODE 145 Reg. 86, Act Sec. 801-2 of the Revenue Act of test.’ Second, and perhaps more signifi cantly, ANN. §§10-31-01 to -14 (1963); OKLA. STAT. ANN. 1934. the Morrissey Court noticed that Congress tit. 18, §§801 to 819 (1963); UTAH CODE ANN. 146 See J. Blum , 25 BTA 119, Dec. 7371 (1932); C. delegated to the Treasury Department the role §§16-11-1 to -15 (1963). H. McCormick, 26 BTA. 1172, Dec. 7763 (1932), of determining the nature of a corporation for 170 See Proposed Reg. §§301.7701-1(d), 301.7701- aff’d , CA-7, 37-1 USTC ¶9187, 68 F2d 653; Prior federal tax purposes.”) 2(g), (h) , 28 FR 13,750, 13,751 (1963) (approved & Lockhart Development Co. , 26 BTA. 1054, 157 See Morrissey, SCt, 36-1 USTC ¶9020, 296 US at by T.D. 6797, 1965-1 CB 553). Dec. 7748, aff’d , CA-10, 70 F2d 154; Brouillard, 354–355 (noting that, because “the [Act] merely 171 It was widely understood at the time that CA-10, 70 F2d 154 (1934), cert. denied , SCt, provided that the term ‘corporation’ should interests in medical practices were almost 293 US 574, 55 SCt 85 (1934). See also Joseph include ‘associations,’ without further defi ni- never freely transferable. Thus, any medical Taubman, The Land Trust Taxable as Association , tion, the Treasury Department was authorized services corporation would lack the corporate 8 TAX L. REV. 103, 109 (noting that “[s]ince the to supply rules for the enforcement of the Act characteristics of free transferability, central- Supreme Court [in Hecht ] had not spelled out within the permissible bounds of administrative ized management and limited liability, making what constituted corporate resemblance, the construction. Nor can this authority be deemed it impossible for the corporation to qualify as a lower courts adopted confusing and contradic- to be so restricted that the regulations, once is- corporation for tax purposes. tory tests that were diffi cult to apply.”). sued, could not later be clarifi ed or enlarged so 172 See, e.g., H.A. Kurzner , CA-5, 69-1 USTC ¶9428, 147 Lloyd M. Smith, Associations Classified as as to meet administrative exigencies or conform 413 F2d 97, 106 n.43. See Rev. Rul. 70-101 , 1970- Corporations Under the Internal Revenue Code , to judicial decision.”); see also Hobbs, supra note 1 CB 278 for list of court cases invalidating the 34 Cal. L. Rev. 461, 462 (1946) (citing Burk- 112, at 478. 1965 proposed regulations. Waggoner Ass’n v. Hopkins , DC-TX, 296 Fed. 492, 158 See text accompanying notes 65, 117 and 118. 173 Rev. Rul. 70-101 , 1970-1 CB 278. 498 (1924), aff’d SCt, 1 USTC ¶143, 269 US 110, 159 See supra Part III.B. 174 See Hobbs, supra note 112, at 498–500. 46 SCt 48 (1925); Page v. McLaughlin , DC-PA, 7 160 See supra Part III.B. 175 P.G. Larson, 66 TC 159, Dec. 33,793 (1976), acq. FSupp 75, 77 (1933)). 161 See, e.g. , Oliver Hart, FIRMS, CONTRACTS, AND 1979-2 CB 1, 2d acq. 1979-2 CB 2. 148 Id., citing Dale H. Flagg, Associations Taxable as FINANCIAL STRUCTURE, 95–120 (1995) (cited in 176 See Hobbs, supra note 112, at 500; see also Note, Corporations, 13 TAXES 589 (1935). Avi-Yonah, supra note 60, at 233). Tax Classifi cation of Limited Partnerships: The IRS 149 T.A. Morrissey, SCt, 36-1 USTC ¶9020, 296 US 162 O.L. Pelton, CA-7, 36-1 USTC ¶9195, 82 F2d 473. Bombards the Tax Shelters, 52 N.Y.U. L. REV. 408, 344, 56 SCt 289. 163 A.R. Kintner, CA-9, 54-2 USTC ¶9626, 216 F2d 418. 410-11 (1977). 150 Reg. §301.7701-2(a)(1) (prior to T.D. 8697, 164 Existing Treasury Regulations gave the IRS lati- The Larson –HUD episode revealed yet 1997-2 IRB) (providing in part that “[a]n tude to determine whether an unincorporated another sign that we were experiencing a

MARCH 2016 265 MODERN REITS AND THE CORPORATE TAX

debacle—when one executive branch agency, sachusetts investment company that heavily 193 A version of the bill passed the House that having been stymied by its own regulations, at- lobbied Senator David Walsh of Massachusetts extended the dividends paid deduction to all tempts to amend those regulations, only to have in connection with the Act. Years later, Mr. Cabot corporations, but the bill failed to pass the Sen- the amendments scuttled by another executive would say, “God, I practically wrote the law.” ate. See Morley, supra note 108, at 360. The branch agency in less than 48 hours. See INTERVIEW BY R.J. TOSIELLO WITH PAUL C. CABOT deduction was then reinserted but only applied 177 Wyoming Limited Liability Company Act, WYO. (Oct. 9, 1978), available in Records Relating to to investment trusts; it was during the hearings STAT. §§17-15-101 to -136 (1977). Investment Banking, 1870-1971 (inclusive) (on discussing this reinsertion that Acting Chief 178 Rev. Rul. 88-76, 1988-2 CB 360. fi le with Harvard Business School Baker Library Counsel Kent asserted that Congress had never 179 Reg. §§301.7701-1 to -7 (1996); T.D. 8697, IRB Historical Collections, Harvard University), cited intended to subject collective investment to 1997-2, 11. by Morley, supra note 108, at 358. the corporate tax. See text accompanying supra 180 See, e.g., Tom Nicholas and Anna Scherbina, Real 184 See supra notes 152–154. notes 183–185. Estate Prices During the Roaring Twenties and the 185 Revenue Act of 1936: CONFIDENTIAL HEARINGS 194 See John H. Gardiner, Real Estate Investment Great Depression, UC DAVIS GRAD. S ch. OF MGMT. ON H.R. 12395 BEFORE THE SENATE COMM. ON Trusts, 100 TR. & EST. 614, 614 (1961) (“In the RESEARCH PAPER No. 18-09 (noting that Manhat- FINANCE , 74th Cong., 2d Sess., pt. 10, at 61. depression years, such a corporate tax [imposed tan real estate prices fell from their 1929 peak 186 See note 182. The 1936 RIC Legislation does not on REITs after Morrissey ] was of minor conse- by 67 percent during the Great Depression). seem to have been enacted primarily to prevent quence, but in the years following World War 181 See Theodore Lynn, Real Estate Investment the double taxation of corporate dividends. See II, the burden was so oppressive that it became Trusts: Problems and Prospects, 31 FORDHAM L. John C. Dawson, Jr., The Real Estate Investment impossible to interest investors in purchasing REV . 73, 78 (1962–1963) (noting that the REIT Trust, 40 TEX. L. REV. 886, 887 (1961–1962) (cit- new share of real estate trusts while the Federal industry may not have lobbied for passthrough ing the legislative history as “indicat[ing] that a government was taking away up to fi fty-two per treatment in 1936 because of “lack of need due desire to eliminate a double tax effect had not cent of the net income in taxes.”). to the absence of taxable incomes,” and quoting been an important consideration in allowing See also Bernstein and Godfrey, supra note a letter from Representative Keogh, who had the regulated investment company special 107, at 642–643. sponsored the REIT legislation, stating, “I am tax treatment. The primary consideration was 195 See sources cited supra note 10 and 11. informed that the practical reason … was that affording the small investors a chance to pool 196 See Johnson, supra note 10, at 72–73. these trusts were generally operating at losses, their resources and at the same time obtain the 197 See sources cited at supra note 194. See also due to defaults by tenants, and were not feeling tax benefi ts available to large investors.”). Mitchell N. Baron, The Tax Status of Real Estate the income tax pinch at the time.”). 187 Id. Investment Trusts: A Reassessment , 9 COLUM. 182 See Act Secs. 27 (providing for a dividends 188 Id. J. L. & SOC. PROBS. 166, 180–181 (1972–1973) paid deddeduction)ductionn) anand 48(e) (defi ning a “mutual 189 Beginning in 1935, one corporation was not (describing the factors contributing to scarcity investmentnvvestmeent co company”)ompanny of the Revenue Act of allowed to deduct the amount of dividends of capital for real estate development). 19361936 (P.(P.L.L. 740740 ), 49 Stat.Sta 16488 (1936). See in receivedve from another corporation. See Thehe 198 SeSee also Bernstein and Godfrey, supra note 107, particularpartiliculaar SiSSectionectii48on 4848(e)(2),8(8(e)( )( whichch provided that, Revenuenu Act of 1935,935, 49 Stat.at. 1014 014 ( (Aug. 30,0, at 643–644. “corporation“corporation shall shall notnoto be consideredred as a mutual 1931935).5). This inintentionaltentiona doubdoublee taxataxation of 199 See Se Roe,Ro supraup a note 12, at 1478–141478–14800 (“Ta(“Tax investmentinvestment cocompanympany [an[and thus nott as entitled to corcorporateor iincomen me was ddesignedsig to pupunish thehe reliefre f for mumutualal funds hahad a fairnefairness-based-b thee dividendsdividends paidpaid deduction]dedue ctionio if, subsequentbsequent to a mumulti-tieredi-ti ed mmonopoliesonopoli tthat resultresulted fromm justifijust fication. cation. TheT wealthy ccouldd get the bbenefie ts datee thirthirtyrty ddaysaysy afteafter the ddate of the enactment the wave of consolidation of the late 19th and of professional management by hiring their own of this Act, at any time during the taxable year— early 20th centuries. See Morley, supra note trustee to manage their portfolio. The middle- (A) More than 5 per centum of the gross as- 108, at 359 (noting that when “President Roo- class could only get this professional help sets of the corporation, taken at cost, was sevelt proposed for the fi rst time a requirement through a mutual fund. But after Morrissey … invested in stock or securities, or both, of any that corporations must pay tax on ordinary getting that professional help was inordinately one corporation, government, or political income in the form of dividends received from expensive. Tax doctrine was reconciled with the subdivision thereof, but this limitation shall other corporations … [he] said unapologeti- goal of giving the middle-class collective access not apply to investments in obligations of cally that part of the inter-corporate dividend to professional investment management by the United States or in obligations of any tax’s purpose was to discourage large holding returning to the view that picking a fragmented corporation organized under general Act of company structures.”) (citing The President’s portfolio was not really a business after all.”). Congress if such corporation is an instrumen- Message to Congress Urging Increased Taxes on 200 See H.R. Report No. 86-2020, 1960-2 CB 731, tality of the United States; or Wealth, WASH. POST, June 20, 1935, at 1.) If RICs 821, 1960 (stating that granting real estate (B) It owned more than 10 per centum of the were allowed to buy up a signifi cant number of collective investment tax parity with collec- outstanding stock or securities, or both, of corporations in a particular industry, then RICs tive investment in securities “is particularly any one corporation; or would be able to engage in the monopolistic important at the present time because of the (C) It had any outstanding bonds or indebted- practices that Congress was trying to prevent shortage of private capital and mortgage money ness in excess of 10 per centum of its gross without having to pay an extra level of tax on for individual homes, apartment houses, offi ce assets taken at cost; or corporate dividend income. buildings, factories, and hotels. At the present (D) It fails to comply with any rule or regulation 190 Arthur Kent, Acting Chief Counsel to the Bureau time the fi nancing of these real estate equities prescribed by the Commissioner, with the of Internal Revenue, noted in a hearing preced- and mortgages is dependent largely on Gov- approval of the Secretary, for the purpose ing the enactment of the 1936 Act that one of ernment-guaranteed money, and investments of ascertaining the actual ownership of its its aims was “to prevent an investment trust or by special groups, such as insurance companies outstanding stock.” investment corporation being set up to obtain and pension trusts.”). 183 The similarity of the 1936 Act’s description of control of some corporation and to manipulate 201 See Dockser, supra note 104, at 123 (“the Com- RICs and their pre-Morrissey operating model its affairs.” See REVENUE ACT OF 1936: CONFIDEN- mittee [drafting the REIT legislation] is careful likely owes, in part, to the fact that diversifi ed TIAL HEARINGS ON H.R. 12395 BEFORE THE SENATE to use as its model of an acceptable real estate investment funds were intimately involved in COMM. ON FINANCE, 74th Cong., 2d Sess., pt. 11, investment trust, the Massachusetts or business the drafting of the relevant provisions of the at 11. trust as it had come to be used. The Committee Act. Paul Cabot, for example, was the president 191 49 Stat. 1648, §14(b). states that, ‘the general requirements include of the State Street Investment Company, a Mas- 192 See Bank, supra note 86, at 931. provisions that the trusts be managed by trust-

266 TAXES The Tax Magazine® MARCH 2016 ees, have transferable shares or certificates Tax Reform Act of 1986, at 391 (“The Congress manage” a healthcare or lodging facility. See of benefi cial interest, and that they be a type believed that [the] requirements of [pre-1986] supra note 52 and accompanying text. of organization which would be taxed as an law … may be overly restrictive and should be 215 See note 1 and accompanying text. ordinary domestic corporation in the absence liberalized ….”); 145 CONG. REC. S5377 (daily ed. 216 See Note, The Real Estate Investment Trust—Past, of the provisions of the bill.’ It is clear from this May 14, 1999) (statement of Sen. Mack) (“As a Present, and Future, 23 U. PITT. L. REV. 779, 779 statement that the Committee had the Massa- result [of the pre-1999 rules on REIT services], (1962) (“At the time [he vetoed the bill], Presi- chusetts or business trust in mind when passing REITs increasingly have been unable to compete dent Eisenhower, following the advice of the the Act.”). with privately-held partnerships and other more Treasury Department, said: ‘Though intended 202 See supra Part IV.A.3. exclusive forms of ownership …. Certainly, this to be applicable only to a small number of 203 See Code Sec. 856(d)(3) (1960). Although is not consistent with what Congress intended trusts, it could, and might well become, avail- providing services would not disqualify the REIT when it created REITs, and when it modifi ed the able to many real estate companies which were per se, any income attributable to the provision REIT rules over the years.”). originally organized and have always carried on of any services was treated as nonqualifying 207 To ensure that the contractor was truly “inde- their activities as fully taxable corporations.’” income for purposes of the income tests. Id. pendent” of the REIT, the 1960 REIT Legisla- (quoting Baldinger, Real Estate Investment Trusts , 204 For example, a 1960 REIT that owned any invention defi ned an independent contractor so as 27 J.B.A. D.C. 584 (1960)).) tory property would lose its REIT status—even if to exclude entities that directly or indirectly 217 Theodore S. Lynn, Harry F. Goldberg and Robert it did not recognize gain from sale of the prop- owned, or whose owners directly or indirectly H. Steinfeld, REAL ESTATE INVESTMENT TRUSTS erty or, indeed, even if did not sell the property owned, a signifi cant stake in the REIT, based on at 1022 (1987), cited by Note, Managing the at all. Code Sec. 856(a)(4) (1960). Contrast that complex attribution rules that had the potential Real-Estate Investment Trust: An Alternative to treatment with today’s REIT rules on inventory, to disqualify many entities that a layman might the Independent Contractor Requirements, 107 which impose a 100-percent penalty tax on consider obviously independent. See Code Sec. HARV. L. REV. 1117, 1126 (1993–1994). inventory gain but otherwise are not relevant 856(d)(3) (1960). This basic defi nition has sur- 218 See Theodore K. Quinn, UNCONSCIOUS PUBLIC to an entity’s qualifi cation as a REIT. See Code vived to this day. See Code Sec. 856(d)(3), (5) . ENEMIES, 121–122 (1962) (noting that “testi- Sec. 857(b)(6). Similarly, in addition to the 208 See Decker et al., supra note 47, at 416–417. The mony developed during hearings held by the 1960 versions of the current 75-percent and statute itself only provided that a REIT could not Subcommittee on Anti-trust and Monopoly 95-percent income tests, the 1960 REIT Legisla- furnish services other than through an indepen- of the Senate Judiciary Committee shows that tion also contained a 30-percent income test, dent contractor—without drawing a distinction more money fl ows through [GM’s] coffers than which prevented a REIT from deriving more than between customary and non-customary services is ever seen by the combined treasuries of forty 30 percent of its income from either (i) the sale or between separate and bundled charges—but states of the union. In this sense, GM is several of securitiesecuriities hheldeld ffor six months or less or (ii) early regulations issued in 1962 made these times richer than the State of New York.”). thehee sale oof real l estatestatee held for four years or less distinctions relevant. See id. 219 During his confi rmation hearings in 1953, Wilson (even(evven ththough,ough, iinn eitheitherer ccase, thatat gain mamay have 209 Even today,t y these requirements continue to waswa asked by the Senate confi rmation panel how qualifiqualifi ededdf forfor oneone or bothbbot of thee other income applyy wwherehere an independentndepe ent cocontractortracto is useded he would address confl icts betweenween his rolee aas tests).tests). Code Code Sec.Sec. 856(c)(4)856(c)6 (1960).0). to providero e noncustomaryncustom y serservices.ices. SSee Reg. g. SecretarySe eta of Defenseefe se anand hihis status aas a larglarge 2055 ForFor a helpfulheelpful summarysummarym of the developmentsevelopments §1.§1.856-4(b)(5)56 b) . shareholdersh eholder oof GM, and famfamouslyusly replirepliedd tthat a specifispeecifi callycally in the areaarear off tenantte services, seese 2102 See Se DecDeckerer et al.,al., supra noteot 47,7, at 41417, n. 30 conflcon ict oughtough neverever exist, becausecause “f“for yyears I Deckercker etet al.,al., suprasupr note 47, at 416–423. For (“A Goldman Sachs report from 1996 stated thought that what was good for our country was other discussions of the modernizing amend- that only 10 REITs of any real size existed during good for GM, and vice-versa.” See Excepts From ments to the REIT rules, see generally, e.g., the 1960s but that those REITs had ‘miniscule’ Two Wilson Hearing Before Senate Committees James S. Halpern, Real Estate Investment Trusts portfolios of real property when compared with on Defense Appointment, N.Y. TIMES , Jan. 24, and the Tax Reform Act of 1976, 31 TAX LAW. 329 other property owners.”) (citing Ralph L. Block, 1953, at 8. (1978) (discussing the amendments contained in INVESTING in REITs: Real Estate Investment Trusts 220 National City Lines, Inc., DC-IL, 118 FSupp 465 the Tax Reform Act of 1986); Tony M. Edwards, 110-111 (2006)). (1953). NAREIT, REITs Modernized (1999), available 211 Act Sec. 1604(b) of the Tax Reform Act of 1976 221 See National City Lines, Inc., CA-7, 186 F2d 562 online at www.reit.com/sites/default/files/ (P.L. 94-455), 90 S tat. 1520, 1749 (1976); Code (1951). For those unfamiliar with the National media/Portals/0/Files/Nareit/htdocs/policy/ Sec. 856(d)(1)(B) (providing that the term City Lines (NCL) conspiracy, the scandal begins government/RMA-2.pdf (summarizing the REIT “rents from real property” includes “charges in the 1930s. Few people remember, but by the Modernization Act of 1999); Tony M. Edwards & for services customarily furnished or rendered 1930s, the United States had one of the most Dara F. Bernstein, NAREIT, REITs Improved , avail- in connection with the rental of real property, extensive and sophisticated electric street able online at www.reit.com/sites/default/fi les/ whether or not such charges are separately car systems in the world. Street cars systems media/Portals/0/Files/Nareit/htdocs/policy/ stated.”). were started by the electric companies, which government/ BNAArticlefi nal%201-03-05.pdf 212 Act Sec. 1604(b) of the Tax Reform Act of 1976 owned rights of way that snaked underneath (summarizing the REIT amendments passed as (P.L. 94-455), 90 Stat. 1520, 1749 (1976); Code the overhead power line systems that snaked part of the American Jobs Creation Act of 2004); Sec. 856(d)(2)(C) (1976). through our cities and used the street car idea Tony M. Edwards & Dara F. Bernstein, NAREIT, 213 See STAFF OF JOINT COMMITTEE ON TAXATION, 99TH as a way to squeeze additional revenue out of REITs Empowered, 24 TAX MANAGEMENT REAL CONG., 1ST SESS., GENERAL EXPLANATION OF THE TAX their power line systems. Since every major city EST. J. 7 (2008), available online at www.reit. REFORM ACT OF 1986 391 (COMM. PRINT 1987) had an electric company, virtually every major com/sites/default/fi les/media/Portals/0/ PDF/ (stating that some REIT restrictions pre-1986 city had an electric street car system. Ironically, REITSEMPOWERED.pdf (summarizing the REIT “may [have been] overly restrictive and should the Los Angeles system was among the fi nest in Investment Diversifi cation and Empowerment be liberalized consistent with maintaining the the nation. Act of 2007). essential passivity of the REIT.”); see also David From the perspective of the automobile, oil, 206 See, e.g. , S. Rep. No. 94-938, at 473-474 (June M. Einhorn, Unintended Advantage: Equity REITs and tire industries, the problem with electric 10, 1976) (noting that the restrictions in the vs. Taxable Real Estate Companies , 51 TAX LAW. street cars was that they did not require driv- 1960 REIT Legislation did “not follow normal 203, 210–211 (1997–1998). ers, gasoline or tires, which made them a direct commercial practice”); see also Joint Commit- 214 As noted above, the only limitation on the competitor to companies that sell cars, oil, tee on Taxation, General Explanation of the operation of a TRS is that it cannot “operate or and tires. This issue laid the groundwork for a

MARCH 2016 267 MODERN REITS AND THE CORPORATE TAX

criminal antitrust conspiracy among some of rule [of non-taxation] should be made a new building in a one factory town because the largest corporations at the time—General to make the income of real estate invest- of the risk that the factory might shut down or Motors, Standard Oil of California (Socal), Phil- ment trust taxable … . move operations somewhere else). lips Petroleum, Mack Manufacturing (the truck Id., at 509–510 (Emphasis in original). 226 See, e.g., Channing, supra note 104, at 510 (“In manufacturer) and Firestone Tire & Rubber. 223 It is unlikely that either RICs or REITs were the real estate trust situation, it is plain that the Those companies formed and funded NCL. NCL contemplated by Congress when drafting the dangers of monopoly do not existing in anything had a fairly simple operating model. It would 1909 Act. See REVENUE ACT OF 1936: CONFI- like the degree in which they are present in the acquire privately owned street car line systems DENTIAL HEARINGS ON H.R. 12395 BEFORE THE securities situation [i.e., where companies own in a particular city, rip out the streetcar lines and SENATE COMM. ON FINANCE, 74th Cong., 2d Sess. controlling interests in non-real estate compa- replace them with motorized buses. The buses, (remarks of Arthur Kent, Acting Chief Counsel to nies] ….”). Channing recognized the relevance of of course, were manufactured by GM and Mack, the Bureau of Internal Revenue), pt. 10, at 61 (“I monopoly to the question of whether collective ran on tires made by Firestone, and used gaso- am not certain that Congress actually intended investment vehicles, such as RICs and REITs line produced by Phillips. See Jonathan Kwitny, to include them [i.e., RICs], or that this situation should be subject to the corporate tax: The Great Transportation Conspiracy, HARPER’S was considered when the association defi nition In the interests of a sound tax structure, MAGAZINE, Feb. 1981, at 14–21. was written into the Act.”). and for other reasons, it is absolutely One aspect of the conspiracy in particular 224 See, e.g. , Eliot, 220 US 178 (1911), discussed necessary to confi ne the tax-exemption illustrates the validity of the policy objectives above in Part IV.A.2(b). Eliot is notable for its to entities which limit their activities underlying the corporate tax. Early on, the detailed description of a real estate trust in entirely to acting as investment media participants in NCL realized that the process of 1911. Like modern REITs, the Cushing Real Estate to the exclusion of all else. If securities buying street car lines, destroying the street car Trust at issue in the case was organized in order investment companies, for example, were infrastructure, and replacing that infrastructure to purchase, improve, hold and sell properties. permitted to acquire controlling interests with motorized buses might not make economic Control of the trust was vested in the trustees, in great industrial corporations, they sense unless one took into account the future who apparently possessed powers similar to would necessarily assume the respon- profi ts that could be made on the sale of buses, a modern board of directors. Trust shares, like sibilities that go therewith. In so doing tires, oil and, in the case of GM, cars as well modern REIT shares, were freely transferable. they would tend inevitably to lose their (the idea being that people would rather buy The trust gave no shareholder any right to the character as investors as they became a car than ride a bus). In order to establish the trust’s property, only to dividends made out of more and more obligated to engage in the stand-alone viability of NCL, NCL attempted net income and net proceeds: business they had come to control, and it to obtain debt and equity funding from banks, [The case concerns] a certain trust is conceivable that they could grow into brokersers and underwriters.uund Because NCL was formed for the purpose of purchasing, monopolies of economic power. notnoot econ economicallynomicaally via viableab on a stand-alone basis, improving, holding, and selling lands Id. thosethoose ffundraisingunndraising eeffortsfffort provedd fruitless, which andnd buildings in Boston, known as the 227 Se See Borden, supra note 9, at 542. bringsbibrings uuss to tthehe totopicpicpi oof retainedned earnings—it Cushingus ng ReaReal Estate Trust.ust. By the teterms 228 See Se generallyg y Borden,, supra notee 9. appearsappears tthathat tthehe priprimarymarm source of funding for off tthe ttrust,ru the propertyprop rty wawass convconveyed 229 CodeCo e Sec.S 85 857(a)(2)(a) . NCLNCL wawass tthehe rretainedetained eaearnings of its sharehold- too ccertainain trustees,ustees, wwhoo eexecutedted a ttrust 230 SeeSe Equinix,Eq x, Inc.’s.’s 2015 FormFor 10-K at 155 ((2015 erss ( i.e.i.e.,, GM,GM, SSocal,ocal, PhPPhillipslipsps aand Mack).ck) agreementgreement wwherebyhereby tthee mmanagementageme of conversion,con ersion, aapprox.ox. $600 millionion distdistribution);bu From tthehe rerecordcordc aas we hhave it, it would appear the property was vested in the trustees, Iron Mountain Incorporated’s 2014 Form 10-K that the entire NCL street car scandal might not who had absolute control and authority at 29 (2014 conversion, approx. $700 million have occurred but for the accumulation of the over the same, with right to sell for cash distribution); Outfront Media Inc.’s 2014 Form retained earnings used by NCL’s shareholders to or credit at public or private sale, and 10-K at 6–7 (formerly CBS Outdoors America fund NCL’s operations. The NCL scandal in some with full power to manage the property Inc.) (2014 spin-off, $547.7 million distribution); ways is the poster-child for the policy objectives as they deemed best for the interest of CareTrust REIT, Inc.’s 2014 10-K at 55 (2014 that that prompted Congress and President the shareholders. The shareholders are spin-off, $132 million distribution). Taft (and Roosevelt before him) to push for the to be paid dividends from time to time 231 See McRae Thompson, C Corporation to REIT corporate tax in 1909. See generally, A STUDY from the net income or net proceeds of Conversions—A Closer Look at the Tax Conse- OF THE ANTITRUST LAWS: HEARINGS BEFORE THE the property, and twenty years after the quences, 17 BUS. ENTITIES 3, 9 (2015) (“In the SUBCOMMITTEE ON ANTITRUST AND MONOPOLY OF termination of lives in being, the property context of a REIT conversion transaction, [the THE COMMITTEE ON THE JUDICIARY, UNITED STATES to be sold, and the proceeds of the sale to purging dividend] results in a one-time taxable SENATE, PART VI, GENERAL MOTORS, 84th Cong. be divided among the parties interested dividend event which may have never occurred 1st sess., Part 6. …. The shares were transferable on the without the REIT conversion. This insures that 222 The one piece of commentary we have found books of the trustees, and on surrender all current and prior C corporation earnings and making these arguments is Channing, supra note of the certifi cate, and the transfer thereof profi ts attributed to the REIT are subject to the 104, at 509–510, written in 1958, between the in writing, a new certifi cate is to issue to double tax that would have applied under the C vetoing of the fi rst legislative REIT proposal in the transferee. No shareholder had any corporation regime and results in a sometimes 1956 and the eventual enactment of the 1960 legal title or interest in the property, and signifi cant acceleration of the investor-level REIT Legislation in 1960. Under a heading en- no right to call for the partition thereof taxation on the shareholders which otherwise titled “Should Real Estate Investment Trusts Be during the continuance of the trust. may have continued to be deferred indefi nitely.” Taxed?”, Channing presciently argued: 225 Company towns were probably aimed more (Emphasis in original)). If the foregoing [argument about why at vertical integration and companies keeping 232 See, e.g. , Boos, supra note 21, at 1289 (“[T]he “conduit” securities investment vehicles, control over workers and preventing unioniza- ability for taxable REIT subsidiaries (TRSs) to such as RICs, generally should not be tion. Also, company towns may have been perform many of the services that would other- taxed] is true in general, the law should evidence of (i) lack of fi nancing for households wise disqualify most entities from operating as not have been framed to tax the income to purchase real estate, and (ii) the fact that real a REIT has allowed virtually any company with of conduits generally in the fi rst place, estate companies may have been reluctant to signifi cant real estate holdings to reduce its tax and the argument here ought to be become too exposed to one employer (e.g., an bill.”); id., at 1291 (“Perhaps the most effective whether an exception from the general apartment company might not want to build way to curb the growth of REIT expansions is

268 TAXES The Tax Magazine® MARCH 2016 to repeal the permissibility of TRSs … [T]he structural components of such buildings from the IRS’s own REIT ruling history—that existence of the TRS negates the original passive or structures) …. Local law defi nitions the focus is on the degree of permanence with function of the REIT itself.”). will not be controlling for purposes of which the relevant asset is affi xed to land or a 233 See Code Sec. 856(b)(5)(B) (1960). determining the meaning of the term building. In other words, how diffi cult is the as- 234 We acknowledge, as some REIT critics have, that “real property” as used in section 856 set to move and how unlikely is it that the asset the meaningfulness of TRSs’ paying tax on their and the regulations thereunder. The term will be moved? The harder and less likely it is to income depends on the IRS’s ability to enforce includes, for example, the wiring in a move, the more likely it is real property. transfer pricing rules that are designed prevent building, plumbing systems, central heat- The precise meaning of the second prong TRSs from shifting too much income to their ing or central air-conditioning machinery, (“asset accessory to the operation of a business”) REIT parents. See, e.g. , Boos, supra note 21, at pipes or ducts, elevators or escalators is far less clear, though what is reasonably clear 1291 (arguing that “the potential for transfer installed in the building, or other items is that it depends on the function of the asset pricing abuse between the REIT and the TRS which are structural components of a (e.g., what it actually does and what purposes is … [a] justifi cation for Congress to consider building or other permanent structure. it serves) rather than its degree of movability, repealing the TRS statute”). Because the Code The term does not include assets acces- and in particular on some notion that the asset imposes very harsh penalties on REITs that act sory to the operation of a business , such as is suffi ciently “passive” in function (whatever on non-arm’s-length terms with their TRSs, see, machinery, printing press, transportation that means). Beyond saying that, it is diffi cult e.g. , sources cited supra note 53, this issue is only equipment which is not a structural com- to distill all of the relevant authorities into a one of enforcement and does not represent a ponent of the building, offi ce equipment, single statement (or few statements) of law, theoretical policy problem with the use of TRSs. refrigerators, individual air-conditioning and although we have a theory on what those In that regard, contrary to REIT critics’ claims units, grocery counters, furnishings of statements might say, fl eshing that out is be- that “REITs are audited relatively rarely,” see id., a motel, hotel, or offi ce building, etc., yond the scope of this article and would only at 1293, we can attest from our own experience even though such items may be termed be a distraction from our main point, which is that audits of TRSs are becoming increasingly fi xtures under local law. that the IRS’s general approach to defi ning real common, with transfer pricing issues normally Reg. §1.856-3(d) (Emphasis added.). It is impor- property has not changed. being the focus of the audit. tant to note that an asset that is otherwise real 240 See Proposed Reg. §1.856-10, REG-150760-13, 235 See supra Part II.B.3. property will not cease to be real property—will 79 FR 27,508 (May 14, 2014). For example, the 236 Obviously, this structure only works where the not be treated as accessory to the operation of proposed regulations contain a safe harbor list of REIT owns all (or at least a super majority) of the a business—simply because it is used in an active assets that automatically qualify as real property, shares of the TRS. In order to prevent unexpected business . As the IRS has stated in a memorandum Proposed Reg. §1.856-10(d)(2)(iii)(B), (3)(ii) , many REITT incomeincome test t issues, any mandatory TRS that addressed certain broadcast towers and of which were previously the subject of published dividenddivvidendd woulwouldld havhavee to either be disregarded related assets: and private IRS rulings, such as microwave and forr purposespurposes ofof tthehe REITR incomee tests in a man- You ou also argue that Congress intended cecellular transmission towers (Rev. Rul. 75-424, nerner similarsiiimilar to hedginghdihedgiiing income,, sees Code ode Sec. thatat REITs ininvestest ononly inn certcertainain papassive 191975-2 CB 269;; LTR 2011290077 (Ap(Apr. 6,, 20112011); 856(c)(5)(G)856(c)(5)(G) , or tretreatedated as qualifyinglifying income typepe investmentve ment propropertyerty aandnd that the LT LTR 2020120600160 1 (A(Aug.g. 1616, 2011));01 )); railroarailroadd tracktracks, forr purppurposesoses ooff tthehe 75-p775-percent incomecome test. towerow aandnd facilitiescilities wwill be operatedated aas an brbridgesges and ttunnelsnels (Rev. RuRul. 69-94, 11969-169 CB 237 See e, e.e.g.g., BoosBoos,, supra noteno e 21,21 at 12900 (“Lawmak-(“Lawmak activective businbusiness.ss. HowHowever,ve Congress ongress was 189189); transmtransmissionon lines ( LTLTR 20072502007250155 (Mar. ers … mimightight cconcludeoncludo that the recent expansion concerned with the lessor [ REIT ] conducting 13, 2007)); pipelines ( LTR 200937006 (Mar. 3, of the defi nition of real property is problematic a business and not with the fact that the 2009)); and certain outdoor advertising displays and requires a reining in of REITs.”); Lee A. Shep- leased assets might be used by the les- ( LTR 201522002 (Feb. 27, 2015); LTR 201431020 pard, Can Any Company Be a REIT?, 140 TAX see in the active conduct of a business . (Apr. 16, 2014); LTR 201431018 (Apr. 22, 2014)). NOTES 755, 755 (2013) (“IRS REIT conversion Obviously, a lessee occupying a hotel or Assets that are not on the safe harbor list are rulings over the last few years have been expan- factory would be using them in the ac- classifi ed under a facts-and-circumstances test sionary interpretations of the statute.”); Popper, tive conduct of a business but the trust that, familiarly, focuses largely on the asset’s supra note 24 (“[B]it by bit, especially in recent would still qualify if its participation was movability and its passiveness. The framework years, … the I.R.S., in a number of low-profi le properly limited. Here, under the terms of of the proposed regulations is thus largely con- decisions, has broadened the defi nition of real the lease, the lessee will operate the busi- sistent with the IRS’s approach to defi ning real estate ….”); Glanz, supra note 24 (“The I.R.S … ness and the [REIT]’s involvement will be property over the last 50 years. ‘is letting people broaden these defi nitions [of as passive as the lessor of an apartment 241 When it comes to technological developments real estate] in a way that they kind of create the building, factory, or hotel. creating REIT assets that did not exist in 1960, image of a loophole.’” (quoting Ryan Alexander, General Counsel Memorandum 32907 (Sept. 3, the fi rst example that comes to mind is the cell president of Taxpayers for Common Sense)). 1964). phone tower. Back in the 1960s, consumer- 238 The defi nition of “real property” is crucial both The defi nition has two key prongs: First, an grade wireless communication systems did not from an income test perspective ( i.e., in order to asset, if it is not land or a building, must be an exist, and most government and commercial determine whether particular rental income is “inherently permanent structure,” a term that wireless communications systems relied on low “rents from real property”), as well as an asset includes a “structural component” of a build- frequency ranges (typically below 175 mhz, and test perspective ( e.g., in order to determine how ing or other inherently permanent structure. occasionally as high as 460 mhz) that required much of the REIT’s assets are good “real estate Second, the asset must not be “accessory to the the use of a small number of high power trans- assets” for purposes of the 75-percent asset test, operation of a business.” mitters located atop tall buildings, mountains or a term that includes interest in “real property”). The meaning of the fi rst prong is clearer than towers. Fifty years later, 10-year-old children are 239 Ever since 1962, the regulations under Code Sec. the second, though neither is obvious from running around with smart phones that transmit 856 have contained the following defi nition of the face of the regulation. With respect to the on extremely high frequencies (typically above real property: fi rst prong (“inherently permanent structure”), 800 mhz) and that require the use of a large The term “real property” means land or although no Code section, regulation or REIT number of very low power transmitters located improvements thereon, such as buildings authority defi nes the term, it is reasonably clear in many different locations. These developments or other inherently permanent struc- at this point—both from case law in non-REIT helped spawn the cell tower sector of the REIT tures thereon (including items which are contexts that has defi ned the same term and industry. See, e.g. , LTR 201129007 (Apr. 6, 2011)

MARCH 2016 269 MODERN REITS AND THE CORPORATE TAX

(modern ruling on cell towers); LTR 201206001 over the years, it has never changed its essential “waveguides” that were affi xed to the towers; (Aug. 16, 2011) (same). function—it is now one of the largest and most a permanent HVAC system in the building that 242 See, e.g., LTR 201537020 (May 22, 2015) and important internet and data connectivity points houses the equipment; and fencing surround- LTR 201314002 (Oct. 9, 2012). Fiber-optic in the world. See Andrew Friedman, Pneumatic ing that building. The IRS ruled that the towers, network systems and data centers provide an Tubes are Reincarnated in the Digital Age, N.Y. the HVAC system, and the fencing were “real interesting example of how technological de- TIMES , April 29, 2001 (“‘Before, one carrier used estate assets” for purposes of the REIT rules velopments can change the appearance of an this entire building and these arcane devices,’ but that the antennae, waveguides, equipment, asset without changing its essential function or said Trey Farmer, executive vice president of and modular racks were “assets accessory to its tax classifi cation as real estate. Fiber-optic FiberNet, the company creating the room, the operation of a business” and thus not “real network systems move data from one place to which will allow telecoms to use one another’s estate assets” under the REIT rules. another at a high rate of speed. Although they networks and outsiders to tap into the building’s These rulings have been cited, and con- operate using completely different technology, fi ber optics. ‘This is its modern evolution. The sistently applied, many times in more recent fi ber optic network systems perform the same more we learned about the building, the more private letter rulings. basic function the pneumatic tube systems of it became this uncanny analogy.’”). 248 See Elaine Misonzhnik, Party Crashers: The House the 19th century. 243 For example, electricity transmission and distri- Ways and Means Committee Seeks to Put an End Pneumatic tube technology originated in bution systems have, until recently, been owned to the Proliferation of Non-Traditional REITs, 56 Europe in the early 19th century and quickly be- by utilities, rather than third parties that leased NATIONAL REAL ESTATE INVESTOR 55, 55 (Sept./ came popular as a fast way to transmit messages to the utilities. Oct. 2014) (“‘There is an obvious tax benefi t and data from one place to another. A pneumatic 244 Jones , SCt, 132 SCt 945 (2012). to [becoming a REIT], but it is also driven in tube system can be localized to a single building 245 Kyllo , SCt, 533 US 27 (2001). part by favorable capital markets conditions.’” or can be used to link together multiple build- 246 See Arthur C. Clarke, PROFILES OF THE FUTURE: (quoting Bob O’Brien, vice chairman of the U.S. ings (e.g., a brokerage house can be linked to a AN INQUIRY INTO THE LIMITS OF THE POSSIBLE 36 real estate services practice at Deloitte)); Brad stock trading room, a telegraph station can be (1962) (“Any suffi ciently advanced technology Thomas, REIT Sector Crackdown is Simply Fool- linked to an offi ce building). By the 1950s, these is indistinguishable from magic.”). ish, THE STREET (Apr. 29, 2013), available online systems had become standard fare in major city 247 Among the many rulings the IRS has issued over at www.thestreet.com/story/11907794/1/reit- offi ce markets, and were viewed as essential to the years on the meaning of “real property” and sector-crackdown-is-simply-foolish.html (“It’s the rapid transmission of information that could “real estate assets,” two early published rulings clear that the increased demand [for REIT stocks] not be moved via telegraph or telephone (e.g., in particular—Rev. Rul. 69-94, 1969-1 CB 189 is not driven by the corporate tax exemption …. contracts and larger objects). (the “Railroad Ruling”), and Rev. Rul. 75-424 , Instead, it seems the strong demand is driven by AlthoAlthough ough ththehe aauthors could not locate any 1975-2 CB 269 (the “Transmission Tower Rul- Mr. Market. REITs today are trading at very high authoritiesuthoritties d discussingiscusssin the classification of ing”)—are seminal and probably among the multiples and that has created an environment pnpneumaticeumatic tubetube systemssystes for purpose of the moree ffrequently cited published rulings in IRSRS fufueled by low cost debt and equity.”). REREITIT rurules, llees, iitt sseemseems cleaclearl that the system, as a pprivateate rulings on “new”n asseasset classclasses,[247]7] 249 Se See Misonzhnik, suprap note 249 (“[W]hat’sW]hat ststandardandard ffeatureeature ooff ooffiffif ce buildingss in Manhattan proprobablyab aass a consequencensequen e of bebeingng googood analo-o- fafar momore likelyke y [[thanan a changeha ge in ththe defi ni-n thrthroughrough tthehe 11960s,960s, wouwwould qqualify as real estate giegies fforo manyan off those nneww assets.s ttionio of ‘realal estate’]tate’] to sloslow down ththee ddesire ununderder tthehe 19619600 reregulations.guula ons.ns In the RailroRailroadad RulinRuling,, a REITEIT ownedown landnd for REIT conconversionssions in tthe near tertermm iis the When n it cocomesmesm tto data centers, we found an that it had acquired from a railroad, along with anticipation of higher interests rates, O’Brien interesting example of how an entire building can certain railroad assets related thereto, including says. If interest rates spike and investors lose adapt to changes in technology without chang- the trackage, roadbed, buildings, bridges and tun- their appetite for REIT stocks, REIT spin-off ing its essential function: 60 Hudson Street in nels used by the railroad. The IRS, without much [sic] will look a lot less attractive.”); Hough, Manhattan’s Tribeca neighborhood, which was reasoning, ruled that the railroad assets were not supra note 25 (“Ultralow bond yields have designed in the 1920s for the Western Union “accessory to the operation of a business” and sent investors scrambling for income, and Telegraph Company and was a technological thus were real property for purposes of Code REITs have become a favorite holding.”); see masterpiece that included an extensive telegraph Sec. 856. Despite the lack of reasoning, it is clear also Thomas, supra note 248 (“A few weeks system and one of the largest pneumatic tube that the IRS’s conclusion comports with the two- back I caught up with Brad Case, Ph.D., CFA, networks then in existence in the United States. pronged analysis described above—few assets, and CAIA, senior vice president of research In addition to having its own internal pneu- buildings included, are much more permanent and industry information with NAREIT, and matic tube system, the Western Union building that railroad tracks, roadbeds, bridges and tun- he provided me with a value proposition on Hudson Street was a nerve center that con- nels, and whatever “passive” means for purposes for a REIT dividend vs. a non-REIT dividend: nected to a larger pneumatic tube system that of the second prong, it is hard to envision how ‘There’s a big difference between cash that a provided access to critical buildings located these types of assets are not passive and thus company has because it raised it externally to throughout lower Manhattan. In that way, a not accessory to the operation of a business. fi nance a planned acquisition [ e.g., as a REIT person could send a pneumatic tube canister to Though the Railroad Ruling is important, would], and cash that it has because it refused the Western Union building, where the canister the Transmission Tower Ruling is probably even to pay dividends to shareholders. Academic could be relayed to another building somewhere more infl uential. There, the IRS addressed the researchers have found time and time again else in the city. See Skyscraper Begun by Western real property status of certain systems for the that executives have a tendency to make poor Union, N.Y. TIMES , August 22, 1928, at 32. transmission of audio and video signals via use of free cash on hand, whereas when they With a pneumatic tube system looking and microwaves. The microwave system consisted have to undergo “capital market scrutiny,” functioning in much the same way as a fi ber of several components: towers built upon pil- they tend to make decisions that are better for optic network system, it ought not be surprising ings or foundations; antennae that transmit shareholders. That may be part of the reason that, when it opened in the 1930s, the Western and receive microwaves and that are affi xed to why listed REIT returns have been systemati- Union building was a data transfer point and the top of the towers; certain equipment that cally better than non-REIT stock returns, not storage center for data transmitting devices. processes the microwave signals and is housed just recently but over more than four decades From the perspective of this article, the most in a nearby building; “modular racks” that sup- of available history.’”); A.D. Pruitt & Amol interesting part of the story is that, although the port the equipment and are wired or bolted Sharma, IRS Puts Breaks on Corporate Push Western Union building may have traded hands to the fl oor and ceiling of the building; certain to Capture Real-Estate Tax Break, WALL ST. J. ,

270 TAXES The Tax Magazine® MARCH 2016 June 7, 2013, available online at www.wsj.com/ mary originations and open-market secondary might a REIT do things in order to earn rent. articles/SB10001424127887324299104578 purchases.”); id, at 115 (describing New Moun- For example, it ought to be common knowl- 531101364286158 (“REITs are popular with tain’s “private equity investment strategy”); edge that most commercial tenants (artists individual investors seeking higher yielding Corporate Capital Trusts II, Form N-2, October excluded) do not want to rent physical space securities.”). 1, 2015, at 4 (“We intend to pursue a strategy in a dilapidated building, even if the building is 250 See supra Part II.C. focused on investing primarily in the debt of well located. At some point, somebody some- 251 See IV.B.1. privately owned U.S. companies with a focus on where has to do something in order to get the 252 See sources cited at supra note 200. originate transactions ….”); Hercules Technol- property in a state where a commercial tenant 253 See sources cited at infra note 261. ogy Growth Capital, Inc., Form N-2, September will want to pay money in order to occupy 254 See STOCK EXCHANGE PRACTICES: REPORT OF THE 29, 2015, at 1 (“We are a specialty finance the property. Once it is acknowledged that COMM. ON BANKING AND CURRENCY, S. REP. No. company focused on providing senior secured certain types of activities—e.g., repairing the 1455, 73d Cong., 2d Sess. 333 (1934); see also loans to venture capital-backed companies in property, maintaining the property, providing Roe, supra note 12, at 1472; Channing, supra technology-related industries ….”). security, trash removal, etc. —are consistent note 104, at 510 (“The dangers [of monopoly 259 Rev. Rul. 67-353, 1967-2 CB 252 (1967). with the receipt of “passive” rental income, by investment companies] have been met, and 260 See, e.g. , Sheppard, supra note 238 (“The value we’ve established that “doing things” to earn apparently effectively met, by conﬁ ning the of [data centers] comes from power services rental income is not inconsistent with a REIT’s interest which a regulated investment company and proximity rather than square footage in status as a “passive” entity. As properties move can hold in any one company to a percentage, Weehawken … [A]s a ﬁ nancial matter, [data up market, the demands for tenant services and by other restrictions.”). center owners] could be considered power and will increase, and unless Congress decides 255 Depending on the governance structure of the telecom resellers, even though they are not to ban REITs from the upmarket real estate companies, the RIC could potentially vote for regulated as utilities.”); Glanz, supra note 24. sector (which would be a complete reversal all directors of all four companies with only 51 261 See Channing, supra note 104, at 510 (“[I]n prin- of the populist and capital markets policies percent of the stock of each company. ciple there is no basis for distinguishing between underlying the 1960 REIT Legislation), the 256 See Legal Advice Issued by Associate Chief dividends, interest, and rents.”). level of services demanded by tenants at a par- Counsel, 2009-010 (Oct. 2, 2009). 262 In other words, if one shifts focus from the ticular property ought to be irrelevant to the 257 Id. things that are being done in order to earn a determination of whether or not the property 258 See, e.g. , New Mountain Finance Corporation, return to the type of return being earned, we belongs inside a REIT, so long as the amounts Form N-2, May 9, 2011, at 2 (“We expect to can see very quickly that, just as a RIC may do received by a REIT are tied to the tenant’s use make investments [in loans] through both pri- things in order to earn interest income, so too of the property.

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