PLR 200205019: Managed commercial rents are not passive investment income

Plain-English summary

An S corporation with accumulated earnings and profits leased commercial properties and provided tenants with extensive maintenance, cleaning, construction oversight, and management services. It asked whether the rents counted as passive investment income under the S corporation termination rule. The IRS ruled that the rents were not passive investment income under IRC § 1362(d)(3)(C)(i), applying the regulation for an active rental business with significant services or substantial costs. The ruling did not decide whether the corporation otherwise qualified for S status. It also warned that rental activity can still be passive under the separate IRC § 469 rules.

Ruling snapshot

• Question: Do the corporation's commercial rents count as passive investment income for the S election termination rule?
• Outcome: Approved: the described rents are not passive investment income under section 1362.
• Key authorities: IRC §§ 469, 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200205019
Washington, DC 20224
Release Date: 2/1/2002
Index Number: 1362.02-03
Person to Contact:

Telephone Number:
(202)622-3060
Refer Reply To:
CC:PSI:2 - PLR–144286-01
Date:
October 26, 2001

X
=

D1 =

D2 =

D3 =

$x =

$y =

State =

Dear . :

This letter responds to a letter dated July 25, 2001, submitted on behalf of X, requesting a ruling that X's rental income from its commercial rental properties is not passive investment income within the meaning of §1362(d)(3)(C)(i) of the Internal Revenue Code.

Facts

X was incorporated in State on D1 as a C corporation. X made an election to be treated as an S corporation effective D3. X had accumulated earnings and profits as of D3. X leases commercial rental properties to various tenants. Through X’s employees, as well as independent contractors, X provides various services to its tenants. Services provided by X include, but are not limited to, the following: maintenance and repairs of the roof, structural components, plumbing, elevators, fire alarms, electrical systems, facade, and parking lot. Moreover, X is responsible for landscaping around the building, including maintenance of the sprinkler system, daily cleaning of tenant offices and
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common areas, supervision of development and construction on the properties, regular monitoring and inspection of the properties, and removal of snow from common areas. In addition to services provided to tenants, X handles the usual marketing, leasing, and administrative functions involved in managing real estate, including but not limited to, screening prospective tenants, negotiating leases, and negotiating all service contracts.

In the fiscal year ending D2, X received or accrued approximately $x in rents and paid or incurred $y in relevant expenses. X represents that it anticipates future figures to be consistent with the income and expense figures for prior periods.

Law and Analysis

Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under §1362(a) is in effect for the taxable year.

Section 1362(d)(2)(A) provides than an election under §1362(a) shall be terminated whenever (at any time after the first day of the first taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(d)(3)(A) provides that an election under §1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years, and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. Any termination under this paragraph shall be effective on and after the first day of the first taxable year beginning after the third consecutive taxable year referred to above.

Section 1362(d)(3)(C)(i) provides that except as otherwise provided, 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)(2) of the Income Tax Regulations 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).

Conclusion
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Based solely on the facts and the representations submitted we conclude that the rental income that X derives from the properties is not passive investment income as described in §1362(d)(3)(C)(i).

Except as specifically set forth above, we express no opinion as to the federal tax consequences of the transaction described above under any other provision of the Code. Specifically, we express no opinion on whether X is a small business corporation eligible to make an S election. Further, the passive investment income rules of §1362 are completely independent of the passive activity rules of section §469; unless an exception under §469 applies, the rental activity remains passive for purposes of §469.

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

Pursuant to the power of attorney on file with this office, a copy of this letter is being sent to X’s authorized representative.

Sincerely yours,
Matthew Lay
Senior Technician Reviewer, Branch 2
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes