Active rental services kept real estate income from being passive investment income

Plain-English summary

A corporation planning to elect S corporation status had accumulated earnings and profits and earned rent through real estate held directly and through limited liability companies. It and its affiliates used officers, employees, and contractors to repair and maintain the properties, provide tenant services, negotiate leases, evaluate prospective tenants, manage insurance claims, and handle property tax appeals. The IRS ruled that these services and costs made the rental activity an active rental business. The rental income therefore was not passive investment income under section 1362(d)(3)(C)(i), which matters because an S election can terminate after three consecutive years of excessive passive investment income when accumulated earnings and profits remain. The IRS did not rule on whether the corporation otherwise qualified as a small business corporation, and it noted that section 469 could still treat the rental activity as passive.

Ruling snapshot

• Question: Was the rent earned from the described properties excluded from passive investment income because the corporation provided significant services or incurred substantial rental-business costs?
• Outcome: approved
• Key authorities: IRC §§ 1361(a)(1), 1362(d)(2), 1362(d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201738011                                              Third Party Communication: None
Release Date: 9/22/2017                                        Date of Communication: Not Applicable
Index Number: 1362.02-00, 1362.02-03
                                                               Person To Contact:
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--------------------------------                               Telephone Number:
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-----------------------------------------------------          Refer Reply To:
                                                               CC:PSI:B03
                                                               PLR-139703-16
                                                               Date: June 21, 2017




Legend

X                 =        ------------------------------------------------------------------------------------------
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State             =        --------------

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

LLCs              =         --------------------------------------------------------------------
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Properties        =         ------------------------------
                           --------------------
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Year            =          -------

M1              =          -----------------

M2               =         --------------

N               =          ---------

P               =          ---------


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

       This letter responds to a letter dated December 21, 2016, submitted by X's
authorized representative on behalf of X, requesting a ruling that rental income that X
and its limited liability companies (LLCs) received from certain real estate is not passive
investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue
Code (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
has accumulated earnings and profits. X owns interests in LLCs treated as
disregarded entities or partnerships for U.S. federal income tax purposes. X and the
LLCs own, lease and manage certain real estate properties (Properties).

       X and the LLCs, through their officers, employees and independent contractors,
have provided and continue to provide certain services with respect to the leasing of
some of the Properties. These services include making repairs to structural
components of properties, including rooftops, floors, walls plumbing, parking lots, air
conditioning and heating. These services also include maintaining common areas of

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properties, janitorial services, landscaping and grass cutting, snow and ice removal from
sidewalks and parking lots, pest control, window washing, periodic inspection of
properties, maintaining exercise facilities, handing and installing fixtures within
residential units, maintaining plumbing and lighting in residential units, screening visitors
for residential tenants, delivering packages to residential tenants, negotiating renewal of
leases, establishing parameters of acceptable tenants and conditions of the leases,
reviewing financial information of prospective tenants, creating the form lease with
respect to certain properties and effecting any modifications necessary for execution of
certain leases, managing procurement of insurance and handling of claims, and making
all decisions related to property tax appeals.

       For the Properties for which it provided services in the Year taxable year, X
collected itself and received through the LLCs approximately $M1 in gross rents and
paid or incurred approximately $M2 in relevant operating expenses excluding
depreciation and interest.

       Approximately N% of the total gross rents from the Properties were attributable to
net leases. With the exclusion of self-developed Properties, the remaining net leases
constituted approximately P% of the gross rents.

      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)(1) defines "rents" as amounts received for the use
of, or 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

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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(c)(5)(ii)(B)(4) provides that "rents" does not include
compensation, however, designated, for the use of, or right to use, any real or tangible
personal property developed, manufactured, or produced by the taxpayer, if during the
taxable year the taxpayer is engaged in substantial development, manufacturing, or
production of real or tangible personal property of the same type.

      Based solely on the information submitted and the representations made, we
conclude that the rental income that X receives itself and through its LLCs from
Properties described above is not passive investment income under § 1362(d)(3)(C)(i).

        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.

       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.

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       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