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Thursday, April 25, 2024
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GiftLaw Pro |
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GiftLaw Note:
X is a Subchapter S corporation. X has 100% ownership interest in three rental properties. X provides various services to the tenants of each property including site inspections, assisting tenants with the sub-leasing of units, maintenance and repairs relating to tenant space improvements and janitorial services. Additionally, X handles the leasing and administrative functions involved with each property including collecting rents and negotiating leases. Sec. 1362(d)(3)(A) provides that an S corporation election shall be terminated whenever the corporation has accumulated earnings and profits at the close of three consecutive taxable years, and has gross receipts for each of those three years of which more than 25% are passive investment income. Sec. 1362(d)(3)(C)(i) defines passive investment income as gross receipts derived from royalties, rents, dividends, interest, annuities and sales or exchanges of stock or securities. Under Reg. 1.1362-2(c)(5)(ii)(B)(2), "rents" does not include rents derived in the active trade or business of renting property. An active trade or business of renting property exists if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. The Service ruled that because X provided a substantial amount of services to the tenants it was in the active business of renting property. Thus, the rental income derived from the property is not passive income as described in Sec. 1362(d)(3)(C)(i).
Editor's Note: It is common for an S corporation to make a direct gift of property to charity or a CRT. When this occurs, it is important to consider whether the gifted property is used in an active trade or business. If it is, both the income from that property and any gain or loss from the sale of that property is subject to unrelated business income (UBI) tax. While the presence of UBI to a public charity is not fatal, a CRT with UBI loses its tax exempt status.
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Dear * * *
This responds to a letter dated January 30, 2006, submitted on behalf of X by X's authorized representative, requesting a ruling that X's rental income from Property 1, Property 2 and Property 3 is not passive investment income within the meaning of § 1362(d)(3)(C)(i).
The information submitted states that X was incorporated in State on Date 1. Effective Date 2, X elected to be treated as an S corporation. X has subchapter C earnings and profits.
X owns a qualified subchapter S subsidiary, QSub, as well as an 100% ownership interest in two limited liability companies, LLC1 and LLC2. LLC1 and LLC2 are each treated as disregarded entities for federal income tax purposes. QSub owns Property 1, LLC1 owns Property 2, and LLC2 owns Property 3.
The information submitted represents that X, either directly or through its independent contractors, provides various services to the tenants of Property 1, Property 2 and Property 3. Services provided by X include but are not limited to the following: site inspections, assisting tenants with the sub-leasing of units, maintenance and repairs relating to tenant space improvements, elevators, roof and HVAC, plumbing, electricity and lighting, fire sprinklers and extinguishers, as well as janitorial, security, window washing, pest control, landscaping and interior design services. In addition to services provided to tenants, X, directly and through independent contractors, handles the leasing and administrative functions involved with Property 1, Property 2 and Property 3, including billing tenants and collecting rents and negotiating leases.
In the taxable year ending Date 3, X received or accrued a total of approximately $w in rents with respect to Property 1 and Property 2, and paid or incurred a total of approximately $x in relevant expenses other than depreciation and mortgage interest. In the taxable year ending Date 3, X received or accrued approximately $y in rents with respect to Property 3, and paid or incurred approximately $z in relevant expenses other than depreciation and mortgage interest.
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 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) 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).
Based solely on the facts and the representations submitted, we conclude that the rental income that X derives from Property 1, Property 2 and Property 3 is not passive investment income as described in § 1362(d)(3)(C)(i).
Except as specifically set forth above, we express no opinion as to the federal tax consequences of the transaction described above under any other provision of the Code. Specifically, we express no opinion on whether X is a small business corporation eligible to make an S election. Further, the passive investment income rules of § 1362 are completely independent of the passive activity rules of section § 469; unless an exception under § 469 applies, the rental activity remains passive for purposes of § 469.
This ruling is directed only to the taxpayer requesting 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 first and second authorized representatives.
Sincerely,
Bradford R. Poston
Senior Counsel
Branch 2 Associate Chief Counsel
(Passthroughs &Special Industries)
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