Serviced medical-office rents are not passive investment income

Plain-English summary

A corporation with accumulated earnings and profits planned to elect S corporation status and operated a commercial property leased as medical offices and related facilities. It actively negotiated leases and renewals, planned and renovated tenant spaces, and provided extensive maintenance, utilities, grounds care, cleaning, repairs, security access, and other property services through employees and contractors. The IRS found that the corporation provided significant services and incurred substantial rental-business costs. Its rents therefore were not passive investment income under section 1362(d)(3)(C)(i), so those receipts would not count toward the passive-income termination test on the facts presented. The ruling did not decide whether the company qualified as a small business corporation and noted that the separate section 469 passive-activity rules could still apply.

Ruling snapshot

• Question: Are rents from the corporation's actively managed medical-office property passive investment income for the S corporation termination test?
• Outcome: approved
• Key authorities: IRC § 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

                                                               Third Party Communication: None
Number: 201725022                                              Date of Communication: Not Applicable
Release Date: 6/23/2017
                                                               Person To Contact:
Index Number: 1362.04-00                                       -------------------------, ID No. ------------------
                                                               -----------------------------------------------------
--------------------------------------------                   Telephone Number:
--------------------------------------------                   ----------------------
-------------------                                            Refer Reply To:

---------------------------                                    CC:PSI:B03
                                                               PLR-135319-16
                                                               Date:
                                                               March 23, 2017



Legend

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

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

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

City     =        ------------------------------

Year1 =           -------

Year2 =           -------

Year3 =           -------------------------------

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

N2       =        --

N3       =        ----------

N4       =        ----------

N5       =        ----------

N6       =        --------------

N7       =        ------------
PLR-135319-16                                2



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

       This responds to a letter dated November 4, 2016, 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
in Year1. X has been taxed as a C corporation since its formation. X currently has
accumulated earnings and profits of $N1. X represents that it intends to elect to be an
S corporation effective for Year2. According to the submission, X is active in the
business of acquiring, developing, leasing and managing commercial real estate,
concentrating in medical office suites and clinics. X’s primary asset is M, located in
City.

       M is composed of a parcel of land situated on two contiguous lots. X acquired
this parcel of land in Year1. At the time of acquisition, M was partially developed as a
plaza containing N2 single-story buildings in a cottage complex along with a single two-
story building, with a combined commercial office space of approximately N3 square
feet. X later constructed another building to the cottage complex and a separate two-
story building in M. With the addition of these two buildings, M had a combined
commercial office space of approximately N4 square feet. In Year3, X finished
construction of a new N5 square foot, tri-level building within M. All of the suite space
comprising M is currently leased for use as medical offices and/or related services.

        X contracts with an independent leasing agent to assist in soliciting prospective
tenants for M, negotiating leases and renewals, and overseeing post-leasing activities
such as build-outs and renovations of suite space. X, with the assistance of the
independent leasing agent, drafts, proposes, presents, and negotiates letters of intent to
lease available suite spaces. Negotiation for leasing regularly requires the use of an
independent space planner to design and tailor the spaces for prospective tenants.
Once letters of intent are accepted, X, with the assistance of the independent leasing
agent, prepares, finalizes, and executes the lease agreements with prospective tenants.
Renewals of leases are similarly handled by X, which are often complicated by requests
for concessions and renegotiation of the leasing rate. Renewals often require
significant time and attention by X.

       X, through its employees, its agents, and the agents’ employees, provides certain
services in maintaining and repairing of the buildings, common areas, and grounds of
M. X utilizes a standard lease agreement for its tenants, and under the lease
agreements X has the obligation to provide certain services with respect to the leasing
of space within M and to maintain or repair the following items: the heat and air
PLR-135319-16                                3

conditioning systems, plumbing, hot water heaters, exterior lighting, signs, lawn care
and gardening, roofs and exterior walls, exterior walkways, courtyards, parking areas,
electricity, water and sewer, drainage, and garbage pickup.

       In addition, the following specific services are provided to M and its tenants by an
employee or independent contractor/worker of X: daily walk-through inspections of M to
report on water breaks, lighting outage, vandalism, damage to building exteriors and
certain interior spaces; sweeping, cleaning and maintaining the common areas of M
such as sideways, walkways, and parking lot; routine periodic inspection of building
exteriors and interiors, including foundations, roofs, exterior lighting, grounds, and
parking lot and engaging in maintenance and repairs as needed; treating the roofs of
the buildings for moss growth yearly; recoating and resurfacing the parking lot; routine
and periodic maintenance of the numerous heating and air conditioning units;
renovating vacant suites for leasing; routine and periodic maintenance of the plumbing
and sewer lines, and their repair and replacement as needed; maintenance, repair and
replacement of exterior lighting and selected interior lighting; janitorial services for
selected units and common areas; exterior window washing; regular maintenance of
grounds and lawn care, and landscaping services when necessary; seasonal snow
removal and ice control; weekly trash removal; periodic pest and vermin control; and
emergency response and property access for public safety.

      In Year3, X collected approximately $N6 in gross rents and incurred
approximately $N7 in relevant operating expenses for the Properties.

      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.

      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
PLR-135319-16                                  4

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 or 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 ruling request, 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
                                       Senior Counsel, Branch 3
                                       Office of Associate Chief Counsel
                                       (Passthroughs & Special Industries)



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