PLR 200226025: Managed commercial property rents are not passive investment income

Plain-English summary

An S corporation with accumulated C corporation earnings and profits rented out a commercial property. It employed staff, maintained an office on site, managed tenants and leases, and performed property maintenance. The IRS concluded that the rental receipts for the two stated years were not passive investment income under the S corporation rule in IRC § 1362(d)(3). That distinction matters because excessive passive investment income can trigger tax or end an S election when accumulated earnings and profits remain. The IRS did not decide whether the company otherwise qualified as an S corporation or whether the rents were passive under the separate § 469 rules.

Ruling snapshot

• Question: Are the corporation's rental receipts passive investment income for the S corporation rules?
• Outcome: Approved: the receipts for the stated years are not passive investment income under § 1362(d)(3).
• Key authorities: IRC §§ 1362(d)(3), 1375(a); Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200226025
Washington, DC 20224
Release Date: 6/28/2002
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:B1-PLR-102759-02
Date:
March 25, 2002

Legend

X
=

D1 =

Property =

Year 1 =

Year 2 =
$a =

$b =

$c =

$d =

Dear

This responds to your letter dated, January 7, 2002, in which you requested a ruling that X’s rental income from certain properties will not constitute passive investment income within the meaning of § 1362(d)(3) of the Internal Revenue Code.

Facts

X elected to be treated as an S corporation, for federal tax purposes, effective D1. At the time that S elected S corporation status, it had C corporation earnings and profits.

CC:PSI:B1-PLR-102759-02
2

X owns Property, which is a commercial facility. X’s duties include the following with respect to the property: supervising contractors; performing landscape maintenance; sweeping sidewalks and the parking lot; repairing the exterior of the buildings, including the roof, downspouts, and the parking lot; maintaining the interior sprinkler system; maintaining the light fixtures in the parking lot; maintaining the perimeter fence; maintaining enclosed garbage areas; negotiating lease terms; maintaining books with regard to the property; securing new tenants; and engaging professionals as needed. Taxpayer employs individuals to perform the routine, day-to- day management of the property and maintains a management office on the property. Taxpayer’s income from the properties during Year 1 totaled $a and its nonreimbursed expenses related to the properties totaled $b. During Year 2, taxpayer’s income from the properties totaled $c and its nonreimbursed expenses totaled $d.

Law and Analysis

Except as provided in section 1362(g), section 1362(a)(1) provides that a small business corporation may elect, in accordance with the provisions of section 1362, to be an S corporation.

Section 1362(d)(3)(A)(i) provides that an election under section 1362(a) shall be terminated 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.

Section 1375(a) imposes a tax on the income of an S corporation if the S corporation has (1) accumulated earnings and profits at the close of such taxable year and (2) gross receipts more than 25 percent of which are passive investment income.

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 sale or exchanges of stock or securities.

Section 1.1362-2(c)(5)(ii)(B)(1) of the Regulations provide1 that “rents” means amounts received for the use of, or the right to use, property (whether real or personal) of a corporation.

Section 1.1362-2(c)(5)(ii)(B)(2) provides that the term “rents” does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in 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 personal employed to provide the services and the types and

CC:PSI:B1-PLR-102759-02
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amounts of costs and expenses incurred (other than depreciation).

Section 1.1362-2(c)(5)(ii)(B)(4) provides that rents do not include compensation, however designated, for the use of, or right to use, any real or tangible personal property developed, manufactured, or produced by the taxpayer, if during the taxable year the taxpayer is engaged in substantial development, manufacturing, or production of real or tangible personal property of the same kind.

Conclusion

Based solely on the representations made and the information submitted we conclude that X’s rental income from the properties, received during Year1 and Year2, is not passive income under § 1362(d)(3)(C)(i).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed regarding X’s eligibility under § 1361 to be an S corporation or regarding whether X’s rental income is passive income under § 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.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to X’s authorized representative.

Sincerely,
David R. Haglund
Senior Technician Reviewer, Branch 1
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)
Enclosures (2)
Copy of this letter
Copy for § 6110 purposes
cc: