Service-intensive rents were not passive investment income

Plain-English summary

A company planning to elect S corporation status owned and managed commercial real estate. Its officers, employees, and contractors provided daily cleaning and security, maintenance and repairs, common-area management, tenant services, leasing, rent collection, financing, insurance, and applicant screening. The IRS found those services and operating costs significant enough for the rents to arise from an active rental business. The rental income therefore was not passive investment income for the S corporation termination rule in section 1362(d)(3). The ruling did not decide whether the company otherwise qualified as an S corporation or whether the rental activity was passive under section 469.

Ruling snapshot

• Question: Were rents from actively managed commercial property passive investment income for the S corporation termination rules?
• Outcome: Approved, the rents were not passive investment income
• Key authorities: IRC § 1362(d)(3); 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: 201523008 Third Party Communication: None
Release Date: 6/5/2015 Date of Communication: Not Applicable
Index Number: 1362.02-00, 1362.02-03
Person To Contact:
----------------------------------- --------------------, ID No. ------------------
---------------------- Telephone Number:
------------------------------------ ----------------------
------------------------------- Refer Reply To:
CC:PSI:B02
PLR-136311-14
Date:
February 04, 2015

Legend

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

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

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

Year 1 = -------

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

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

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

   This letter responds to a letter dated September 25, 2014, submitted by X's

authorized representative on behalf of X, requesting a ruling that rental income that X
received from certain real estate is not passive 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 anticipates making 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, through its officers, employees and independent contractors, has provided and

continues to provide certain services with respect to the leasing of the Property. These
services include daily janitorial and rubbish removal services, regular maintenance,
repairs and inspection covering plumbing, electrical and drainage systems as well as
roofing, landscaping and building improvements. These services also include daily
security services and management and control of all common areas, including parking
PLR-136311-14 2

lots and picnic table areas. X additionally negotiates and executes leases with tenants,
settles tenant disputes and collects rents and monthly sales reports, negotiates bank
loans and insurance contracts for the Property and performs background checks on
prospective tenants.

   For the Year 1 taxable year, X collected approximately $N1 in gross rents and

paid or incurred approximately $N2 in relevant operating expenses excluding
depreciation. X represents that these figures are generally representative of the
amounts of income and expenses it incurs with respect to the Property in a typical year.

  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
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).

  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).
PLR-136311-14 3

    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
§ 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 representative.

                                             Sincerely,



                                             Bradford R. Poston
                                             Senior Counsel, Branch 3
                                             Office of the Associate Chief Counsel
                                             (Passthroughs and Special Industries)

Enclosures: (2)

Copy of this letter

Copy for § 6110 purposes