PLR 200240005: Actively managed commercial rents are not passive investment income

Plain-English summary

An S corporation rented commercial properties and used employees to find tenants, manage leases, provide services, and maintain the buildings. The IRS ruled that its rental receipts were not passive investment income under § 1362(d)(3), which matters to the rule that can terminate an S election after three years of excessive passive investment income and accumulated earnings. The IRS did not decide whether the company otherwise qualified as an S corporation. It also explained that this conclusion did not change the separate passive activity rules under § 469.

Ruling snapshot

• Question: Were the corporation's commercial rental receipts passive investment income for the S election termination rule?
• Outcome: Approved: the receipts were not passive investment income under § 1362(d)(3)(C)(i).
• 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

Number: 200240005
Washington, DC 20224
Release Date: 10/4/2002
Index Number: 1362.02-03 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:1-PLR-111137-02
Date:
June 19 2002

Legend:

X
=

State =

D1
=

D2
=

D3
=

D4
=

Properties =

a
=

b
=

Dear
:

This responds to your letter dated December 27, 2001, submitted on behalf of X, requesting a ruling that the rental income received by X from renting certain properties is not passive investment income within the meaning of section 1362(d)(3)(C)(i) of the Internal Revenue Code. FACTS

X was incorporated in State on D1. X elected to be treated as an S corporation for its taxable year beginning D2.

X owns Properties, all of which are commercial facilities. The duties of X’s employees include the following: seek and screen clients; negotiate and sign leases; ensure that tenants understand and comply with their leases; plant and maintain landscaping; provide security guards, trash removal, snow removal, and janitorial services; maintain air conditioning, heating, plumbing, and water/sewage systems; repair as needed buildings, roofs, structural components and facades, mechanical systems and electrical systems.

From D3 to D4, X received or accrued $a in rents and paid or incurred $b in relevant expenses with respect to Properties.

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) 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 subparagraph (C), section 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 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). 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 type.

CONCLUSION

Based solely on the facts as presented in this ruling request, and viewed in light of the applicable law and regulations, we conclude that the rents X receives from the rental of Properties are not passive investment income under section 1362(d)(3)(C)(i).

Except as specifically set forth above, no opinion is expressed concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed concerning whether X otherwise satisfies the S corporation eligibility requirements under section 1361. Further, the passive investment income rules of section 1362 are completely independent of the passive activity rules of section 469; unless an exception under section 469 applies, the rental activity remains passive for purposes of section 469.

This ruling is directed only to the taxpayer who requested 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 the taxpayer.

Sincerely,

/s/ Carolyn Gray

Carolyn Gray
Acting Assistant Branch Chief, Branch 1
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures (2):
Copy of this letter
Copy for section 6110 purposes