PLR 200304026: Serviced apartment rents are not S corporation passive investment income

Plain-English summary

An S corporation with accumulated earnings and profits owned and operated an apartment building with residential and commercial tenants. Its employees, manager and contractors maintained the building, provided tenant services and handled leasing. The IRS ruled that the rents were earned in an active rental business and therefore were not passive investment income under section 1362(d)(3)(C)(i). This matters because excess passive investment income over three years can end an S election. The IRS did not decide the company's eligibility for S status and said the separate section 469 passive activity rules could still treat the rental activity as passive.

Ruling snapshot

• Question: Are rents from the serviced apartment property passive investment income for section 1362 purposes?
• Outcome: Approved: the described rents are not passive investment income under section 1362.
• Key authorities: IRC §§ 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: 200304026 Washington, DC 20224
Release Date: 01/24/2003
Index Number: 1362.02-03 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-140806-02
Date:
October 24, 2002

Legend

Company:

Property:

Shareholder:

State:
a:
b:
c:
d:
e:
f:
g:
h:
i:
k:

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Dear
:

This letter responds to your letter received July 15, 2002, 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) of the Internal Revenue Code.

FACTS

Company was incorporated under the laws of State in a and elected under § 1362(a) to be an S corporation effective b. It has subchapter C earnings and profits.

Company owns, leases, and operates an apartment building with residential and commercial tenants (the Property). Through its c employees (d part-time), a property manager, and third-party contractors (including the building superintendent), Company provides various services with respect to the Property. These services include regular property inspection; common area maintenance and repair (interior and exterior); maintenance and repair of building structural and mechanical components; operation of the building’s mechanical plant; appliance servicing or replacement; installation and maintenance of window guards; common janitorial services, including refuse collection; maintenance and repair of sidewalks, including cleaning and snow removal; grounds maintenance; provision of certain utilities and repair services to tenants; and maintenance of a system for emergency repairs. 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. The rental income and expense figures for h are i and k, respectively.

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.

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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 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).

CONCLUSION

Based on the facts and representations submitted by Company, 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 be 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 a copy of this letter to your authorized representative.

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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,

/s/

JAMES A. QUINN
Senior Counsel, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosure: Copy for § 6110 purposes