PLR 200206031: Active rental services keep an S corporation's rents outside passive investment income

Plain-English summary

An S corporation that owned and operated rental real estate asked whether its rental income was passive investment income under section 1362. The corporation and its employees provided extensive property management, maintenance, security, emergency, and tenant services, along with ordinary leasing and administrative functions. The IRS ruled that the rents were derived from an active trade or business and therefore were not passive investment income under section 1362(d)(3)(C)(i). The letter separately states that the section 1362 passive investment income rules do not determine whether the activity remains passive under section 469.

Ruling snapshot

• Question: Is the S corporation's rental income passive investment income when it provides substantial services and incurs substantial costs in operating the property?
• Outcome: Approved, the rents were not passive investment income under section 1362(d)(3)(C)(i).
• Key authorities: IRC §§ 1362(a), 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

Number: 200206031
Washington, DC 20224
Release Date: 2/8/2002
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-139477-01
Date:
November 8, 2001

Company:

Property:

Shareholders:

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

Dear

This letter responds to your letter dated June 6, 2001, as well as subsequent correspondence, requesting a ruling that the rental income received by Company from the Property is not passive investment income within the meaning of § 1362(d)(3)(C)(i) 2 PLR-139477-01

of the Internal Revenue Code.

FACTS

Company was incorporated in State on a and purchased by the Shareholders in b. It elected under § 1362(a) to be an S corporation effective c. Company has accumulated earnings and profits.

Company owns and operates rental real estate (the Property).

Company employs d persons full time, including the Shareholders, who oversee the entire operation of the Property from their on-site office. In its real estate leasing and management business, Company provides various services to the Property. These services include the maintenance and repair of roads, parking areas, and streetlights; maintenance of the pool and pool house; maintenance of the clubhouse, including laundry and kitchen facilities; maintenance of two outdoor recreation areas; inspection of residences for resale; grounds maintenance and landscaping; maintenance of electrical connections; maintenance of storm drains and water and sewer lines; snow and ice removal; cable TV service and maintenance of the cable system; security patrols; and 24-hour-a-day emergency assistance. 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 e in rents and paid or incurred approximately f in relevant expenses for g on the Property.

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 3 PLR-139477-01

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 submitted and representations made, we conclude that the rents Company receives from the Property are not passive investment income under § 1362(d)(3)(C)(i).

Except for the specific ruling above, we express or imply no opinion concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, we express or imply no opinion regarding Company's eligibility to elect 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 the original of this letter to you and a copy to the taxpayer and to the taxpayer’s other 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,
JEANNE SULLIVAN
Senior Technician Reviewer, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosure: copy for § 6110 purposes