PLR 200031038: Rental receipts, usufruct ownership, and an S corporation trust provision

Plain-English summary

An S corporation asked about three issues affecting its stock ownership and rental receipts. It owned and managed rental properties, partly through subsidiaries, and represented that its staff provided services and incurred costs in the rental business. The IRS ruled that the rents from those properties were not passive investment income under section 1362(d)(3)(C)(i). It also ruled that a trust holding a usufructuary interest in the corporation's stock was treated as the stock's owner for section 1361 purposes. Finally, a trust provision allowing early termination if its existence threatened the corporation's status under the Bank Holding Company Act would not itself prevent the trust from qualifying as a qualified subchapter S trust, based on the representation that the provision could never operate. The IRS expressly gave no opinion on whether the corporation qualified as an S corporation, the subsidiaries qualified as QSubs, or the trust otherwise qualified as a QSST. The rental activity could still be passive under section 469.

Ruling snapshot

• Question: How are the rental receipts and usufruct-held shares treated, and does the trust's early termination clause bar QSST status?
• Outcome: Approved. The IRS granted all three requested rulings, subject to the stated representations and caveats.
• Key authorities: IRC §§ 1361, 1362(d)(3)(C), and 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B); Rev. Rul. 64-249.

Full text (IRS public release)

Internal Revenue Service         Department of the Treasury

Index Number:       1362.02-03   Washington, DC 20224
                    1361.03-02
                                 Person to Contact:
Number: 200031038                Telephone Number:
Release Date: 8/4/2000
                                 Refer Reply To:
                                 CC:DOM:P&SI:3 PLR-101790-00
                                 Date:
                                 May 5, 2000


      Company:

      Sub A:

      Sub B:

      Sub C:

      Corp X:

      Corp Z:

      Trust M:

      Trust N:

      State:

      Properties:

      Types:

      Statute 1:

      Statute 2:

      a:

      b:

      c:

      d:

      e:
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       f:

       g:

       h:

       i:

       j:

       k:

Dear

        This letter responds to a letter from your authorized representative dated
January 13, 2000, as well as subsequent correspondence, requesting rulings on 1) the
proper treatment under § 1362(d)(3)(C) of the Internal Revenue Code of rental income
from the Properties, 2) the proper owner under § 1361(b)(1)(B) of Company stock held
in usufruct, and 3) the effect of the early termination provision in Trust M’s governing
instrument (the “Provision”) on the ability of Trust M to qualify under § 1361(d) as a
qualified subchapter S trust (QSST). Company represents the following facts.

      Company, an S corporation, is engaged in the real estate rental business
through 2 of its wholly-owned subsidiaries (Sub A and Sub B). It receives from this
business several types of rental income (Types). It intends to elect under
§ 1361(b)(3)(B) to treat Sub A and Sub B as qualified subchapter S subsidiaries
(QSubs).

        Company owns and manages substantial interests in approximately a acres of
land in State. It owns Properties 1-9 equally with Corp X, an unrelated corporation.
Sub B owns Property 10 equally with Corp Z, an unrelated corporation. It manages
daily the land use agreements and associates activities of approximately b surface
tenants and manages routinely the leases and associated surface activities of an ever-
changing number of oil and gas leases.

      There are c persons engaged in a wide variety of land management activities
necessary to generate Company’s rental income: d are employed by Company and e
by Sub A. One of these persons performs significant services for Company but is
employed by Sub C, for which a QSub election will not be made.

       The Company received or accrued approximately f in rents and paid or incurred
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approximately g in relevant expenses on the Properties for h. The comparable figures
for i are j and k.

      Company expects that the services and costs detailed in its ruling request will, in
the aggregate, approximate the operations of Company’s integrated real estate rental
business in future years.

      Except as provided in § 1362(g), § 1362(a)(1) provides that a small business
corporation may elect, in accordance with the provisions of § 1362, to be an S
corporation.

       Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) terminates
whenever the corporation (I) has accumulated earnings and profits at the close of each
of three consecutive tax years, and (II) has gross receipts for each of such tax years
more than 25 percent of which are passive investment income.

       Except as otherwise provided in subparagraph (C), § 1362(d)(3)(C)(i) provides
that 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)(1) of the Income Tax Regulations provides that
"rents" means amounts received for the use of, or the right to use, property (whether
real or personal) of the corporation.

        Section 1.1362-2(c)(5)(ii)(B)(2) 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).

       Trust M owns, among other assets, a usufructuary interest in Company stock.
Trust N, the principal beneficiary of Trust M, holds the naked ownership interest in the
Company stock subject to the usufruct. The usufructuary interest terminates at the
death of the income beneficiary of Trust M.

       Section 1361(a)(1) provides that the term "S corporation" means, with respect to
any tax year, a small business corporation for which an election under § 1362(a) is in
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effect for the year.

       Section 1361(b)(1) provides that the term "small business corporation" means a
domestic corporation that is not an ineligible corporation and that does not, among
other things, have as a shareholder a person (other than an estate, a trust described in
§ 1361(c)(2), or an organization described in § 1361(c)(6)) who is not an individual.

      A usufruct under State law is defined as a real right of limited duration on the
property of another. Statute 1. The usufructuary has the right to possess the property
subject to the usufruct and to derive the utility, profits, and advantages that the property
produces. Statute 2. The usufructuary is bound to deliver the property subject to the
usufruct to the naked owner at the termination of the usufruct. Statute 2.

        In Rev. Rul. 64-249, 1964-2 C.B. 332, the taxpayer and her husband owned, as
community property, all of the stock of a small business corporation. Upon his death,
the husband bequeathed his shares of stock in the corporation to his children, with a
usufruct for life to the taxpayer. The taxpayer was considered neither a guardian nor a
trustee for the benefit of her children, but rather held her interest as usufructuary for her
own benefit. Rev. Rul. 64-249 provided that the relationship between the children and
the taxpayer was roughly comparable to the relationship between remainderman and
life tenant in a common law state. As a result, the usufructuary (the taxpayer) had the
income interest and was required to include in her gross income the dividends paid with
respect to the stock. Rev. Rul. 64-249 held that a usufructary under Louisiana law is
considered to be a shareholder of a small business corporation. Because the taxpayer
in Rev. Rul. 64-249 acquired one-half of the community property at the death of her
spouse and one-half as usufructuary, she was regarded as the only shareholder of the
small business corporation.

        Trust M will terminate at the later of the expiration of 20 years from the settlor’s
death or the death of the income beneficiary. In addition, Trust M will terminate at any
time its existence jeopardizes Company’s current status under the Bank Holding
Company Act of 1956 as amended in 1970 (the early termination provision). The
income interest will terminate at the earlier of the termination of Trust M or the income
beneficiary’s death.

       At the time Trust M was formed, Company was a significant shareholder in a
national bank. Company has since divested itself of this bank stock. Trust M currently
owns no interest in a bank or a bank holding company. Company represents that
neither it nor Trust M will ever be subject to the Bank Holding Company Act, and that it is
now impossible for Trust M’s existence to jeopardize Company’s status under the
Act, making the early termination provision of the trust instrument effectively inoperable.
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       According to § 1361(b)(1)(B), an S corporation can have as a shareholder no trust
other than one described in § 1361(c)(2). Section 1361(d)(1) provides that a
QSST with respect to which a beneficiary makes an election under paragraph
§ 1361(d)(2) shall be treated as a trust described in § 1361(c)(2)(A)(i).

      Section 1361(d)(3) provides that, for purposes of § 1361(d), the term “qualified
subchapter S trust” means a trust–

      (A) the terms of which require that–

             (i) during the life of the current income beneficiary there shall be only 1
             income beneficiary of the trust,

             (ii) any corpus distributed during the life of the current income beneficiary
             may be distributed only to such beneficiary,

             (iii) the income interest of the current income beneficiary in the trust shall
             terminate on the earlier of such beneficiary’s death or the termination of
             the trust, and

             (iv) upon the termination of the trust during the life of the current income
             beneficiary, the trust shall distribute all of its assets to such beneficiary,
             and

      (B) all of the income (within the meaning of § 643(b)) of which is distributed (or
      required to be distributed) currently to 1 individual who is a citizen or resident of
      the United States.

       Regarding § 1361(d)(3)(A)(iv), the trust instrument of Trust M provides for early
termination in the event that the existence of the trust threatens the status of Company
under the Bank Holding Company Act. However, Company represents that this trust
provision will never be operative.

      Based solely on the facts as represented by Company in this ruling request, we
conclude that–

      1) the rents Company receives from the Properties are not passive investment
      income under § 1362(d)(3)(C)(i);

      2) Trust M, as usufructuary, is treated as the owner of the Company stock
      subject to usufruct for purposes of § 1361; and
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      3) the early termination provision in the trust agreement for Trust M will not
      preclude Trust M from qualifying as a QSST under § 1361(d).

        Except for the specific rulings above, no opinion is expressed or implied
concerning the federal income tax consequences of the facts of this case under any
other provisions of the Code. Specifically, no opinion is expressed on whether Company
is eligible to be an S corporation, on whether Subs A and B are eligible to be QSubs, or
on whether Trust M is eligible to be a QSST. 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.

      In accordance with the 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), this ruling may not be used or cited as precedent.

                                         Sincerely,
                                         JONI LARSON
                                         Acting Assistant to the Chief, Branch 3
                                         Office of Assistant Chief Counsel
                                         (Passthroughs and Special Industries)
enclosure: copy for § 6110 purposes