PLR 200408017: Natural resource partnership receipts retain their character

Plain-English summary

An S corporation with accumulated earnings and profits owned interests in publicly traded partnerships that operated natural resource businesses. It asked how its shares of the partnerships' gross receipts count under the S corporation passive investment income rules. The IRS ruled that the corporation must include its distributive shares of those receipts when applying the limits that can trigger tax or terminate an S election. Receipts from the partnerships' mineral and natural resource operations retain their operating character and are not passive investment income under section 1362(d)(3). The IRS did not decide whether the corporation was otherwise eligible for S status.

Ruling snapshot

• Question: Do natural resource partnership receipts count as passive investment income for the S corporation?
• Outcome: Approved: include the receipts, but the described operating receipts are not passive investment income.
• Key authorities: IRC §§ 702(b), 1362(d)(3), 1375(a), 7704.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200408017
Release Date: 2/20/04
Index Number: 1362.02-03

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Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:PSI:3 PLR-143377-03
Date:
November 12, 2003

Company: ----------------------------------
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Date: ------------------

MLPs: ----------------------------------------
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Dear ----------------:

This letter responds to a letter from your authorized representative dated July 10, 2003, as well as subsequent correspondence, submitted on behalf of Company, requesting rulings under '' 1362(d)(3) and 1375(a) of the Internal Revenue Code.

Company, an S corporation, was taxed under subchapter C before Date.
Company has accumulated earnings and profits.

Company is a diversified investment and manufacturing concern. In addition to its printing, real estate, and equipment leasing businesses, Company holds a professionally managed portfolio of stocks and bonds. As part of its investment strategy, Company has invested in publicly traded limited partnerships (the MLPs). The business activities of the MLPs include the exploration for, and the development, mining, production, processing, refining, transporting, and marketing of, minerals and natural resources.

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Company represents that the MLPs meet the qualifying income exception of ' 7704(c) and, thus, are taxed as partnerships for federal tax purposes. Company also represents that the MLPs are not electing large partnerships as defined by ' 775 and, thus, the normal flowthrough provisions of subchapter K apply to their partners.

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 1375(a) provides that a tax is imposed on the income of an S corporation for any tax year in which the corporation has accumulated earnings and profits at the close of that year and gross receipts more than 25 percent of which are passive investment income.

Section 702(a)(7) provides that, in determining income tax liability, each partner shall take into account separately his distributive share of the partnership's items of income, gain, loss, deduction, and credit to the extent provided by regulations.

Section 1.702-1(a)(8)(ii) provides that each partner must take into account separately his distributive share of any partnership item that would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately.

Section 702(b) provides that the character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share under ' 702(a)(1) through (7) shall be determined as if the item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.

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Except as provided in ' 7704(c), ' 7704(a) provides that a publicly traded partnership (PTP) shall be treated as a corporation for federal income tax purposes.

Section 7704(b) provides that the term PTP means any partnership if interests in that partnership are traded on an established securities market or are readily tradable on a secondary market (or the substantial equivalent thereof).

Section 7704(c)(1) provides that ' 7704(a) shall not apply to a PTP for any tax year if the partnership meets the gross income requirements of ' 7704(c)(2) for that year and each preceding tax year beginning after December 31, 1987, during which the partnership (or any predecessor) was in existence. Section 7704(c)(2) provides that a partnership meets the gross income requirement for any tax year if at least 90 percent of the partnership's gross income for that year consists of qualifying income.

Section 7704(d)(1)(E) provides that income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber) is qualifying income. For purposes of this section, mineral or natural resource means any product of a character with respect to which a deduction for depletion is allowable under ' 611, but is not a product described in ' 613(b)(7)(A) or (B).

Rev. Rul. 71-455, 1971-2 C.B. 318, deals with an S corporation that operates a business in a joint venture with another corporation. In the tax year at issue, the total business expenses exceeded gross receipts. The revenue ruling holds that, in applying the passive investment income limitations, the S corporation should include its distributive share of the joint venture=s gross receipts and not its share of the venture=s loss. In accordance with ' 702(b), the character of these gross receipts were not converted into passive investment income upon their allocation to the S corporation.

Company=s distributive shares of gross receipts from the MLPs, if separately taken into account, might affect its federal income tax liability. Under ' 1362(d)(3), the status of Company as an S corporation could depend upon the character of its distributive shares of gross receipts from the MLPs. Thus, pursuant to ' 1.702-1(a)(8)(ii), Company must take into account separately its distributive shares of the gross receipts from the MLPs. The character of these partnership receipts for Company will be the same as the character of the partnership receipts for the MLPs, in accordance with ' 702(b).

Based solely on the facts and representations submitted by Company, we conclude thatB

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(1) Company=s distributive shares of the gross receipts of the MLPs will be included in its gross receipts for purposes of '' 1362(d)(3) and 1375(a).

(2) Company=s distributive shares of the MLPs= gross receipts attributable to the exploration for, and the development, mining, production, processing, refining, transporting, and marketing of, minerals and natural resources will not constitute passive investment income as defined by ' 1362(d)(3)(C).

Except for the specific rulings above, we express or imply no opinion concerning the federal income 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.

In accordance with the 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,

/s/

JEANNE SULLIVAN
Senior Technician Reviewer, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosure: copy for ' 6110 purposes

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