PLR 200638007: Serviced property rents are not passive investment income for S corporation test

Plain-English summary

An S corporation with accumulated earnings and profits received rent from three properties held through a qualified S subsidiary and disregarded companies. It represented that it provided tenant services, maintained the properties, and handled leasing and administration directly or through contractors. The IRS ruled that the rent from these properties was not passive investment income for the S election termination rule in section 1362(d)(3). It expressly left open whether the corporation qualified for an S election and said the rental activity could still be passive under the separate section 469 rules.

Ruling snapshot

• Question: Do rents from the three properties count as passive investment income under section 1362(d)(3)?
• Outcome: Approved; the rents are excluded from that passive investment income category.
• Key authorities: IRC §§ 1362(d)(3), 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224
Number: 200638007
Release Date: 9/22/2006
Index Number: 1362.02-03, 1362.02-00,
1362.00-00
Person To Contact:
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-----------------, ID No. -------------
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Telephone Number:
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Refer Reply To:
CC: PSI: B02 – PLR-107488-06
Date: June 1, 2006

X = --------------------------------------
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State = ---------
QSub = ------------------------------------------------ LLC1 = ------------------------ LLC2 = -------------------------- Property 1 = ---------------------------------------------------------- Property 2 = ------------------------------------------------- Property 3 = ------------------------------------ Date 1 = -------------------- Date 2 = ---------------------- Date 3 = -------------------------- w= --------------- x= --------------- y= --------------- z= ---------------

Dear ---- -----:

This responds to a letter dated January 30, 2006, submitted on behalf of X by X's authorized representative, requesting a ruling that X's rental income from Property 1, Property 2 and Property 3 is not passive investment income within the meaning of § 1362(d)(3)(C)(i).

The information submitted states that X was incorporated in State on Date 1.
Effective Date 2, X elected to be treated as an S corporation. X has subchapter C earnings and profits.

X owns a qualified subchapter S subsidiary, QSub, as well as an 100% ownership interest in two limited liability companies, LLC1 and LLC2. LLC1 and LLC2
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are each treated as disregarded entities for federal income tax purposes. QSub owns Property 1, LLC1 owns Property 2, and LLC2 owns Property 3.

The information submitted represents that X, either directly or through its independent contractors, provides various services to the tenants of Property 1, Property 2 and Property 3. Services provided by X include but are not limited to the following: site inspections, assisting tenants with the sub-leasing of units, maintenance and repairs relating to tenant space improvements, elevators, roof and HVAC, plumbing, electricity and lighting, fire sprinklers and extinguishers, as well as janitorial, security, window washing, pest control, landscaping and interior design services. In addition to services provided to tenants, X, directly and through independent contractors, handles the leasing and administrative functions involved with Property 1, Property 2 and Property 3, including billing tenants and collecting rents and negotiating leases.

In the taxable year ending Date 3, X received or accrued a total of approximately $w in rents with respect to Property 1 and Property 2, and paid or incurred a total of approximately $x in relevant expenses other than depreciation and mortgage interest. In the taxable year ending Date 3, X received or accrued approximately $y in rents with respect to Property 3, and paid or incurred approximately $z in relevant expenses other than depreciation and mortgage interest.

Section 1361(a)(1) defines an "S corporation" as a small business corporation for which an election under § 1362(a) is in effect for the taxable year.

Section 1362(d)(2)(A) provides than an election under § 1362(a) shall be terminated whenever (at any time after the first day of the first taxable year for which the corporation is an S corporation) such corporation ceases to be a small business corporation.

Section 1362(d)(3)(A) provides that an election under § 1362(a) shall be terminated whenever the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years, and has gross receipts for each of such taxable years more than 25 percent of which are passive investment income. Any termination under this paragraph shall be effective on and after the first day of the first taxable year beginning after the third consecutive taxable year referred to above.

Section 1362(d)(3)(C)(i) provides that except as otherwise provided, 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)(2) of the Income Tax Regulations provides that "rents" does not include rents derived in the active trade or business of renting property.
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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, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation).

Based solely on the facts and the representations submitted, we conclude that the rental income that X derives from Property 1, Property 2 and Property 3 is not passive investment income as described in § 1362(d)(3)(C)(i).

Except as specifically set forth above, we express no opinion as to the federal tax consequences of the transaction described above under any other provision of the Code. Specifically, we express no opinion on whether X is a small business corporation eligible to make an S election. Further, the passive investment income rules of § 1362 are completely independent of the passive activity rules of section § 469; unless an exception under § 469 applies, the rental activity remains passive for purposes of § 469.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

Pursuant to the power of attorney on file with this office, a copy of this letter is being sent to X's first and second authorized representatives.

Sincerely,

Bradford R. Poston
Senior Counsel, Branch 2
Associate Chief Counsel
(Passthroughs & Special Industries)

Enclosures: 2
Copy of this letter
Copy for § 6110 purposes