PLR 200351015: Commercial property rents are not passive investment income

Plain-English summary

An S corporation owned five commercial rental properties and provided extensive property, tenant, and leasing services through a management company. It asked whether its rent counted as passive investment income under the rule that can terminate an S election after three consecutive years. Based on the described services and expenses, the IRS ruled that rent from the five properties was not passive investment income under section 1362. The IRS cautioned that this conclusion did not decide whether the rental activity was passive under the separate section 469 rules or whether the corporation otherwise qualified for S status.

Ruling snapshot

• Question: Did rent from the five managed commercial properties count as passive investment income under section 1362?
• Outcome: Approved: the rent was excluded from passive investment income for that rule.
• Key authorities: IRC § 1362(d)(3)(C)(i); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200351015
Washington, DC 20224
Release Date: 12/19/2003
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:2 - PLR–130435-03
Date:
September 5, 2003

Legend
X
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State
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Property 1 =

Property 2 =

Property 3 =

Property 4 =

Property 5 =

Date 1 =
Date 2 =
Date 3 =
$x
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$y
=
Dear :

This responds to a letter dated May 4, 2003, 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 five commercial properties: Property 1 and Property 2, Property 3, Property 4, and Property 5. X, through a management company, provides various services with respect to the properties. Services provided by X through X’s management company include, but are not limited to, the following: regular property inspections, common area maintenance and repair, maintenance and repair of the buildings’ structural, electrical, and mechanical components, equipment services and/or replacement, janitorial services, maintenance and repair of sidewalks and paved areas, including occasional pressure cleaning, ground maintenance, and provision of specific repairs services to tenants and maintenance of the emergency system. The management company also generally handles landscaping, irrigation, common signage, and normally prepares and arranges for the preparation of any required tenant improvements at the inception of the lease. In addition to services provided to tenants, X’s management company handles the leasing, and administrative functions involved in managing real estate, including lease negotiations, marketing and advertizing, collecting rents, and keeping monthly reports.

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

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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 we conclude that the rental income that X derives from Property 1, Property 2, Property 3, Property 4, and Property 5 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