PLR 200335018: Rental receipts from actively managed properties are not passive income

Plain-English summary

An S corporation owned and managed commercial and residential rental properties. Its employees and contractors performed repairs, maintenance, landscaping, and pest control, and the corporation paid insurance and property taxes. The IRS ruled that its rental receipts came from an active rental business and were not passive investment income under section 1362(d)(3)(C)(i). The ruling assumed a valid S corporation election and did not decide whether the corporation otherwise qualified as an S corporation. The distinction matters because sustained excessive passive investment income can terminate an S election when a corporation has accumulated earnings and profits.

Ruling snapshot

• Question: Are receipts from the corporation's actively managed rental properties passive investment income for the S corporation termination rule?
• Outcome: Approved; the receipts were treated as active rental income, assuming a valid S election.
• 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: 200335018 Washington, DC 20224
Release Date: 8/29/2003
Index Number: 1362.02-03 Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:2 - PLR-104665-03
Date:
May 28, 2003

X
=

Properties =

D1
=

D2
=

D3
=
PLR-104665-03
-2-

$x
=

$y
=

Dear
:

This letter responds to a letter dated December 30, 2002, and subsequent correspondence submitted by X’s authorized representative, requesting a ruling that X's rental income from the Properties is not passive investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code.

The information submitted states that X is a corporation that incorporated on D1 and elected under § 1362(a) to be an S corporation effective D2. X owns, manages and rents the Properties, which are commercial and residential real estate.

Through X’s employees, as well as independent contractors, X provides various services to the tenants of the Properties as part of its real estate leasing and management business. These services include (not all services are applicable to all of the Properties): maintaining and repairing plumbing and roofs; repairing or replacing appliances, air conditioners, heating units, windows and doors; repairing all electrical problems; maintaining the landscaping; and pest extermination. X also is responsible for paying all of the insurance and property taxes on the Properties.

In the taxable year ending D3, X accrued approximately $x in rents and incurred approximately $y in relevant expenses.

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 § 1362(d)(3)(A) 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
PLR-104665-03
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"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).

Based solely on the facts and the representations submitted, and the assumption that X makes a valid election to be an S corporation, we conclude that the rental income that X derives from the Properties is income from the active trade or business of renting property and 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. Further, we express no opinion on whether X is otherwise a valid S corporation.

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 yours,

J. THOMAS HINES
Chief, Branch 2
Office of the Associate Chief Counsel
(Passthroughs and Special Industries)

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