PLR 200240017: Managed rental property income excluded from S corporation passive income test

Plain-English summary

An S corporation owned rental real estate and employed a manager to handle leasing, collections, inspections, maintenance, and tenant needs. The corporation also paid substantial operating costs, including repairs, security, utilities, and property taxes. The IRS ruled that the property's rents were not passive investment income under § 1362(d)(3)(C)(i). That classification affects the separate passive income tax and S election termination rules. The IRS did not decide whether the company otherwise met S corporation requirements and said the § 469 passive activity rules remained separate.

Ruling snapshot

• Question: Are rents from the actively managed property passive investment income for the S corporation rules?
• Outcome: Approved: the rents were excluded from passive investment income.
• Key authorities: IRC §§ 1362(d)(3), 1375(a), and 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200240017
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-126407-02
Date:
June 24 2002

Legend:
X =

Y =

State =
D1 =
D2 =
D3 = a = b =

Dear
:

This responds to your letter dated April 30, 2002, submitted on behalf of X, requesting a ruling that the rental income received by X in the course of its operations from a real property is not passive investment income within the meaning of § 1362(d)(3) of the Internal Revenue Code.

Facts

X was incorporated in State on D1. X made an election to be treated as an S corporation effective D2. X owns a rental real property. X employs Y as property manager to manage X’s real property.

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In operating the property, Y is responsible for obtaining and negotiating leases; handling all aspects of tenant billings and collections; monitoring tenant compliance with lease terms; collecting rents from delinquent tenants either directly or with the aid of collectors or attorneys; payments of all expenses; maintenance of required insurance policies; preparation of monthly and quarterly financial reports; being on call 24 hours a day; inspection of the buildings for cleanliness, general conditions and mechanical systems not less than once a week; comprehensive inspection of structural, mechanical and utility supply systems not less than seasonally; assisting in the procurement of and approving of all contracts with respect to operations and management; and supervising and coordinating the maintenance and repairs of tenant space, common area, roofs, and other structural elements of the buildings.

In operating the property, X pays for advertizing and marketing, capital improvements, janitorial services, insurance, fire-safety inspection, landscaping, repairs and maintenance, rubbish removal, security, snow removal, and utilities. In addition, X pays commissions, management fees, payroll and payroll taxes, professional fees including legal and accounting, and real estate taxes.

For the tax year ending D3, X received or accrued $a in rental income and paid or incurred $b in relevant operating expenses.

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.

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 receipt 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

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corporation are derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provided 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

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 its property are not passive investment income under § 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 § 1361. 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.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) 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,
Carolyn Gray
Acting Assistant to the Branch Chief, Branch 1 Office of Associate Chief Counsel
(Passthroughs and Special Industries)

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