PLR 200137020: Active rental services keep a company's rents out of S corporation passive income

Plain-English summary

A company that owns commercial real estate asked whether rent from its properties would count as passive investment income under the S corporation rules. It represented that it manages the properties itself and provides maintenance, repairs, and other services to tenants. Based on those facts, the IRS ruled that the rents were excluded from passive investment income under § 1362(d)(3)(C)(i). This matters because excessive passive investment income can terminate an S election when the corporation also has accumulated earnings and profits. The IRS gave no opinion on whether the company qualified to elect S corporation status and said the separate § 469 passive activity rules could still apply.

Ruling snapshot

• Question: Do rents from the company's serviced commercial properties count as passive investment income under § 1362?
• Outcome: Approved: the rents are not passive investment income on the represented facts.
• Key authorities: IRC § 1362(d)(3); 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: 200137020
Release Date: 9/14/2001
Person to Contact:
Index Nos.: 1362.02-03
Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-110283-01
Date:
June 12, 2001

Company:

Properties:

State:

Shareholders:

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

Dear

This letter responds to a letter from your authorized representatives dated February 13, 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 is not passive investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code. Company represents the following.

2
PLR-110283-01

FACTS

Company was incorporated on a under the laws of State. It anticipates electing under § 1362(a) to be an S corporation.

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

Company provides various services to the Properties in its real estate leasing business. It does not use a real estate management company. These services (not all services are provided to all properties) include maintenance and repair of building structural components, including foundations, roofs, exterior walls, downspouts, and gutters; maintenance and repair of electrical, plumbing, and sewage systems exterior to the leased premises; policing, maintenance, and repair of common areas, including parking lots, driveways, loading docks, package pickup stations, sidewalks and ramps, and exterior stairways; major repair and replacement (as needed) of interior building systems, such as heating, air conditioning, plumbing, and electrical; operation and maintenance of common area lighting; maintenance of smoke detectors and fire extinguishers, landscaping and lawn maintenance; snow and ice removal; and pest control. 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 b in rents (including expense reimbursements) and paid or incurred approximately c in relevant expenses (including reimbursed amounts) for d on the Properties. The rental income and expense figures for e are f and g, respectively. 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

3
PLR-110283-01

"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 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 to elect S corporation status. 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