PLR 1045006: Rental income from an actively operated office-property business was not passive investment income

Plain-English summary

The IRS ruled for an S corporation that developed, owned, operated, and leased high-technology office buildings. The corporation provided substantial property and tenant services, including maintenance, security, cleaning, landscaping, and facility management. Based on those facts, the IRS concluded that the corporation's rental income was not passive investment income for purposes of the S corporation termination rule in IRC § 1362(d)(3). The ruling did not address other federal tax consequences, and it stated that the rental activity remained passive for purposes of the separate passive activity loss rules under IRC § 469 unless an exception applied.

Ruling snapshot

• Question: Is rental income from the taxpayer's actively operated office properties passive investment income under IRC § 1362(d)(3)(C)(i)?
• Outcome: Approved
• Key authorities: IRC §§ 1361, 1362, and 469; Treas. Reg. § 1.1362-2

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

                                                          Third Party Communication: None

Number: 201045006 Date of Communication: Not Applicable
Release Date: 11/12/2010
Person To Contact:
Index Number: 1362.04-00 ------------------------, ID No. -------------
Telephone Number:
------------------------------------ ---------------------
-------------------------------- Refer Reply To:

-------------------------- CC:PSI:B02
------------- PLR-108435-10
Date:
-------------------------- July 14, 2010

Legend

X = ---------------------------------

Y = ----------------------------------

a = --

b = --

c = ----

d = --------------

e = --------------

f = --------------

g = --------------

L = ----------------------------------------------------------------------------------------------

M = ---------------------------------------------------------------------------------------------------------------

N = ---------------------------------------------------------------------------------------------------------------

PLR-108435-10 2

O = ---------------------------------------------------------------------------------------------------------------

P = ---------------------------------------------------------------------------------------------------------------

State = ------
Date1 = ------------------

Date2 = -----------------------

Date3 = ----------------------

Year1 = -------

Year2 = -------

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

   This responds to a letter dated February 19, 2010, submitted on behalf of X by

X’s authorized representative, requesting a ruling that the rental income received by X
from certain rental real estate is not passive investment income within the meaning of
§ 1362(d)(3)(C)(i) of the Internal Revenue Code (the Code).

    The information submitted states that X was incorporated under the laws of State

on Date1. Y is a wholly-owned subsidiary of X that was incorporated under the laws of
State on Date2. X elected to be an S corporation effective Date3, and X also made the
election under § 1362(b)(3)(B) to treat Y as a qualified subchapter S subsidiary effective
Date3. X, through Y, develops, owns, operates and leases high-technology office
buildings, and provides high-technology companies with facilities, security, office
management, and onsite technologies. Y currently owns a office buildings, and
operates and leases a total of b office buildings (including buildings leased from third
parties): L, M, N, O, and P (collectively, the “Properties”). Y also owns undeveloped
land contiguous to the Properties, and this undeveloped land gives Y the potential to
significantly increase the amount of high-technology office space it can develop, own,
operate and lease in the future.

     Y’s tenants primarily include small high-technology companies that are in the

initial stages of their development and growth. Y provides its tenants with office space
with potential to expand as the tenants grow in size. Y also provides its tenants with
expertise and assistance in the areas of space planning, leasing, and facility
management. Y currently has c tenants that occupy the Properties.
PLR-108435-10 3

   Y utilizes a standard form lease with a base year for all of its tenants. Under the

form lease, Y is generally responsible for the payment of taxes, maintenance,
insurance, and utilities. The tenants pay a certain base rent and a share of the
operating expenses for the calendar year in which the tenancy begins. Thereafter, the
tenants are responsible for their proportionate share of any increase in the operating
expenses over the base year expenses. X and Y operate, manage, and maintain the
Properties through a full-time employee, certain other individuals, and a property
management company. The services provided for the Properties include (1) the
maintenance of all mechanical, electrical, BMS and control monitoring, emergency
power, fire alarm, elevators, plumbing, and other major and minor systems in the
Properties; (2) the performance of exterior and interior cleaning, painting, decorating,
plumbing, carpentry, landscaping, roofing, maintenance of heating, ventilating and air
conditioning systems, and such other normal maintenance, repair work and minor
construction as may be necessary; (3) investigating all necessary preventative
maintenance programs; (4) purchasing supplies, materials and services; and (5)
regularly inspecting and testing the physical condition of the Properties. X and Y also
provide various services to the tenants including janitorial services, security services,
rubbish removal, interior and exterior landscape maintenance, vermin extermination,
and other services that may be required for the proper operation of the Properties.

   In Year1, X collected approximately $d in gross rents and incurred approximately

$e in relevant operating expenses for the Properties. In Year2, X collected
approximately $f in gross rents and incurred approximately $g in relevant operating
expenses for the Properties. X also represents that X and Y both have accumulated
earnings and profits.

  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) shall be

terminated whenever the corporation (1) has accumulated earnings and profits at the
close of each of three consecutive taxable years, and (2) has gross receipts for each of
such taxable 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)(iii)B)(i) 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.
PLR-108435-10 4

    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 the active trade or business of renting property only if, based
on all of 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 are substantial costs are incurred in the rental
business is determined based upon all of 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 submitted and the representations made, we conclude

that the rental income X receives from its operations described above is not passive
investment income under § 1362(d)(3)(C)(i).

    Except as specifically set forth above, no opinion is expressed concerning the

federal tax consequences of the facts described above under any other provision of the
Code, including whether X was or is a small business corporation under § 1361(b).
Further, the passive investment income rules of § 1362 are independent of the passive
activity loss rules of § 469; unless an exception under § 469 applies, the rental activity
remains passive for purposes of § 469.

   The ruling contained in this letter is based upon information and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

   This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3)

of the Code provides that it may not be used or cited as precedent.

    In accordance with the power of attorney on file with this office, copies of this

letter are being sent to X’s authorized representatives.

                                   Sincerely,

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

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes