An S corporation's rental income from actively managed real estate is not passive investment income

Plain-English summary

An S corporation that carries over accumulated earnings and profits from a
prior C corporation life can lose its S status (and owe a special tax) if more
than 25% of its gross receipts are "passive investment income," which
normally includes rents, for three straight years. Here, an S corporation
sold its operating business but kept several properties and leased them back
to the buyer under leases charging a fixed amount plus a percentage of
receipts. The company asked the IRS to confirm this rental income is not
passive investment income. Under the regulations, rents earned in an active
trade or business of renting property (where the corporation provides
significant services or incurs substantial costs) do not count as passive.
Given the active involvement, a management company handling tenants,
renovations, permits, leasing, rent collection, and maintenance, plus
hands-on, experienced shareholders, the IRS ruled the rental income is not
passive investment income under § 1362(d)(3)(C)(i). The IRS cautioned that
this passive investment income analysis is separate from the passive
activity loss rules of § 469, under which the rentals may still be passive.

Ruling snapshot

• Question: Is rental income from an S corporation's actively managed
  leased properties "passive investment income" that could jeopardize its S
  election?
• Outcome: Approved (ruled not passive investment income)
• Key authorities: IRC § 1362(d)(3); IRC § 1375; 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: 202614002                                              Third Party Communication: None
 Release Date: 4/3/2026                                         Date of Communication: Not Applicable
 Index Number: 1362.00-00, 1362.02-00,
               1362.02-03                                       Person To Contact:
                                                                ----------------------------, ID No. --------------
 -----------------------------                                  -----------------
 -----------------------------------------                      Telephone Number:
 -------------------------                                      ---------------------
                                                                Refer Reply To:
                                                                CC:PT&E:B01
                                                                PLR-104810-22
                                                                Date:
                                                                December 22, 2025

LEGEND

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

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

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

 Year 1                =            --------

 Year 2                =            -------

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

 n                     =            ---

 Properties            =            --------------------------------

 $a                    =            ----------------

 $b                    =            ---------------

                                    ------------
 $c                    =
                                    ---------------------------------------------
 Business              =
                                    ----------

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

      This responds to a letter dated December 30, 2021, and subsequent
correspondence, submitted on behalf of X by X’s authorized representatives, requesting
PLR-104810-22                                2

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

                                          FACTS

      X was incorporated under the laws of State on Date 1 and elected under § 1362(a)
to be an S corporation effective Date 2. X has had approximately $a in accumulated
earnings and profits since Date 2.

      Until Year 1, X owned and operated Properties, which were used in Business. In
Year 1, X sold Business to a buyer. X retained ownership of certain Properties and leased
those Properties to the buyer.

      The current leases provide for the payment of rent equal to a fixed amount plus a
percentage of X’s gross receipts over a certain threshold from the operation of each
property. During Year 2, X collected approximately $b in gross rents and paid or incurred
approximately $c in related operating expenses, including management fees, legal and
professional fees, repairs and maintenance, utilities, and mortgage interest.

       X entered into an agreement with a management company, which provides the
following services: communicating with tenants regarding any remodeling and
renovations to Properties; approving or disapproving renovations; supervising the
renovation process; participating in any applications for building permits, zoning variances
and similar requirements; identifying new tenants; negotiating and executing leases,
renewals and other agreements with tenants; collecting rents and other amounts due from
tenants; enforcing tenants’ obligations under the leases; inspecting the structural and
exterior portions of Properties; arranging for maintenance of Properties, including lawn
and landscaping maintenance, snow removal services and repairs. Two of the
management company’s employees are assigned to work on X matters.

       The shareholders of X have extensive experience in building, developing,
operating, and owning real estate. The shareholders of X communicate daily with the
management company to discuss income, expenses, tenant issues, renovations, and
other business issues. The shareholders monitor the operations of Business to ensure
that Business is operating profitably. The shareholders also communicate regularly with
the management company and the managers of Business to discuss the operations of
Business. Additionally, the shareholders regularly search for new properties to acquire
and develop.

                                  LAW AND ANALYSIS

      Section 1361(a)(1) defines an “S corporation” as a small business corporation for
which an election under § 1362(a) is in effect for the taxable year.
PLR-104810-22                                 3

        Section 1362(d)(3)(A)(i) provides that an S corporation election shall be terminated
whenever the corporation (I) has accumulated earnings and profits at the close of each
of 3 consecutive taxable years, and (II) has gross receipts for each of such taxable years
more than 25 percent of which are passive investment income. The termination is
effective on and after the first date of the first taxable year beginning after the third
consecutive taxable year referred to in § 1362(d)(3)(A)(i). Section 1362(d)(3)(A)(ii).

       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 1375(a) imposes a tax on the income of an S corporation if the S
corporation has (1) accumulated earnings and profits at the close of such taxable year,
and (2) gross receipts more than 25 percent of which are passive investment income.

        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 the term “rents” does not include
rents derived in the active trade or business of renting property. Rents 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).

                                      CONCLUSION

      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).

         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 the appropriate party. While this office has not verified any of the material submitted in
PLR-104810-22                                           4

support of the ruling request, it is subject to verification on examination.

      This ruling is directed only to the taxpayer who requested it. According to
§ 6110(k)(3), this ruling may not be used or cited as precedent.

        Pursuant to the power of attorney on file with this office, we are sending a copy of
this letter to your authorized representatives.

                                                  Sincerely,


                                                  _____________________________
                                                  Joy C. Spies
                                                  Senior Technician Reviewer, Branch 1
                                                  Office of the Associate Chief Counsel
                                                  (Passthroughs, Trusts, and Estates)



Enclosure
      Copy for § 6110 purposes

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