2014-Issue 35—On July 29, 2014, Windstream Holdings, Inc. announced its plans to spin-off certain telecommunication network assets into a publicly traded real estate investment trust (REIT) following the issuance of a favorable private letter ruling from the Internal Revenue Service. According to the company, a successful REIT formation transaction will enable it to accelerate the pace of its network investments, enhance its service offerings to customers and maximize shareholder value. Furthermore, the proposed transaction is expected to result in significant financial flexibility by reducing debt and thereby increasing cash flow available to make broadband investments, transition faster to an IP network and pursue additional growth opportunities to better serve customers. As the IRS continues to issue favorable REIT qualification rulings across various industries, many companies holding a significant amount of real property may think that they could benefit immensely from a successful REIT formation transaction. These candidates should begin their analysis by obtaining a basic understanding of the critical business and tax issues that may accompany a REIT conversion process.        

Background — What Is a REIT?
A REIT is often described as a mutual fund for real estate. A REIT generally pays no federal corporate-level income tax if it distributes 100 percent of its current REIT taxable income to its shareholders annually. Additionally, a REIT must maintain compliance with numerous organizational and operational requirements. Some of the key requirements summarized at a high level include, but are not limited to, the following:

• A REIT must predominantly own “real property”;
• A REIT must predominantly realize income from renting and/or selling real property used in a trade or business;
• A REIT may not hold more than a 10 percent interest in any corporation other than another REIT, a taxable REIT subsidiary (TRS), or a qualified REIT subsidiary (QRS);
• Not more than 5 percent of the total value of a REIT’s assets may be made up of stock in a corporation other than a TRS, a QRS or another REIT;
• A REIT must distribute at least 90 percent of its REIT taxable income to its shareholders on an annual basis (note that any retained income may be subject to ordinary corporate income tax rates);
• A REIT must have at least 100 direct shareholders; and
• Five or fewer individuals generally cannot own more than 50 percent of the value of the REIT’s stock.

Companies considering the REIT conversion process must weigh the current and recurring costs of the additional disclosures and/or corporate governance required to meet the REIT qualification requirements. Furthermore, key business risks such as tax law changes, capital market acceptance and operations/execution must be evaluated.

REIT Conversion Structure Alternatives
The markets use the term “REIT conversion” rather broadly. The companies that have successfully converted have actually used several different routes, including:

• Conversions of existing entities: An existing entity that can meet the definition of a REIT simply makes an election to be taxed as such.
• Operating company (“OpCo”) / property company (“PropCo”) splits: A company with a significant operating business and with significant real property splits into two companies which then enter into a long-term real property lease arrangement.
• Spin-off transactions: A company spins-off (taxable or tax-free) its real property into a REIT, which transacts with unrelated third parties.
• Mergers & acquisitions: A company drops its real property into a subsidiary, which then merges with an existing REIT.

Each REIT conversion alternative has unique complexities, and all forms invoke a significant amount of business and tax considerations.

Sample of Key Business Issues
A REIT conversion process requires the consideration of key business issues including, but not limited to, the following:

• Strategic concerns: Significant changes to a company’s current business model and/or legal structure may be required for REIT qualification requirements. These changes may conflict with the long-term growth strategy of a company.
• Financial considerations: A REIT conversion candidate needs to quantify the requisite liquidity to ensure sufficient cash flow exists to qualify for REIT status, on both an initial and ongoing basis. Covenants related to corporate debt and property-level financing should be reviewed to consider the impact of a REIT conversion transaction. Lastly, REITs generally have more access to favorable alternative financing mechanisms (i.e., unsecured debt), which should be considered in the evaluation process.
• Regulatory and compliance issues: An immense amount of legal, accounting and tax due diligence is required to execute a successful REIT formation or conversion. Furthermore, a significant amount of additional infrastructure may be needed to monitor the ongoing reporting and compliance issues required for a REIT.

Sample of Key Tax Issues
The following outlines certain critical tax issues to address in the evaluation process:

• Taxable REIT subsidiaries: An exception to the aforementioned restriction on REIT ownership of other corporate stock allows a REIT to wholly own a TRS. The TRS may generally be used to hold non-real property and earn non-real property income that would not be qualifying if owned/earned directly by the REIT. However, a REIT must carefully monitor the value of its TRS stock because it can’t exceed 25 percent of the total value of all the REIT’s assets.
• Transfer tax and property tax exposure: Significant consideration must be given to the state and local tax implications that could result from a REIT conversion event.
• Built-in-gains tax: To the extent that a built-in-gain exists on the REIT conversion date, a REIT must recognize taxable income and pay tax at corporate tax rates to the extent that certain built-in-gain asset(s) are sold at a gain within the recognition period (currently 10 years).
• Distribution of earnings & profits: To qualify as a REIT, an electing corporation must distribute 100 percent of its prior C-corporation E&P before the end of its first REIT tax year using a combination of cash and/or stock dividends. Such dividends will be considered fully taxable stock dividends to the REIT shareholders.
• Taxable/tax-free formation structure: The initial formation transaction may be structured as taxable or non-taxable. To the extent that the REIT desires a non-taxable formation transaction, then the “built-in-gain” tax period will generally apply. To the extent that the REIT desires a taxable formation transaction, then the shareholders of the legacy company may be subject to a significant amount of current tax.
• Tenant services issues: A REIT cannot generate more than a de minimis amount of income from certain non-customary tenant services rendered directly to tenants by the REIT.
• Penalty tax exposure: REITs are subject to a 100 percent prohibited transaction tax on certain amounts related to transactions involving the sale of dealer property and/or certain non-arm’s-length related-party transactions.

Alvarez & Marsal Taxand Says:
Similar to Windstream, many companies may be thinking they can extract an immense amount of value from their real estate holdings. For companies that are able to successfully implement a REIT conversion, the benefits from both a tax and business perspective could be immense. It is important to remember, however, that the REIT conversion process is only one strategic alternative — one that will not ultimately make sense for many of the candidates. If, based on an analysis of all of the applicable business and tax considerations, a REIT conversion transaction is deemed to be prohibitive or even impossible for a given company, then alternative strategies may still exist to unlock the value of a valuable real estate portfolio. For example, a company could structure a debt-financed distribution or enter into sale/leaseback transactions. To effectively evaluate all of its options, a company should give significant consideration to the impact on both the company and its shareholder group as part of any strategic decision-making process.