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Editorial 12 MIN READ

The single-purpose entity, revisited: twenty months under the new Code

A 30 percent cap on interest, a pass-through deduction written for operators not shells, and a CMBS market that tightened the independent-manager page

The Editors
Staff, Incorporator.org
12 min read Updated
Contents 7 sections
  1. The § 163(j) problem highly-leveraged SPEs did not have in 2017
  2. § 199A and why the SPE's deduction is often zero
  3. What CMBS lenders are asking for now
  4. Delaware statutory trust, the quieter 2018 refresh
  5. Opportunity zones pulled SPE practice into the fund form
  6. The SPE in 2019, in one paragraph
  7. Sources

single-purpose entity built before December 22, 2017 was a creature of state law and loan-document covenants. A single-purpose entity built in 2019 is that, plus a new federal tax overlay that decides, each year, how much of the entity's interest expense it can deduct and whether its cash yield to the owner qualifies for a 20 percent pass-through deduction. The two answers do not always line up.

Our October 2017 piece on the SPE walked the state-law spine. This one picks up twenty months later, after the Tax Cuts and Jobs Act (Pub. L. 115-97, signed December 22, 2017), the first and second rounds of proposed opportunity zone regulations, the first round of § 199A final regulations, and a refresh of the rating agencies' SPE language for conduit CMBS.

The § 163(j) problem highly-leveraged SPEs did not have in 2017

Section 163(j), as rewritten by TCJA § 13301, caps the deduction for business interest at the sum of business interest income, 30 percent of adjusted taxable income, and floor plan financing interest. Anything above the cap is disallowed for the year and carried forward indefinitely under § 163(j)(2). The pre-TCJA statute limited earnings stripping by foreign-parented groups; the post-TCJA statute limits every taxpayer with a business, unless a carve-out fits.

The single-purpose entity sits in the middle of this statute for a structural reason. An SPE formed to hold a mortgaged building is, by design, highly leveraged relative to its taxable income. The loan-to-value on a stabilized conduit deal routinely runs 65 to 75 percent; debt service on the mortgage is the entity's largest expense; and depreciation drives taxable income well below cash flow. Under the statute as written for 2018 through 2021, adjusted taxable income is computed without regard to depreciation, amortization, or depletion, which inflates the denominator and softens the cap. From tax years beginning January 1, 2022 forward, § 163(j)(8)(A)(v) removes those addbacks, and the cap tightens hard on exactly the class of SPE that holds real property or long-lived equipment. Counsel drafting a ten-year fixed-rate loan today is underwriting a borrower that will be inside the tighter rule for most of the term.

Three exits matter for SPE practice. The first is the § 163(j)(7)(B) election for a real property trade or business (defined by reference to § 469(c)(7)(C)). The electing entity steps outside § 163(j) entirely, and pays for it with a longer depreciation tail: 40 years for nonresidential real property, 30 years for residential rental, 20 years for qualified improvement property, under § 168(g)(2)(C) as amended by TCJA § 13204. The election is irrevocable. For a leveraged stabilized asset the math usually comes out in favor of electing; for a development-stage SPE with short-lived interior build-out, the longer recovery period hurts more than the interest cap.

The second is the § 163(j)(7)(C) election for a farming business, on a parallel track for assets with a recovery period of 10 years or more.

The third is the small-business exemption in § 163(j)(3), which our deeper walk-through from last May spelled out: a taxpayer that meets the § 448(c) gross-receipts test ($26 million for 2019, after the first inflation adjustment under § 448(c)(4), per Rev. Proc. 2018-57, 2018-49 I.R.B. 827) is outside § 163(j) entirely, unless it is a tax shelter. The syndicate prong of the tax-shelter definition is the one that bites in SPE practice. A partnership SPE with passive investors that allocates more than 35 percent of its losses to limited partners or limited entrepreneurs in a given year is a "syndicate" under § 1256(e)(3)(B) and loses the small-business off-ramp for that year, even if gross receipts are well under the threshold. Real-estate SPEs whose depreciation generates a first-year book loss hit this line routinely. The aggregation rules in § 448(c)(3)(C), which borrow § 52(a) and § 52(b) controlled-group concepts, also catch a parent sponsor with many small SPE subsidiaries. Counsel testing whether an individual SPE is exempt has to test the whole commonly controlled group.

The operating answer on most new CMBS loans in 2019: the borrower elects under § 163(j)(7)(B), accepts the 40-year ADS tail, and walks out of § 163(j). The answer on a new project-finance LLC with a short-lived asset base usually goes the other way.

§ 199A and why the SPE's deduction is often zero

Section 199A, added by TCJA § 11011, grants a deduction of up to 20 percent of qualified business income from a domestic trade or business conducted by a pass-through owner. An SPE held by an individual, trust, or estate runs into two gating questions before the deduction can apply.

The first is whether the SPE conducts a "trade or business" in the § 162 sense. A shell entity whose only activity is owning a building triple-net leased to a single tenant has historically sat on the edge of the trade-or-business line. Final § 199A regulations issued in T.D. 9847 (84 Fed. Reg. 2952, February 8, 2019) decline to define "trade or business" beyond the § 162 standard, and announce at § 1.199A-1(b)(14) that a rental activity meeting the common-law trade-or-business test qualifies. Notice 2019-07, 2019-09 I.R.B. 740 (released January 18, 2019), adds a safe harbor: a "rental real estate enterprise" qualifies as a § 162 trade or business for § 199A purposes if the taxpayer maintains separate books and records, performs 250 or more hours of rental services per year (aggregated across all rental properties in the enterprise for taxable years ending in 2018 through 2022, separately per enterprise after that), and keeps contemporaneous records. The notice carves out real estate rented under a triple-net lease and real estate used as a residence by the taxpayer for any part of the year. A conventional CMBS SPE holding a single triple-net asset is therefore outside the safe harbor and has to argue § 162 the hard way. A multifamily SPE with in-house or contracted property management usually clears the safe harbor without drama.

The second question is the wage-and-UBIA limitation in § 199A(b)(2). Above the applicable threshold ($160,700 for single filers, $321,400 for joint for 2019, per Rev. Proc. 2018-57), the deduction for each qualified trade or business is capped at the greater of 50 percent of W-2 wages paid by the business or 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property. An SPE with no employees (the norm) pays no W-2 wages and is forced onto the 25 percent plus 2.5 percent UBIA prong. The 2.5 percent UBIA calculation is strong for asset-heavy real estate SPEs in the early years after acquisition and decays over the depreciable life of the property (ten years, or the property's recovery period if longer, under § 199A(b)(6)).

The combination matters because § 199A is a reason to hold real property directly in a pass-through, and it is also a reason the aggregation rules in the final regulations at § 1.199A-4 (allowing common-control aggregation of multiple trades or businesses under certain conditions) are worth reading carefully. A sponsor holding twelve multifamily SPEs in common control can aggregate and use one entity's wages against another's UBIA, so long as the five-part aggregation test is met. The aggregation election is made on the return and is binding in subsequent years.

What CMBS lenders are asking for now

The basic SPE covenants described in the 2017 piece remain the spine of a CMBS borrower's organizational documents. What shifted through 2018 and into 2019 is the language around the independents and around the bankruptcy-consent right. Originators have been tightening for a decade in response to In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), and the post-TCJA refinancing wave gave them a reason to refresh the standard form.

Three changes show up in closing documents this year. One, the independent-manager provider requirements are stricter. Lenders now commonly insist on a natural person furnished by a corporate-services firm with at least a specified number of concurrent independent appointments, and they exclude providers that employ former officers or significant creditors of the sponsor within a lookback longer than the five years standard in 2017. Two, the definition of "bankruptcy consent" has expanded to cover not just a voluntary petition but also the consent to an involuntary petition, the solicitation of an involuntary petition from a complicit creditor, the admission in writing of an inability to pay debts, and any amendment to the separateness covenants themselves. Three, loan documents increasingly require unanimous consent of all independent managers rather than a majority, in deals that previously specified a majority. Pricing does not move for the tightened language, but counsel's carveouts list has to be negotiated with more care than in 2015.

The non-consolidation opinion remains the gating deliverable for loans above roughly $50 million in principal. Opinion givers have added paragraphs addressing post-TCJA interest deductibility (to confirm the § 163(j)(7)(B) election, where made, is reflected in the borrower's tax posture) and the borrower's status as a separate taxpayer for purposes of the small-business exemption. Neither addition changes the core consolidation analysis under In re Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988) and In re Owens Corning, 419 F.3d 195 (3d Cir. 2005). They close loops that closing counsel used to leave unaddressed.

Delaware statutory trust, the quieter 2018 refresh

The Delaware Statutory Trust Act in 12 Del. C. § 3801 et seq. received a round of technical amendments under 81 Del. Laws c. 320 (House Bill 338, signed July 2018). The amendments confirm that a series of a statutory trust is bound by the governing instrument whether or not the series executed it, and address the fiduciary duties of trustees of registered investment companies and business development companies. For the SPE bar, the practical consequence is a cleaner record when a statutory trust is used to hold a portfolio of like assets in a series structure, which is the form 1031 DST sponsors have leaned on since IRS Rev. Rul. 2004-86, 2004-2 C.B. 191, blessed the Delaware statutory trust as a grantor trust for like-kind exchange purposes. The amendments do not alter the basic separateness virtues that make the statutory trust useful in aircraft, railcar, and pass-through real estate deals; they tidy the edges.

What practitioners are watching into the back half of 2019 is whether the legislature will take another pass at Chapter 38 to address series statutory trust registration and taxation, following the 2018 additions to 6 Del. C. § 18-215 that created the registered-series LLC. No bill is pending in Dover as of early June. The statutory trust form remains slightly older and slightly less flexible than the LLC on the series question, and counsel who need a protected-series structure today usually default to the LLC.

Opportunity zones pulled SPE practice into the fund form

The April 17, 2019 second round of proposed regulations under § 1400Z-2 (REG-120186-18, published at 84 Fed. Reg. 18652 on May 1, 2019) answered enough open questions to let capital move. Sponsors forming a Qualified Opportunity Fund in 2019 are almost uniformly choosing a two-tier structure: a QOF entity (typically a Delaware LLC taxed as a partnership) that holds equity in one or more Qualified Opportunity Zone Businesses (QOZBs), which are the operating SPEs that own the projects. The SPE at the bottom is a familiar creature with a new federal overlay bolted on: the QOZB tests under § 1400Z-2(d)(3) require that substantially all of the QOZB's tangible property be qualified opportunity zone business property, that at least 50 percent of its gross income derive from the active conduct of a trade or business in the zone (with three safe harbors in the April proposed regulations), that a substantial portion of its intangible property be used in that trade or business, and that less than 5 percent of its property consist of nonqualified financial property (subject to a working-capital safe harbor of up to 31 months).

The rating-agency separateness covenants and the QOZB-qualification covenants do not interfere with each other, but they have to be drafted in parallel. A QOF-SPE pairing is a bankruptcy-remote vehicle wearing a second hat as a compliant tax shelter. Opinion letters at closing now cover both. Sponsors are adding a second set of representations to the operating agreement that track the § 1400Z-2 tests and survive through the ten-year hold, which is the minimum duration for the basis step-up to fair market value on exit under § 1400Z-2(c). When the sponsor refinances the project before year ten, the refinance has to thread the QOZB tests and the loan covenants without tripping either. The lender's non-consolidation opinion and the tax counsel's QOF opinion end up on the same closing checklist.

The SPE in 2019, in one paragraph

A well-drafted SPE in mid-2019 is still a Delaware LLC formed shortly before closing, owning exactly the collateral, with rating-agency separateness covenants, at least one independent manager (two for larger loans) from a provider that clears the tightened criteria, and a springing-member provision that keeps it alive past its ordinary member's bankruptcy. What is new is the tax file: a § 163(j)(7)(B) election on the inaugural return for the real-property borrower that wants interest deductibility at any leverage, a § 199A posture that the SPE's owners can actually use (which in practice means a rental enterprise clearing Notice 2019-07 or an aggregated group clearing the final regs), and, for the growing share of SPEs that double as QOZBs, a working-capital schedule that fits the 31-month safe harbor. None of this showed up in the 2017 closing binder. All of it is load-bearing now.

The regime writes an odd role for the SPE. The state statutes want it passive and the loan documents want it powerless, but the new federal statutes want it engaged enough to be a trade or business. Drafters used to settle the first two and ignore the third. The third has a deadline attached, and the deadline is the first return after closing.

Sources

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