PLR 200508007: Active commercial rental income is not passive investment income for S corporation rule

Plain-English summary

A company that owned and managed commercial properties planned to elect S corporation status. Because it had accumulated earnings and profits, it asked whether its rents counted as passive investment income under IRC § 1362, which can cause an S election to terminate if passive receipts exceed a threshold for three consecutive years. The company described employees, contractors, property upkeep, repairs, and other services it provided in its rental business. The IRS ruled that rents from those properties were not passive investment income under § 1362. It did not rule on the company's eligibility for S corporation status and noted that the separate passive activity rules under § 469 could still treat the rentals as passive.

Ruling snapshot

• Question: Did the company's commercial property rents count as passive investment income under § 1362?
• Outcome: No, based on the represented rental services and costs.
• 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: 200508007
Release Date: 2/25/05
Index Number: 1362.02-03

-------------------------------
Person To Contact:
---------------------------
--------------------, ID No. -------------
-----------------------------
Telephone Number:
---------------------------------
---------------------
Refer Reply To:
CC:PSI:3 – PLR-136860-04
-
Date:
-
November 04, 2004

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

Properties: -------------------------------------
--------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------
--------------------------------------------------------------------------
--------------------------------------------------------------------------------------
---------------------------------------------------------------------------
--------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
--------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
--------------------------------------------------------------
---------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------
-------------------------------------------------------------
------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------

2
PLR-136860-04

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

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

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

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

c: ---

d: ----------------

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

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

g: -------------------

h: ----------------

i: ----------------

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

This letter responds to a letter from your authorized representative dated June 24, 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 was incorporated under the laws of State on a and intends to elect under ' 1362(a) to be an S corporation effective b. Company has accumulated earnings and profits.

3
PLR-136860-04

Company owns, leases, and manages commercial real estate.

Through its c full-time employees, as well as independent contractors, Company provides various services in its real estate leasing and management business. These services include regular property inspection, including daily inspection for safety and cleanliness; cleaning and maintenance of common areas and parking facilities; maintenance and repair of building structural components (foundations, roofs, and exterior walls), including painting of exterior walls and trim as needed; maintenance and repair of building systems (plumbing, electrical, and HVAC); landscaping and grounds maintenance; selection and engagement of all subcontractors for remodels, facelifts, tenant improvements, and repairs (remodeling is done by an on-staff general contractor and electrician, along with assistants); monitoring or testing of fire alarms, sprinkler systems, and elevators, ensuring performance of required inspections and maintenance; provision of security lighting; and provision of emergency contact source and access. 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 (including its allocable shares of partnership rental income and expenses) and paid or incurred approximately e in relevant expenses for f on the Properties. The comparable 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.

4
PLR-136860-04

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

enclosures: copy for ' 6110 purposes

cc: