PLR 200446009: Rental receipts from managed properties were 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 properties counted as passive investment income under the S corporation termination rule. The company used employees and contractors to maintain and manage seven of its eight properties, while one property was under a triple net lease. The IRS ruled that rents from the seven managed properties were not passive investment income under section 1362(d)(3)(C)(i). It did not make that ruling for the triple net leased property or determine the company's S corporation eligibility. The letter also distinguished this rule from the separate passive activity rules in section 469.

Ruling snapshot

• Question: Were rents from the seven actively managed properties passive investment income for the S corporation rule?
• Outcome: Approved for Properties A, B, C, D, E, G, and H; no ruling for Property F.
• 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
Washington, DC 20224
Number: 200446009
Release Date: 11/12/04
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-116690-04
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Date:
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July 21, 2004

Company: ----------------------------------
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Shareholder: --------------------
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Properties - A: -------------------------------------------
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B: -------------------------------------------------
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C: ------------------------------------------------
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D: --------------------------------------
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E: --------------------------------------
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F: ---------------------------------------------------
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G: ------------------------------------------------
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H: ------------------------------------------------
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State: -------------------

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

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

c: --
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d: -------------

e: -------------

f: -------------------------

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

This letter responds to a letter from your authorized representative signed March 15, 2004, 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, incorporated under the laws of State on a, intends to elect under ' 1362(a) to be an S corporation effective b. Company has accumulated earnings and profits.

Company owns, leases, and manages commercial real estate.

Company employs c persons full-time, including Shareholder, and one person part-time. Through these employees, as well as independent contractors, Company provides various services in leasing and managing the Properties (except for Property F, which is under a triple net lease). These services include monthly property inspection, grounds maintenance and landscaping, maintenance and repair of building structure and systems (plumbing, electrical, heating, and air conditioning), parking lot maintenance, the provision of utilities (except for Properties C and G and a portion of Property H), trash collection (except for Properties C and G), snow removal, pest control (as needed), and the approval and supervision of capital improvements. 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 d in rents and paid or incurred approximately e in relevant expenses for f on the Properties (except Property F).

LAW AND ANALYSIS
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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 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 Properties A, B, C, D, E, G, and H 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 a copy of this letter to your authorized representative.
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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 Technical Reviewer, Branch 3
Office of Associate Chief Counsel
(Passthroughs and Special Industries)

enclosures: copy for ' 6110 purposes

cc: