Thursday, May 2, 2024
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GiftLaw Note: Company (X), an S corporation, owns several commercial and rental real estate properties that are leased to tenants. Through its agent, X provides certain services in connection with leasing the properties which include maintaining and repairing the buildings, common areas and grounds, cleaning, painting, electrical, plumbing, roof and structural maintenance, garbage and recycling, landscaping and extermination services. In Year 1, X collected $a in gross rents and incurred $b in relevant operating expenses. X requested that the Service classify the $a income received as active rather than passive investment income in order to avoid the Sec. 1375(a) tax on S corporations with excess passive income.

The Service concluded that X's $a rental income is not passive investment income and the Sec. 1375(a) tax does not apply. "Rents" are included in the Sec. 1362(d)(3)(C)(i) definition of passive investment income. Sec. 1.1362-2(C)(5)(ii)(B)(1)-(2) further defines rent as amounts received for the use of, or right to use, property. However, rents derived from the active trade or business of renting property, such as a corporation providing significant services or incurring substantial costs in the rental business are not passive investment income. In maintaining, repairing, cleaning, recycling, etc., X provided significant services with respect to the property management and therefore rents received are not passive investment income.

Editor's Note: Although X desired to avoid classifying the rental income as passive, in a charitable context, passive income classification is preferred in order to avoid unrelated business income tax (UBIT). While a charity may hold stock in a Subchapter S corporation, if the corporation is an active trade or business, all income will be UBIT and taxable for the charity.
Dear * * *:

This letter is in response to your letter, on behalf of X, dated October 16, 2007, seeking a written determination that rental income received from residential and commercial properties is not passive investment income under § 1362(d)(3)(C)(i) of the Internal Revenue Code.

FACTS


The information submitted states that X was incorporated on Date 1 in accordance with the laws of State. X intends to elect to be an S corporation effective Date 2. On Date 2, X expects to have accumulated earnings and profits from prior years.

X owns Property 1, Property 2, Property 3, Property 4, Property 5, Property 6, Property 7, Property 8, and Property 9 (collectively, "the Properties"), commercial and rental real estate properties that are leased to tenants. X, through its agent and the agent's employees, provides certain services with respect to the leasing of the Properties. These services involve maintaining and repairing the buildings, common areas and grounds of the Properties, including cleaning, painting, electrical, plumbing, roof and structural maintenance, garbage and recycling, landscaping services, and extermination services.

In Year, X collected approximately $A in gross rents and incurred approximately $B in relevant operating expenses.

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.

Section 1362(d)(3)(A)(i) provides that an S corporation election shall be terminated whenever the corporation (I) has accumulated earning 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 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 "rent" 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 types and amounts of costs and expenses incurred (other than depreciation).

CONCLUSION


Based solely on the facts and representations submitted, we conclude that the rental income that X derives from the Properties is not passive investment income as described in § 1362(d)(3)(C)(i).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter. Specifically, no opinion is expressed concerning whether X is a small business corporation eligible to make an S corporation election. 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.

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 will be sent to the taxpayer's representative.

Sincerely,

Audrey W. Ellis
Senior Counsel, Branch 1
(Passthroughs & Special Industries)

Related Topics On No Passive Rental Income for S Corporation

4.14.1  Sub S Taxation:    The most common type of corporation is a traditional "C corporation." All companies whose stock is publicly traded are C corporations. C corporations pay tax on their net income at the corporate level and then when that income is distributed to shareholders in the form of dividends, the shareholders also pay tax. The result is that C corporation income is taxed twice - once at the corporate level and once at the shareholder level.



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