Tax Structures for Separating Retail from its Real Estate

By Stuart E. Leblang, Michael J. Kliegman,  and Amy S. Elliott

It is no secret that retail is struggling.  Consumers have moved much of their shopping online and experts are warning that retail industry bankruptcies and restructurings are set to spike over the next year. ¹ Big names like J. C. Penney Co. Inc. (JCP), ² Macy’s, Inc. (M) ³ and Sears Holding Corp. (SHLD), ⁴ the parent company of Kmart, have recently announced numerous store closings and efforts to monetize some of their brick and mortar holdings.

Activist investors frustrated by declining stock prices have encouraged retailers with valuable real estate portfolios (Nordstrom Inc., JWN 5 ) to sell and lease back their real estate—often to tax-advantaged real estate investment trusts (REITs)—in order to raise cash for shareholder dividends.  They have also set their sights on casual dining companies with large property holdings like Ruby Tuesday Inc. (RT). ⁶ 

There are several approaches such companies can consider to unlock real estate value.  Recent tax changes—notably, elimination of the tax-free REIT spinoff transaction—have, to a large degree, focused planners’ attention on the least-inefficient tax alternatives.  And, of course, viable approaches are dependent on a company’s particular attributes, including both tax and commercial.

We offer below brief summaries of several alternatives.  In comparing them, it is useful to have a point of view about the relative importance of the following objectives:

• Effecting a complete legal separation of the real estate from the operating business;
• Monetizing the real estate;
• Removing the real estate from the balance sheet of the operating company, despite continued ownership of a significant percentage;
• Obtaining a market-based valuation of the real estate, even if it remains on the balance sheet of the operating company; and
• Increasing the visibility of the real estate part of the balance sheet.

Prior to December 7, 2015, corporations had a pretty tax efficient way to enhance liquidity using their real estate.  They could simply spin it off tax-free into a newly formed REIT and engage in a leaseback on a triple-net basis (a transaction referred to as an OpCo/PropCo).  The arrangement causes the stream of rental income and any gain on the appreciated real estate to escape corporate tax (a five year waiting period is required before corporate tax on sale of the real estate can be eliminated).  Such a maneuver was successfully used by Darden Restaurants Inc. (DRI) to spin off about 420 properties, primarily its Olive Garden locations, into a newly formed REIT (Four Corners Property Trust Inc., FCPT).  Other companies that engaged in OpCo/PropCo REIT spins include Penn National Gaming Inc. (PENN) and Windstream Holdings Inc. (WIN).

But late in 2015, Congress enacted tax code sections 355(h) and 856(c)(8), which limit businesses from separating their real estate assets from their operating businesses and placing the former into a REIT by way of a tax-free spinoff.  Doing so now triggers the recognition of corporate-level gain on the appreciated property in the same way as a traditional sale-leaseback.  Retailers lacking sufficient NOLs to mitigate this tax hit should consider tax-free options.  These and other alternatives are discussed below:

1.  TAXABLE REIT SPINOFF OR SALE

The traditional sale-leaseback is always an option for corporations willing to part with their real estate in a taxable transaction, especially if the corporation has enough accumulated NOLs to offset any tax hit from the gain recognition.  A retailer or restaurant could part with its real estate by way of an outright sale, which could be to a preexisting REIT possibly in exchange for REIT shares, or as part of a separation and taxable spinoff.  This latter option—a taxable sale to a newly formed, related REIT—was contemplated by Sears in 2014.  It ultimately went forward with the $2.7 billion plan, resulting in the creation of Seritage Growth Properties (SRG) in 2015.  Today 224 of the REIT’s 266 properties are leased to Sears. ⁷ There is speculation that Sears will file for Chapter 11 bankruptcy in July after two years have passed since the asset sale to Seritage so that the transaction could not be unwound as a fraudulent conveyance.⁸

1.  TAXABLE SALE OF CORE BUSINESS FOLLOWED BY CONVERSION TO REIT

If a retailer finds that the value of the real estate that it owns comes close to its whole enterprise value—so that its core business is essentially of negligible worth—it may make the most sense to divest of the operating business in a taxable sale, leaving the real estate assets in the corporate shell.

At that point, the company could then elect to be taxed as a REIT, which could lease back the properties to the new retail operator.  Selling the operating business instead of the real estate would mean that the gains inherent in the real estate would not be taxable when the company converted to a REIT.  However, this option requires the corporation to distribute all of its pre-REIT earnings and profits (E&P) to its shareholders before the end of its first taxable year by way of a so-called purging distribution.  Depending on the amount of E&P, this may present significant tax, legal and corporate finance challenges.  A useful way to gauge the likely scale of a company’s E&P is to look at its retained earnings.

If otherwise feasible, distributing even a rather large amount of E&P may be sensible from a tax standpoint, particularly when measured against the amount of unrealized gain in the real estate assets.  Shareholder level taxation on a cash distribution is generally far more palatable than a similar, or larger, amount of corporate tax.

1.     A “CAPTIVE” REIT

Another option is to hive down the real estate to a newly formed REIT at least initially controlled by the company, leasing back the properties from the REIT.  In addition to issuing preferred shares to investors to satisfy the REIT requirements, an initial public offering of common shares in the REIT subsidiary can establish a trading market in the real estate portfolio.  Even with retention of voting control, management of the retail business will lose a certain amount of control over the terms of the leases, renewals, etc., but, of course, no less than in the formerly “optimal” plan to fully spinoff the real estate into a public REIT.  And indeed, establishing a true arms’ length relationship between OpCo and PropCo seems an important component of unlocking the real estate value.

It is important to remember with this and some of the other strategies that investors may be happy with the market pop that comes from the pricing visibility created by separating out the real estate from the core business operations; achieving liquidity from a sale transaction may not be necessary.

1.  REAL ESTATE PARTNERSHIP

If an outright sale of either the real estate or the operating business is precluded by prohibitive tax cost, another alternative is to enter into a private partnership with one or more real estate investors.  This may be done with or without monetization.  In the former case, a so-called leveraged partnership structure can be used.  The partnership takes out a loan secured by the real estate and if the retailer guarantees the partnership loan, it would be able to take distributions of cash from the partnership tax- free.  Such structures have been successfully challenged by the IRS in connection with attempts to avoid or defer tax on the sale of an operating business.  Regulations finalized in 2016 dramatically tightened the requirements, making it more likely that such an arrangement would constitute a disguised sale.  In the context of a strategy to heighten market visibility of corporate real estate, with a significant retained interest by the corporate group and substantive guarantees of debt, a retail group may well be able to reap some cash from the arrangement without a challenge from the IRS.

Instead of a private partnership arrangement, the company could bring public investors into a publicly traded partnership.  As is the case with the publicly traded subsidiary REIT above, the company would continue to own a high percentage interest in the partnership, but having established an independent entity with shares traded on a public market, the real estate would be separately valued and a pure play would be available to investors.  The tax code treats most publicly traded partnerships as corporations for US tax purposes, but allows certain types of qualifying income to allow the partnership to be traded as such for tax purposes.  Most familiar as qualifying income is natural resource businesses, but real property rents qualify as well.  A comparison between a REIT and PTP will indicate tax, legal and other commercial differences that favor one or the other.

1.  TAX-FREE UPREIT STRUCTURE

An alternative to a leveraged partnership that might address the liquidity problem is an umbrella partnership REIT structure, also called an UPREIT.  The general partner in the partnership that holds the operating company’s real estate is a REIT.  Although initially the operating company (a limited partner) will not have much liquidity upon contributing its real estate to the partnership, it will benefit from deferral and eventually may be able to exchange its partnership interests either for cash or for shares in the REIT, which the retailer can more readily cash out.  An example in IRS regulations provides that such an arrangement will not be recast.¹⁷

1.  TRACKING STOCK

Finally, the retailer could reorganize, placing all of its real estate assets into a new division or subsidiary separate from its core operations and providing arm’s-length lease terms between the two entities.  It could then recapitalize, issuing to its shareholders two new classes of stock in lieu of their common:  Series R (retail operations) common and Series P (property holdings) common.  As with other tracking stock, the principal difference between the two classes of common would be the legal source and policies regarding dividends.  Series P dividends would be based on the separate pool of earnings and cash flow from the real estate operations, while those of Series R would be the core operations.

The initial recapitalization into the tracking stock arrangement would ordinarily be tax-free.  Thereafter, the two classes would trade separately.

Not mentioned among these six alternatives is simply borrowing against the real estate, which could offer a more speedy capital infusion than the various restructurings contemplated above.  However, firms considering more drastic real estate separation strategies generally find themselves facing immediate threats from activist investors, changing business realities and creditors.  The options enumerated in this article should provide an outline of possible value-creation transactions for the many retailers and restaurants running out of ways to improve their balance sheets.

^{[1] Garcia, Tonya, March 9, 2017, “From a risk-of-bankruptcy standpoint, the retail business is the new oil and gas,” MarketWatch (http://on.mktw.net/2kK3KVy).}

^{[2] February 24, 2017, JCPenney “expects to close two distribution facilities and approximately 130 - 140 stores . . . The Company also is in the process of selling its supply chain facility in Buena Park, Calif. in an effort to monetize a lucrative real estate asset.” (http://ir.jcpenney.com/phoenix.zhtml?c=70528&p=irol-newsArticle&ID=2249169)}

^{[3] January 4, 2017, Macy’s plans “to close approximately 100 stores. . . as well as monetizing locations with highly valued real estate.” (http://phx.corporate-ir.net/phoenix.zhtml?c=84477&p=irol-newsArticle&ID=2234057)} 

^{[4] January 5, 2017, Sears “to market certain real estate properties with the goal of raising over $1 billion…We have executed several different forms of real estate monetization in the past and expect these structures could be among the options.” (https://searsholdings.com/press-releases/pr/2024)}

^{[5] Collings, Richard, February 3, 2016, “Why Nordstrom Is an Enticing Bargain for Activist Investors,” TheStreet (https://www.thestreet.com/story/13445804/2/why-nordstrom-is-an-enticing-bargain-for-activist-investors.html).}

^{[6] Orol, Ronald. March 27, 2017, “Ruby Tuesday’s Real Estate Whets Activists’ Appetite:  Activists could push Ruby Tuesday to sell itself, its real estate…” The Deal (http://pipeline.thedeal.com/article/14060793/index.dl).}

^{[7] http://www.seritage.com/about-us}

^{[8] WYCO Researcher, April 19, 2017, “Sears Holdings Bankruptcy Filing Expected On July 10 Or Soon After,” Seeking Alpha (https://seekingalpha.com/article/4063238-sears-holdings-bankruptcy-filing-expected-july-10-soon).}

^{[9] JC Penney Form 10-K for the fiscal year ended January 28, 2017 (http://bit.ly/2pSay5C).}

^{[10] Macy’s 2016 Annual Report (http://bit.ly/2o4Ckzw).}

^{[11] Nordstrom Form 10-K for the fiscal year ended January 28, 2017 (http://bit.ly/2o4sQV3).}

^{[12] https://searsholdings.com/docs/investor/SHC_2016_Form_10-K.pdf}

^{[13] See http://bit.ly/2pSay5C line for “accumulated deficit.”}

^{[14] See http://bit.ly/2o4Ckzw line for “accumulated equity.”}

^{[15] See http://bit.ly/2o4sQV3 line for “accumulated deficit.”}

^{[16] See https://searsholdings.com/docs/investor/SHC_2016_Form_10-K.pdf line for “retained deficit. ”}

^{[17] See reg. section 1.701-2(d), Example 4.}