PLR 200033018: actively managed property rents are not S corporation passive investment income

Plain-English summary

A real estate company owned, leased, and managed residential and commercial properties it had developed. Its employees and contractors supplied maintenance, repairs, tenant work, grounds care, emergency response, marketing, and leasing services. The company intended to elect S corporation status and asked whether its rents counted as passive investment income under section 1362(d)(3). Based on the represented services and costs, the IRS ruled that they did not. The letter gave no opinion on S corporation eligibility under section 1361 and said that the separate section 469 passive activity rules could still treat the rental activity as passive.

Ruling snapshot

• Question: Are rents from the company's managed properties passive investment income under section 1362(d)(3)(C)(i)?
• Outcome: Approved. The IRS concluded that the rents were not passive investment income under that provision, while reserving S corporation eligibility and section 469 treatment.
• Key authorities: IRC §§ 1362(a), 1362(d)(3), 1361, and 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service         Department of the Treasury

Index Number:       1362.02-03   Washington, DC 20224



                                 Person to Contact:
Number: 200033018                Telephone Number:
Release Date: 8/18/2000
                                 Refer Reply To:
                                 CC:DOM:P&SI:3 PLR-102740-00
                                 Date:
                                 May 16, 2000


      Company:

      Entity:

      Properties:




      City:

      a:

      b:

      c:
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       d:

       e:

       f:

       g:

Dear

        This letter responds to your letter dated January 26, 2000, as well as subsequent
correspondence, submitted 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. Company
represents the following facts.

      Company, in existence since a, was originally an Entity. It stopped doing
business as an Entity on b and became a real estate development and management
company. Company intends to elect under § 1362(a) to be an S corporation.

        Company owns, leases, and manages the Properties, all of which were
developed and constructed by Company. It leases the Properties, located in City, to
various residential and commercial tenants. Company maintains a centrally-located
office that is within walking distance of the vast majority of the Properties.

       Company has c employees, d of which are full-time and d of which share
responsibilities with a related, family-owned real estate development and leasing
business. Through these employees, as well as a variety of independent contractors,
Company provides various services in its real estate leasing and management business
(provided to most but not all properties). These services include regular property

inspection; maintenance and repair of building structures and systems, such as roofs,
heating and air conditioning, and plumbing; repair and replacement of appliances
(residential properties); tenant buildout (commercial properties); carpet cleaning and
replacement; painting; grounds care and landscaping; parking lot maintenance; snow
removal; rubbish removal (commercial properties); pest control; and 24-hour on-call
service for emergencies and tenant problems. In addition to the services provided to
tenants, Company handles the usual marketing, leasing, and administrative functions
involved in leasing and managing real estate.

       Company received or accrued approximately e in rents and paid or incurred
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approximately f in relevant expenses for g on the Properties.

      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 § 1362(d)(3)(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 the number of persons
employed to provide the services and the types and amounts of costs and expenses
incurred (other than depreciation).

      Based solely on the facts as represented by the taxpayers in this ruling request,
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 income 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.
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      In accordance with the power of attorney on file with this office, we are sending a
copy of this letter to Company.

      This ruling is directed only to the taxpayers 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