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July 28, 2014

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Taxes:

Prisons become landlords, other business restructure to avoid taxes

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M Resort Spa Casino, which opened in Henderson on March 1, was designed to attract visitors and locals alike by offering unique amenities.

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A small but growing number of U.S. corporations — including Penn National Gaming, which owns the M Resort in Henderson — are making an aggressive move to reduce, or even eliminate, their federal tax bills.

Companies as diverse as private prisons and billboard companies are declaring that they are not ordinary corporations. Instead, they say, they are special trusts that are typically exempt from paying federal taxes.

The trust structure has been around for years, but, until recently, it was generally used only by funds holding real estate. Now, the likes of the Corrections Corp. of America, which owns and operates 44 prisons and detention centers across the nation, have quietly gotten permission from the Internal Revenue Service to put on new corporate clothes and, as a result, save many millions on taxes.

The Corrections Corp., which is making the switch now, expects to save $70 million in 2013. Penn National Gaming, which operates the M and 21 other casinos, recently won approval to change its tax designation.

Changing from a standard corporation to a real estate investment trust, or REIT — a designation signed into law by President Dwight D. Eisenhower — has suddenly become a hot corporate trend. One Wall Street analyst has characterized the label as a “golden ticket” for corporations.

“I’ve been in this business for 30 years, and I’ve never seen the interest in REIT conversions as high as it is today,” said Robert O’Brien, the head of the real estate practice at Deloitte & Touche, a big accounting firm.

At a time when deficits and taxes loom large in Washington, some question whether the new real estate investment trusts deserve their privileged position.

When they were created in 1960, they were meant to be passive investment vehicles, like mutual funds, that buy up a broad portfolio of real estate — whether shopping malls, warehouses, hospitals or even timberland — and derive almost all of their income from those holdings.

One of the bedrock principles — and the reason for the tax exemption — was that trusts do not do any business other than owning real estate.

But bit by bit, especially in recent years, that has changed as the IRS, in a number of low-profile decisions, has broadened the definition of real estate and allowed companies to split off parts of their business that are unrelated to real estate.

For example, prison companies such as the Corrections Corp. and the Geo Group successfully argued that the money they collect from governments for holding prisoners is essentially rent. Companies that operate cellphone towers have said that the towers themselves are real estate.

The conversions generally do not require the companies to change their underlying business. The chief executive of Corrections Corp., Damon Hininger, told investors in February that the new structure should help in the company’s aim of “housing more and more population for federal, state and local levels as they grow or deal with overcrowding.”

The IRS released its latest decision, allowing a data and document storage company to convert, on April 5. The letter did not include the name of the company, but several data storage companies, including Iron Mountain and Equinix, are converting.

A few days later, a strategist at the Wall Street firm Jefferies wrote in a report: “It is not a far stretch to envision REITs concentrated in railroads, highways, mines, landfills, vineyards, farmland or any other ‘immovable’ structure that generates revenues.” Today, there are more than 1,000 real estate investment trusts, about 10 percent of them traded publicly on the stock market. Investors like them because, by law, they must distribute at least 90 percent of their taxable income to their shareholders — a particularly alluring prospect today, given the low interest rates paid by many other basic investments.

The benefits of converting are obvious for stockholders and corporate insiders. The switch typically drives up a company’s stock price. Investors are drawn by the prospect of lucrative dividends under the new structure. The mere rumor that a company might convert has been enough to send its stock price soaring.

The trend has been a concern to advocates of the traditional trusts, who fear that the newcomers may eventually jeopardize the tax status of older funds that do not do any business other than owning real estate.

“I worry that in a world where Congress is very sensitive to taxes, a lot of these structures could end up attracting a lot of attention that might not be entirely positive,” said Ross Smotrich, an analyst at Barclays.

More broadly, Steven Rosenthal, a staff member at the Joint Committee on Taxation during the 1990s and now a visiting fellow at the nonpartisan Tax Policy Center, said the trend raises questions about the purpose of corporate income taxes at a time when there are so many ways around them. The conversions are one of many strategies that businesses use to avoid paying the corporate tax rate of 35 percent.

“What is there about a business owning real estate that suggests we should not tax them?” Rosenthal said.

Some congressional staff members said they had noticed the recent conversions and were monitoring the issue.

Lawyers also have been finding creative ways to follow the letter of the law by splitting off parts of a company into subsidiaries that can be taxed. In the legal world, the most controversial effort is being undertaken by Penn National, the casino company. It won approval from the IRS late last year to turn itself into a real estate holding company. In the process, it created a tax-paying subsidiary that holds the casino operations and pays rent to the parent company.

O’Brien said he has been talking with other casino operators that are looking at making similar moves. The ruling also could open the door for restaurant companies such as McDonald’s and retailers such as J.C. Penney to follow a similar route, though neither company has indicated it is considering such a move.

For now, companies such as the Corrections Corp. are quickly moving through the process.

“The good news about this is that we are going to be able to enjoy a full year of tax savings for 2013,” Hininger, the chief executive, said in February.

Last week, the company’s share price hit its highest level in more than a decade.

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