PLR 200438002: Actively managed rental income is not passive investment income

Plain-English summary

A real estate company with accumulated earnings and profits planned to elect S corporation status. It asked whether rents from its commercial and residential properties would count as passive investment income under the rule that can end S status. The company employed staff, managed leasing, and performed extensive maintenance and repair work. The IRS ruled that its rents were derived from an active rental business and were not passive investment income for this purpose. It emphasized that this ruling did not decide whether the company qualified as an S corporation or whether its rentals were passive activities under section 469.

Ruling snapshot

• Question: Do the company's rental receipts count as passive investment income under section 1362?
• Outcome: Approved; the rents are not passive investment income on the stated facts.
• Key authorities: IRC §§ 1362(d)(3), 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200438002
Release Date: 9/17/04
Index Number: 1362.02-03

------------------
Person To Contact:
------------------------------------------- --------------------, ID No. -------------
-----------------------------------
Telephone Number:
--------------------------------
---------------------
Refer Reply To:
CC:PSI:3 – PLR-102195-04
-
Date:
-
May 04, 2004

Company: ------------------------------------
--------------------------

Shareholders: ------------------
-------------------------------------------------------
----------------------------------------------
-------------------------------------------------------
--------------------------------------------
-------------------------------------------------------
--------------------------------------------
-------------------------------------------------------
--------------------------------------------------
-------------------------------------------------------

Properties - ----------------------------------------------
-----------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------

State: -------------

a: ----------------------

b: ------------

c: ------------

d: -------

2
PLR-102195-04

Dear --------------:

This letter responds to your letter dated December 18, 2003, as well as subsequent correspondence, submitted on behalf of Company, requesting a ruling that the rental income received by Company from the Properties is not passive investment income within the meaning of ' 1362(d)(3)(C)(i) of the Internal Revenue Code.

FACTS

Company, a C corporation in State, intends to elect under ' 1362(a) to be an S corporation effective a. Company has accumulated earnings and profits.

Company owns, leases, and manages commercial and residential real estate.

Company employs 6 persons full-time: its president, vice-president, contract manager, maintenance manager, and (for Properties B and C) on-site property managers. It also employs independent contractors for jobs that cannot be done by the maintenance manager. Company is solely responsible for all repairs and maintenance of the Properties (except for any internal tenant improvements at Property A), which it inspects on a regular basis. This responsibility covers common areas; building structural and external components (except for windows at Property A), including roofs and foundations; building mechanical systems, such as heating and air conditioning; plumbing; parking lots and paved areas; grounds and landscaping; and (for Property C) the pool. In addition to the services provided to tenants, Company handles the usual leasing and administrative functions involved in managing rental real estate.

Company received or accrued approximately b in rents and paid or incurred approximately c in relevant expenses for d on the Properties. These figures are comparable to those experienced by Company in prior years, and it expects to have similar income and expenses on these properties in subsequent years.

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.

3
PLR-102195-04

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 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 Properties 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 be an S corporation. Further, the passive investment income rules of ' 1362 are 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 the original of this letter to you and copies to Company and to Company’s other authorized representative.

4
PLR-102195-04

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/

JAMES A. QUINN
Senior Counsel, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosures: copy for ' 6110 purposes

cc: ---------------------------------------------------------------
---------------------------------
---------------------------

-----------------------------------
---------------------------------------------
-------------------------------------
------------------------------------

--------------------------------
----------------------------------------------------
-------------------------------------------
-----------------------------------------