PLR 200112032: Active property rents excluded from S corporation passive investment income

Plain-English summary

An S corporation owned industrial rental properties, restaurant buildings, and undeveloped or underused property. Its employees negotiated leases, handled tenants and collections, maintained the properties, arranged repairs, and participated in development. Based on those activities, the IRS ruled that the property's rental receipts were not passive investment income under section 1362(d)(3)(C)(i). The IRS did not decide whether the corporation otherwise qualified for S status. It also explained that the separate passive activity rules of section 469 may still treat the rental activity as passive.

Ruling snapshot

• Question: Do the corporation's rents count as passive investment income under the S corporation rules?
• Outcome: Approved; the described rents are excluded under section 1362.
• Key authorities: IRC §§ 1362(d)(3)(C)(i), 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Number: 200112032 Washington, DC 20224
Release Date: 3/23/2001
Index Number: 1362.02-03 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:1-PLR-116615-00
Date:
December 19, 2000

Legend:

X
=

State =
D1 =
D2 =
D3 =
Properties =

a
=
b
=
c
=
d
=

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PLR-116615-00

e
=
f
=
:
This responds to your letter dated August 4, 2000, submitted on behalf of X, requesting a ruling that the rental income received by X from renting certain properties is not passive investment income within the meaning of section 1362(d)(3)(C)(i) of the Internal Revenue Code.

FACTS

X was incorporated in State on D1. X elected to be treated as an S corporation effective D2. X owns Properties in State, consisting of a industrial rental properties, b rental restaurant buildings, and c undeveloped or underutilized properties. X maintains a staff of d employees involved in its day-to-day operations. The employees’ duties include the following: negotiate and sign leases; settle tenant disputes; evaluate backgrounds of prospective tenants; oversee rental collections; serve notices to pay or quit and notices to vacate; show properties to prospective tenants; answer tenant complaints; prepare vacant properties for lease; inspect properties for repair; perform plumbing, electrical and carpentry maintenance; maintain common areas; and arrange for hiring of repair subcontractors as needed. X also directly participates in the development of its undeveloped or underdeveloped Properties.

During D3, X received or accrued $e in rents and paid or incurred $f in relevant expenses with respect to Properties.

LAW AND ANALYSIS

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

Section 1362(d)(3)(A)(i) provides that an election under section 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), section 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.

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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).

Section 1.1362-2(c)(5)(ii)(B)(4) provides that rents do not include compensation, however designated, for the use of, or right to use, any real or tangible personal property developed, manufactured, or produced by the taxpayer, if during the taxable year the taxpayer is engaged in substantial development, manufacturing, or production of real or tangible personal property of the same type.

CONCLUSION

Based solely on the facts as presented in this ruling request, and viewed in light of the applicable law and regulations, we conclude that the rents X receives from the rental of Properties are not passive investment income under section 1362(d)(3)(C)(i).

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed concerning whether X otherwise satisfies the S corporation eligibility requirements under section 1361. Further, the passive investment income rules of section 1362 are completely independent of the passive activity rules of section 469; unless an exception under section 469 applies, the rental activity remains passive for purposes of section 469.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to the taxpayer.

Sincerely,
/s/David R. Hagllund
Senior Technician Reviewer, Branch 1
Office of Associate Chief Counsel
(Passthroughs and Special Industries)
Enclosures (2):
Copy of this letter
Copy for section 6110 purposes