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Provisions - Fiscal Year 2000 Budget

Text of the REIT Provisions in the Administration's
Proposed Fiscal Year 2000 Budget (February 1, 1999)

Repeal tax-free conversions of large C corporations to S corporations.-
A corporation can avoid the existing two-tier tax by electing to be treated as an S corporation or by converting to a partnership. Converting to a partnership is a taxable event that generally requires the corporation to recognize any built-in gain on its assets and requires the shareholders to recognize any built-in gain on their stock. By contrast, the conversion to an S corporation is generally tax-free, except that the S corporation generally must recognize the built-in gain on assets held at the time of conversion if the assets are sold within ten years. The Administration proposes that the conversion of a C corporation with a value of more than $5 million into an S corporation would be treated as a liquidation of the C corporation, followed by a contribution of the assets to an S corporation by the recipient shareholders. Thus, the proposal would require immediate gain recognition by both the corporation (with respect to its appreciated assets) and its shareholders (with respect to their stock). This proposal would make the tax treatment of conversions to an S corporation generally consistent with conversions to a partnership. The proposal would apply to elections that are first effective for a taxable year beginning after January 1, 2000 and to acquisitions of a C corporation by an S corporation made after December 31, 1999.

Modify structure of businesses indirectly conducted by REITs.-
REITs generally are restricted to owning passive investments in real estate and certain securities. No single corporation can account for more than five percent of the total value of a REIT's assets, and a REIT cannot own more than 10 percent of the outstanding voting securities of any issuer. Through the use of nonvoting preferred stock and multiple subsidiaries, up to 25 percent of the value of a REIT's assets can consist of subsidiaries that conduct otherwise impermissible activities. Under the proposal, the 10 percent vote test would be changed to a "vote or value" test. This would prevent REITs from undertaking impermissible activities through preferred stock subsidiaries. However, the proposal also would provide an exception to the five and 10 percent asset tests so that REITs could have "taxable REIT subsidiaries" that would be allowed to perform noncustomary and other currently prohibited services with respect to REIT tenants and other customers. Under the proposal, there would be two types of taxable REIT subsidiaries, a "qualified independent contractor subsidiary" and a "qualified business subsidiary." A qualified business subsidiary would be allowed to undertake nontenant related activities that currently generate bad income for a REIT. A qualified independent contractor subsidiary would be allowed to perform noncustomary and other currently prohibited services with respect to REIT tenants as well as activities that could be performed by a qualified business subsidiary. All taxable REIT subsidiaries owned by a REIT could not represent more than 15 percent of the value of the REIT's total assets, and within that 15 percent limitation, no more than five percent of the total value of a REIT's assets could consist of qualified independent contractor subsidiaries. A number of additional constraints would be imposed on a taxable REIT subsidiary to ensure that the taxable REIT subsidiary pays a corporate level tax on its earnings. This proposal would be effective after the date of enactment. REITs would be allowed to combine and convert preferred stock subsidiaries into taxable REIT subsidiaries tax free prior to a certain date.

Modify treatment of closely held REITs.-
When originally enacted, the REIT legislation was intended to provide a tax favored vehicle through which small investors could invest in a professionally managed real estate portfolio. REITs are intended to be widely held entities, and certain requirements of the REIT rules are designed to ensure this result. Among other requirements, in order for an entity to qualify for REIT status, the beneficial ownership of the entity must be held by 100 or more persons. In addition, a REIT cannot be closely held, which generally means that no more than 50 percent of the value of the REITs stock can be owned by five or fewer individuals during the last half of the taxable year. Certain attribution rules apply in making this determination. The Administration has become aware of a number of tax avoidance transactions involving the use of closely held REITs. In order to meet the 100 or more shareholder requirement, the REIT generally issues common stock, which is held by one shareholder, and a separate class of nonvoting preferred stock with a relatively nominal value, which is held by 99 "friendly" shareholders. The closely held limitation does not disqualify the REITs that are utilizing this ownership structure because the majority shareholders of these REITs are not individuals. The Administration proposes to impose as an additional requirement for REIT qualification that no person can own stock of a REIT possessing 50 percent or more of the total combined voting power of all classes of voting stock or 50 percent or more of the total value of all shares of all classes of stock. For purposes of determining a person's stock ownership, rules similar to the attribution rules contained in section 856(d)(5) would apply. The proposal would be effective for entities electing REIT status for taxable years beginning on or after the date of first committee action.