Olive Garden’s Taxes Are About to Change: Here’s Why
June 25, 2015
There’s been a lot of talk about Olive Garden in the media over the last few months, especially after one hedge fund released a 294-page report detailing everything that could be improved about the popular food chain. Now, Olive Garden’s parent company, Darden Restaurants Inc., has announced a major shift in the company’s legal organization – driven in part by how the U.S. tax code treats business income.
Two days ago, Darden Restaurants announced that it will spin off about 430 of its over 1,500 restaurant properties – mostly Olive Garden locations – into a new legal entity, known as a real-estate investment trust (or REIT). The REIT will then begin to lease all 430 properties back to Darden Restaurants, which will operate them as usual.
Several financial factors led Darden Restaurants to sell nearly a third of its properties. Selling assets and then leasing them back is a common strategy for freeing up short-term cash, which Darden says it needs to pay down about $1 billion in debt. In addition, REITs have historically offered investors higher-than-average returns to equity, due to their stable income and unusually good leverage. This is likely the primary reason why one of Darden’s major investors, Starboard Value, has pressured the corporation for over a year to create a REIT out of its assets.
However, the federal tax treatment of Real Estate Investment Trusts almost certainly played a role in Darden’s decision to transfer its assets to one. Congress first created REITs as a form of business organization in 1960, in order to give a tax preference to professionally managed real estate portfolios that individuals could invest in. Every year, REITs are required to distribute over 90% of their income to shareholders as dividends, in addition to several other legal requirements. But, in return, REITs are not required to pay taxes on any income they pass on to investors. As such, they are pass-through businesses, and do not face the multiple layers of taxation faced by traditional C Corporations – like Darden Restaurants.
It has become increasingly popular for companies to transfer their assets into REITs in order to operate under a more favorable tax structure. In April, Sears sold 254 store properties to a Real Estate Investment Trust, while Pinnacle Entertainment offloaded $4.1 billion in casino real estate to one last November. The recent popularity of REITs is due, in part, to new IRS rules that expanded the definition of “real estate,” allowing REITs to profit off of assets such as fiber optic and copper wire networks.
So, it is likely that Darden Restaurants' decision to spin off its property to a REIT was at least partially motivated by the tax advantages of doing so. It’s important to note that the income from this new REIT will still be taxed – just on the individual level, rather than first on the business level. As we’ve often noted, there are multiple tax codes for businesses in the United States, each with its own advantages and disadvantages. Operating a pass-through business, such as a REIT, is a legal option that owners can choose under current American statutes.
Of course, a basic principle of sound tax policy is that similar types of income should face a similar tax burden. If companies such as Olive Garden increasingly find the standard C corporation tax code damaging to their growth, this only points to the need for comprehensive corporate tax reform.