PLR 1232023: IRS finds active rental operations did not generate passive investment income

Plain-English summary

An S corporation owned and actively managed commercial real estate. Its shareholder and officers performed extensive maintenance, tenant-management, leasing, and marketing services, while the corporation also incurred operating expenses. The IRS ruled that the corporation's rental income was not passive investment income for purposes of the S corporation termination rules in IRC § 1362(d)(3). The IRS also ruled that a statement attached to a prior Form 1120S did not validly revoke the S election. The ruling did not address whether the rental activity was passive under the separate rules of IRC § 469.

Ruling snapshot

• Question: Was the corporation's commercial rental income passive investment income, and did its prior filing revoke its S election?
• Outcome: Approved.
• Key authorities: IRC §§ 1361, 1362, and 469; Treas. Reg. §§ 1.1362-2 and 1.1362-6; § 6110(k)(3).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201232023 Third Party Communication: None
Release Date: 8/10/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 1362.02-00, 1362.02-03 -------------------, ID No. -----------------
Telephone Number:
--------------------
----------------------------------- Refer Reply To:
-------------------------------- CC:PSI:B02
--------------------- PLR-148601-11
------------------------------ Date:
April 04, 2012

Legend

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

A= -----------------------------

State = ----------

Date 1 = ----------------------

Date 2 = ----------------------

Year 1= -------------------------

Year 2= -------------------------

N1= -----------------------------

N2= -----------------------------

N3 -----------------------------

N4 ----------------------

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

    This letter responds to a letter dated November 21, 2011, and subsequent

correspondence, submitted by X’s authorized representatives on behalf of X, requesting
a ruling that rental income that X received from certain real estate is not passive

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investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue
Code.

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

and subsequently made an election to be treated as an S corporation effective Date 1.
X owns, leases and manages a certain commercial real estate property (the “Property”).
X has accumulated earnings and profits.

  X, through its shareholder and officers, has provided and continues to provide

certain services with respect to the leasing of the Property. These services include
inspecting, maintaining, and repairing the building, including the roofs, canopies,
external walls, windows, floors, foundations, guttering and downspouts, plumbing,
painting and internal light fixtures. These services also include inspecting, maintaining
and repairing all common areas, including the parking lots, sidewalks, curbs and
external light fixtures, and maintenance of Property grounds, including landscaping,
garbage removal and snow and ice removal. X negotiates leases, renewals and other
agreements with tenants, collects rents, monitors compliance with lease terms,
addresses tenant complaints and requests and advertises available commercial space
and solicits new tenants as applicable.

  For the Year 1 and Year 2 taxable years, X collected approximately $N1 and

$N2, respectively, in gross rents and paid or incurred approximately $N3 and $N4,
respectively, in relevant operating expenses excluding depreciation.

   In Year 2, X’s former accountant attached a statement X’s Year 1 Form 1120S,

U.S. Income Return for an S Corporation, indicating that X’s S corporation election had
terminated effective Year 1 because of excess passive investment income. This
statement did not satisfy the requirements for an effective S corporation election
revocation set forth in §§ 1.1362-2(a)(1) and 1.1362-6(a)(3) of the Income Tax
Regulations.

  Section 1361(a)(1) of the Code defines an “S corporation” as a small business

corporation for which an election under § 1362(a) is in effect for such year.

  Section 1362(d)(2)(A) provides that 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

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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) 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, 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).

   Section 1.1362-2(a)(1) provides that an election made under § 1362(a) is

terminated if the corporation revokes the election for any taxable year of the corporation
for which the election is effective. Section 1.1362-2(a)(1) further provides that a
revocation may only be made with the consent of shareholders who, at the time the
revocation is made, hold more than one-half of the number of issued and outstanding
shares of stock (including non-voting stock) of the corporation.

    Section 1.1362-6(a)(3)(i) provides that an S corporation revokes its S election by

filing a statement with the service center where its election was properly filed. The
revocation statement must include the number of shares of stock (including non-voting
stock) issued and outstanding at the time the revocation is made. Section 1.1362-
6(a)(3)(i) further provides that a revocation is not valid unless all shareholders of the
corporation at the time of the election consent to the election in the manner required
under § 1.1362-6(b).

  Based solely on the information submitted and the representations made, we

conclude that the rental income that X receives from its operations described above is
not passive investment income under § 1362(d)(3)(C)(i). We further conclude that the
statement attached to X’s Year 1 Form 1120S was not an effective revocation of X’s S
corporation election.

    Except as expressly provided herein, we express or imply no opinion concerning

the tax consequences of any aspect of any transaction or item discussed or referenced
in this letter. Specifically, we express or imply no opinion on whether X is a small
business corporation under § 1361(b). Further, the passive investment income rules of

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§ 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.

   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.

   Pursuant to the power of attorney on file with this office, a copy of this letter is

being sent to X’s authorized representatives.

                                               Sincerely,



                                               Bradford R. Poston
                                               Senior Counsel, Branch 2
                                               Office of the Associate Chief Counsel
                                               (Passthroughs and Special Industries)

Enclosures: (2)

Copy of this letter

Copy for § 6110 purposes

cc: