PLR 200016011: Active rental income is not passive investment income for S corporation rule

Plain-English summary

An S corporation with accumulated earnings and profits owned and operated commercial and residential rental properties. It asked whether its rental receipts counted as passive investment income under section 1362(d)(3), which can terminate an S election after three consecutive years above the statutory threshold. The IRS ruled that the rents were not passive investment income, based on the services and costs of the corporation's active rental business. It did not decide whether the company otherwise qualified as an S corporation. The letter also says this ruling does not decide whether the rentals are passive activities under the separate section 469 rules.

Ruling snapshot

• Question: Do the company's rental receipts count as passive investment income under section 1362(d)(3)?
• Outcome: Approved: the rents are not passive investment income under that rule.
• Key authorities: IRC § 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Number: 200016011 Washington, DC 20224
Release Date: 4/21/2000
Index Number: 1362.02-03 Person to Contact:

Telephone Number:

Refer Reply To:
PLR-115467-99 / CC:DOM:P&SI:3
Date:
March 31, 2000

LEGEND

Company: =

Shareholders =

State
=

Properties =

d1
=

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d2
=

d3
=

x
=

y
=

z
=

This letter responds to a letter dated September 15, 1999, and subsequent correspondence by your authorized representative on behalf of Company, requesting a ruling that the rental income received by Company from the Properties is not passive investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code.

Facts

According to the information submitted, Company, a subchapter C corporation with accumulated earnings and profits, was incorporated in State on d1, and elected under § 1362(a) to be treated as an S corporation effective d2. Company, which is owned by the Shareholders, is in the sole business of owning and operating commercial and residential rental real estate (the Properties). At the time Company submitted its ruling request, it owned x properties. The Shareholders are also employees of Company.

Through its employees, as well as through independent contractors, Company provides various services in its rental real estate business. In addition to the services provided to tenants, Company handles the usual marketing, leasing, and administrative functions involved in leasing and managing the Properties.

For the fiscal year ending d3, Company received or accrued y in rents and paid or incurred z in relevant expenses on the Properties. Company represents that it anticipates future figures to be consistent with the income and expense figures for prior periods.

LAW AND ANALYSIS

Section 1361(a)(1) defines an “S corporation” as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

Section 1362(d)(2)(A) provides than an election under § 1362(a) shall be terminated whenever (at any time after the first day of the first taxable year for which corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(d)(3)(A) provides that an election under § 1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close

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of each of 3 consecutive taxable years, and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. Any termination under this paragraph shall be effective on and after the first day of the first taxable year beginning after the third consecutive taxable year referred to above.

Section 1362(d)(3)(C)(i) provides that except as otherwise provided, the term "passive investment income" means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.

Section 1.1362-2(c)(5)(ii)(B)(2) of the Income Tax Regulations provides that "rents" does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation).

After applying the relevant law to the facts submitted and the representations made, we conclude that the rents Company receives from the Properties are not passive investment income under § 1362(d)(3)(C)(i).

Except for the specific ruling above, no opinion is expressed or implied concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed regarding Company's eligibility under § 1361 to be an S corporation. Further, the passive investment income rules of § 1362 are completely independent of the passive activity rules of § 469; unless an exception under § 469 applies, the rental activity remains passive for purposes of § 469.

Pursuant to a power of attorney on file with this office, we are sending a copy of this letter to your authorized representative.

This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3) of the Code, this ruling may not be used or cited as precedent.

Sincerely yours,
William P. O'Shea
Chief, Branch 3
Office of the Assistant Chief Counsel
(Passthroughs and Special Industries)