PLR 9936040: Active commercial property rents excluded from passive investment income

Plain-English summary

An S corporation with accumulated earnings and profits rented commercial properties that it developed and managed. Its employees and contractors maintained the properties, marketed space, adapted space for tenants, and provided other services. The IRS ruled that the rents were not passive investment income under section 1362 because the company operated an active rental business with significant services and costs. This matters because too much passive investment income over three consecutive years can terminate an S election when the corporation has accumulated earnings and profits. The IRS did not decide whether the company otherwise qualified as an S corporation, and it said the rental activity could still be passive under the separate section 469 rules.

Ruling snapshot

• Question: Are the company's commercial property rents passive investment income for the S corporation termination rule?
• Outcome: Approved: the rents are not passive investment income under section 1362(d)(3)(C)(i).
• Key authorities: IRC §§ 1361, 1362(d)(3), 469; Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(2)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Index Number: 1362.02-03
Washington, DC 20224

Number: 199936040
Person to Contact:
Release Date: 9/10/1999
Telephone Number:

Refer Reply To:
PLR-103890-99 CC:DOM:P&SI:3
Date:
June 15, 1999

LEGEND

Company =

d1
=

d2
=

d3
=

X
=

Y
=

Z
=

Properties =

Redmond, Washington

PLR-103890-99
2

Dear
:

This letter responds to a letter dated February 8, 1999, and subsequent correspondence submitted by your authorized representative on behalf of Company, requesting a ruling that Company’s income from certain properties is not passive investment income within the meaning of § 1362(d)(3)(C)(i) of the Internal Revenue Code.

FACTS

According to the information submitted, Company, which has accumulated earnings and profits, was incorporated in d1, and elected under § 1362 to be taxed as an S corporation effective d2. Company is primarily engaged in the business of developing and managing the Properties, which are commercial rental real estate. Through its employees and through independent contractors, Company provides a variety of services to the Properties. Company is responsible for the maintenance and repair of the interior and exterior of the Properties, which in addition to the actual structures, includes the parking lots, streetlights, and landscaping. Additionally, Company actively advertises and markets available space, modifies space to fit tenants' needs, reviews tenants' insurance policies, and employs approximately X full time employees to provide other needed services to the Properties.

In the fiscal year ending d3, Company received or accrued approximately Y in rents and paid or incurred Z in relevant expenses. Company represents that it anticipates future figures to be consistent with the income and expense figures for prior periods.

LAW

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.

Section 1362(d)(2)(A) provides than an election under § 1362(a) shall be terminated whenever (at any time after the first day of the first taxable year for which 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.

PLR-103890-99
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Section 1.1362-2(c)(5)(ii)(B)(2) of the Income Tax Regulations 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).

After applying the relevant law to the facts submitted and the representations made, we conclude that the rents Company receives from the Properties are not passive investment income under § 1362(d)(3)(C)(i).

Except for the specific ruling above, no opinion is expressed or implied concerning the federal tax consequences of the facts of this case under any other provision of the Code. Specifically, no opinion is expressed regarding Company's eligibility under § 1361 to be an S corporation. Further, the passive investment income rules of § 1362 are completely independent of the passive activity rules of § 469; unless an exception under § 469 applies, the rental activity remains passive for purposes of § 469.

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

PLR-103890-99
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This ruling is directed only to the taxpayer who requested it. According to § 6110(k)(3) of the Code, this ruling may not be used or cited as precedent.

Sincerely yours,

William P. O'Shea
Chief, Branch 3
Office of the Assistant Chief
Counsel
(Passthroughs and Special
Industries)

Enclosures (2):

Copy of this letter
Copy for § 6110 purposes