PLR 200308002: Commercial property rents are not passive investment income

Plain-English summary

An S corporation owned and managed six commercial rental properties. It described tenant services, property maintenance, and the work of its employee and contractors, and asked whether its rent was passive investment income. The IRS ruled that the rent was not passive investment income under § 1362(d)(3)(C)(i), which matters because excessive passive investment income can terminate an S election in the circumstances stated in that section. The letter did not decide whether the corporation was otherwise eligible for S status. It also says the separate passive activity rules in § 469 may still treat the rentals as passive.

Ruling snapshot

• Question: Do rents from the corporation's commercial properties count as passive investment income for the S election termination rule?
• Outcome: Approved, the rents do not count as passive investment income under the stated facts.
• Key authorities: IRC § 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200308002
Washington, DC 20224
Release Date: 2/21/2003
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:2 - PLR–117281-02
Date:
October 30,2002

Legend
X
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State =
Property 1 =
Property 2 =
Property 3 =
Property 4 =
Property 5 =
Property 6 =
Year 1 =
Date 1 =
Date 2 =
Date 3 =
$x =
$y =

Dear :

This responds to a letter dated March 15, 2002, submitted on behalf of X by X’s authorized representative, requesting a ruling that X's rental income from its commercial rental properties is not passive investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code.
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The information submitted states that X was incorporated in State on Date 1. X elected to be treated as an S corporation effective Date 2. X owns, leases, and manages 6 commercial properties: Property 1, Property 2, Property 3, Property 4, Property 5, and Property 6. Through X’s employee, as well as through independent contractors, X represents that it provides various services to its tenants. Services provided by X include, but are not limited to, the following: keeping in good order, condition, and repair the buildings, gutters, air-conditioning systems, and the heating systems. X also provides the following services with respect to X’s properties: grounds maintenance, snow removal, debris removal, repairs, and replacement of roofs. In addition to services provided to tenants, X handles the development, leasing, and administrative functions involved in managing real estate, including but not limited to, collecting rents, paying weekly or monthly bills, and negotiating, hiring, and supervising contractors.

In the taxable year ending Date 3, X received or accrued $x in rents and paid or incurred $y in relevant expenses other than depreciation. X represents that it anticipates future amounts to be consistent with the income and expense amounts for prior periods.

Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

Section 1362(d)(2)(A) provides than an election under § 1362(a) shall be terminated whenever (at any time after the first day of the first taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(d)(3)(A) provides that an election under § 1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years, and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. Any termination under this paragraph shall be effective on and after the first day of the first taxable year beginning after the third consecutive taxable year referred to above.

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 sales or exchanges of stock or securities.

Section 1.1362-2(c)(5)(ii)(B)(2) of the Income Tax Regulations 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
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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).

Based solely on the facts and the representations submitted we conclude that the rental income that X derives from Property 1, Property 2, Property 3, Property 4, Property 5, and Property 6 is not passive investment income as described in § 1362(d)(3)(C)(i).

Except as specifically set forth above, we express no opinion as to the federal tax consequences of the transaction described above under any other provision of the Code. Specifically, we express no opinion on whether X is a small business corporation eligible to make an S election. Further, the passive investment income rules of § 1362 are completely independent of the passive activity rules of section § 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) of the Code provides that it may not be used or cited as precedent.

Pursuant to the power of attorney on file with this office, a copy of this letter is being sent to X’s authorized representative.

Sincerely yours,
J. Thomas Hines
Chief, Branch 2
Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes