How America’s Largest Private Prison Operator Plans to Beat Corporate Income Tax

Although many on the left have rightly repudiated the myriad manifestations of prison privatization characterized, in part, by involuntary prison labor, ongoing health and safety violations, corporate financing and even “the New Jim Crow,” few, if any, have called attention to the relatively obscure relationship between private prison companies and their IRS corporate classification filing status. Though unsexy, tax literacy is crucial for understanding the ways in which private prison operators stylize themselves to public agencies and private investors alike. Surprisingly, IRS filing designations might offer the public its clearest glimpse into the intentions of private prison companies behind closed doors.

Less than a month ago, the nation’s largest private prison owner and operator, Corrections Corporation of America (CCA), first announced its plan to assess the feasibility of a Real Estate Investment Trust (REIT) conversion. Never before heard of an REIT? (Pronounced REE-EAT.) No worries, you’re not alone.

CCA bills its potential conversion into a REIT as a way to “increase long-term shareholder value,” but it will also allow the company to 1) reduce its federal corporate tax liability to zero. and 2) “leverage” (nonexistent) revenue to create the illusion of “more cash on hand.” Does this represent a deathbed conversion? From second quarter 2011 to first quarter 2012, CCA earned 16 percent less income than it did over the course of its 2010-2011 quarterly counterparts. Further, the company has 45 percent less cash on hand than it did just three months ago. CCA is scrambling and investors know it.

According to the US Securities and Exchange Commission (SEC), a REIT is a company that owns – and typically operates – income-producing real estate or real estate-related assets. Established in 1960 by President Dwight D. Eisenhower, REITs were intended to bring the benefits of commercial real estate investment to all investors by providing a way for individuals to earn a share of the income produced through commercial real estate ownership without actually having to go out and purchase it. What distinguishes REITs from other real estate companies is that a REIT must acquire and develop its real estate properties primarily to operate them as part of its own investment portfolio, as opposed to reselling those properties after they have been developed.

In the United States, REITs do not pay corporate income tax and pass the tax burden directly to individual investors, who pay ordinary income tax on REITs’ capital gains and dividends that are distributed. To qualify as a REIT, a company must have the majority of its assets and income tethered to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

But here’s the catch.

Ever since January 2009, REITs have been able to manipulate money markets by paying uncollateralized (read: fake) money to investors. In October 2008, the trade group that represents REITs – the National Association of Real Estate Investment Trusts – petitioned the IRS for a favor: allow REITs to pay their dividends in stock instead of cash. Why? The Association had become concerned that during the property boom of the early 2000s, the real estate industry had borrowed too much money and on unfavorable terms; the industry had doubled its commercial mortgage-backed securities debts between 2002-2007 to $380 billion and has had scant cash on hand ever since.

Faced with the prospect of the entire REIT industry discarding property into an already shallow market, the IRS obliged – and since 2009, REITs have been able to issue stock for 90 percent of their dividend instead of paying shareholders in cash.

By issuing Revenue Procedure 2008-68, the IRS established the circumstances under which REITs may issue stock dividends and still maintain their REIT status. The statute essentially provides a “safe harbor” for any REITs employing this “IOU tactic” to recapitalize their balance sheets. (And in some senses being offered a stock dividend may be even worse than an IOU because it represents a short-term tax liability without the benefit of cash.) Then, on December 23, 2009, the IRS issued Revenue Procedure 2010-12, which extends the original statute to dividend payments made on or before December 31, 2012. (It seems likely that the IRS will further extend this statute by the end of 2012.) It is certainly difficult to imagine a cash-strapped company like CCA not electing to take advantage of this revenue procedure.

If CCA chooses to convert itself into an REIT, then it will effectively be able to “borrow” cash from shareholders without any real intention of ever paying it back. Presumably, these new shares will someday be dispersed in cash dividends, but for some struggling REITs, that day may never arrive. Adding insult to injury, shareholders will need to raise cash to pay income tax on the uncertain value of the stock they receive. Sound suspiciously like an asset-backed security that precipitated the global economic collapse of 2008? Well, it is.

An REIT conversion would reduce CCA’s federal income tax liability to zero, ensure that it retains enough cash on hand for future acquisitions and allow CCA to grow steadily without rewarding its shareholders. Further, a REIT conversion would prove unimpeachably that, for all of its bloviating rhetoric, CCA is a business concerned with the health of buildings, not bodies and communities.