PLR 200128025: Active rental income excluded from S corporation passive investment income

Plain-English summary

An S corporation with accumulated earnings and profits owned and managed six rental properties. Its employees and contractors provided maintenance, repairs, improvements, security, and other services to tenants. The IRS ruled that, on the represented facts, rent from those properties was earned in an active rental business and was not passive investment income under IRC § 1362(d)(3). That matters because excessive passive investment income over three consecutive years can terminate an S election. The ruling did not address the validity of the company's S election or whether the rental activity was passive under the separate § 469 rules.

Ruling snapshot

• Question: Is rent from the six managed properties passive investment income under § 1362(d)(3)?
• Outcome: Approved; the rent is not passive investment income under that provision.
• Key authorities: IRC §§ 1362(d)(3), 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Washington, DC 20224
Number: 200128025
Release Date: 7/13/2001 Person to Contact:
Index Number: 1362.02-03
Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-100017-01
Date:
April 12, 2001

Company:

Properties:

State:
a:
b:
c:
d:
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e:
f:
g:
h:

Dear

This letter responds to a letter from your authorized representative dated December 19, 2000, as well as subsequent correspondence, submitted on behalf of Company. We have been asked to rule 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.

FACTS

Company was incorporated under the laws of State in a and has elected under § 1362(a) to be an S corporation effective b. It has accumulated earnings and profits.

Company owns, leases, and manages residential, commercial, and industrial rental real estate (the Properties).

Through its c full-time and d part-time employees, as well as through outside vendors and independent contractors, Company provides various services to Properties 1-6 in its real estate leasing and management business. These services (not all services are provided to all properties) include maintenance of common areas and facilities; maintenance and repair of structural portions of the properties, including foundations, exterior walls, and roofs; parking lot and sidewalk repair; making and supervising of tenant improvements; interior and exterior renovations; repair or replacement of electrical fixtures; appliance repair; inspection and maintenance of alarms and fire sprinklers; provision of water and sewer; trash removal and recycling; landscaping; pest control; janitorial services; advertising and promotion of tenant businesses; and the provision of security guards. In addition to the services provided to tenants, Company handles the usual leasing and administrative functions involved in managing real estate.
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Company received or accrued approximately e in rents and paid or incurred approximately f in relevant expenses for g on the Properties. The figures for h are comparable.

LAW AND ANALYSIS

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 Company in this ruling request, we conclude that the rents Company receives from Properties 1-6 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 4
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election to be treated as 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.

Under 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), this ruling may not be used or cited as precedent.

Sincerely,

/s/

MARY BETH COLLINS
Assistant to the Chief, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosure: copy for § 6110 purposes