PLR 200135009: Commercial rents excluded from S corporation passive investment income

Plain-English summary

An S corporation with accumulated earnings and profits leased commercial properties and provided maintenance, security, and management services through staff and contractors. It asked whether rents under new leases counted as passive investment income, which can threaten an S election after three qualifying years. Based on the represented services and expenses, the IRS ruled that the rents were excluded from passive investment income under § 1362(d)(3). The IRS did not rule on the validity of the company's S election. It also stressed that this result does not decide whether the rental activity is passive under the separate § 469 rules.

Ruling snapshot

• Question: Are rents from the company's commercial properties passive investment income under § 1362(d)(3)?
• Outcome: Approved: the rents under the new leases are not passive investment income on the stated facts.
• Key authorities: IRC § 1362(d)(3)(C)(i); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200135009
Washington, DC 20224
Release Date: 8/31/2001
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-107764-01
Date:
May 29, 2001

Company:

Properties:

State:

Shareholder:

New Leases:
a:
b:
c:
d:
e:

Dear

This letter responds to a letter from your authorized representative dated January 20, 2001, as well as subsequent correspondence, submitted on behalf of Company. We have been asked to rule that the rental income to be received by Company from the Properties under the New Leases 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, incorporated under the laws of State, elected under § 1362(a) to be

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an S corporation effective a. It has accumulated earnings and profits.

Company owns and leases commercial real estate (the Properties).

Through its b part-time employees, as well as through a related property management firm and independent contractors, Company provides various services to the Properties under the New Leases in its real estate leasing business. These services (not all services are provided to all properties) include maintenance and repair of building structural components and systems, including foundations, roofs, and plumbing and electrical systems; parking lot, sidewalk, and fence maintenance and repair; maintenance of building exteriors, including painting; maintenance and repair of fire sprinklers; safety inspections; supervision of tenant improvements; trash and snow removal; landscaping; pest control; janitorial services, including window washing; and 24-hour on-call security service and property management. In addition to the services provided to tenants, Company handles the usual leasing and administrative functions involved in managing real estate.

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

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

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

enclosure: copy for § 6110 purposes