PLR 200404019: Actively managed property rents are not passive investment income

Plain-English summary

A corporation planning an S election owned and leased commercial real estate and had accumulated earnings and profits. Its shareholder employees and contractors provided maintenance, cleaning, repairs, landscaping, and other services to tenants, and none of the tenants had a net lease. The IRS ruled that the rents were earned in an active rental business and were not passive investment income for the S corporation termination rule in § 1362(d)(3). The IRS did not decide whether the corporation could elect S status, and it said the rental activity could still be passive under the separate § 469 rules.

Ruling snapshot

• Question: Do the property rents count as passive investment income under the S corporation rules?
• Outcome: Approved: the rents are excluded from passive investment income.
• Key authorities: IRC § 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200404019
Washington, DC 20224
Release Date: 1/23/2004
Index Number: 1362.02-03
Person to Contact:

Telephone Number:

Refer Reply To:
CC:PSI:3 PLR-151924-03
Date:
October 17, 2003

Company:

Shareholders:

Property:
a:
b:
c:
d:
e:
f:
g:
h:
i:

Dear
:

This letter responds to your letter dated May 27, 2003, as well as subsequent correspondence, submitted on behalf of Company, requesting a ruling that the rental income received by Company from the Property is not passive investment income

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within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code.

FACTS

Company, owned equally by the Shareholders, was incorporated on a and intends to elect under § 1362(a) to be an S corporation effective b. Company has accumulated earnings and profits.

Company owns, operates, and leases commercial real estate (the Property). It has c tenants, none of whom is under a net lease.

All of the Shareholders are officers and employees of Company. Through the Shareholders, as well as independent contractors, Company provides various services to the Property, including regular property inspection; common area maintenance and repair, including carpeting and painting; janitorial and cleaning services; maintenance and repair of building structural components, including roofs and facades; upkeep and repair of building systems (heating, air conditioning, plumbing, water and sewer, electrical, and lighting); parking lot maintenance; landscape maintenance; snow removal; and pest control. 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 d in rents and paid or incurred approximately e in relevant expenses for f on the Property. The rental income and expense figures for g are h and i, 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.

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

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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 solely on the facts and representations submitted, 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 elect to be treated as 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.

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 yours,
/s/
MARY BETH COLLINS
Senior Technician Reviewer, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

Enclosure: copy for § 6110 purposes

cc: