If a S corporation has any accumulated earnings and profits, its S status is at risk due to “excess passive income” if it incurs such income for three straight years under IRC §1362(d)(3). While rentals can generate such passive income, a rental does not provide such passive income if it is deemed to be derived in the active trade or business of renting property (Reg. §1.1362-2(c)(5)(ii)(B)(2)). In PLR 201725022, the taxpayer asked the IRS to find that the rental income being received by a C corporation would not be treated as “passive income” if the corporation elected S status.
The corporation provided the rental involved significant services. The ruling notes:
M is composed of a parcel of land situated on two contiguous lots. X acquired this parcel of land in Year1. At the time of acquisition, M was partially developed as a plaza containing N2 single-story buildings in a cottage complex along with a single two-story building, with a combined commercial office space of approximately N3 square feet. X later constructed another building to the cottage complex and a separate two-story building in M. With the addition of these two buildings, M had a combined commercial office space of approximately N4 square feet. In Year3, X finished construction of a new N5 square foot, tri-level building within M. All of the suite space comprising M is currently leased for use as medical offices and/or related services.
X contracts with an independent leasing agent to assist in soliciting prospective tenants for M, negotiating leases and renewals, and overseeing post-leasing activities such as build-outs and renovations of suite space. X, with the assistance of the independent leasing agent, drafts, proposes, presents, and negotiates letters of intent to lease available suite spaces. Negotiation for leasing regularly requires the use of an independent space planner to design and tailor the spaces for prospective tenants. Once letters of intent are accepted, X, with the assistance of the independent leasing agent, prepares, finalizes, and executes the lease agreements with prospective tenants. Renewals of leases are similarly handled by X, which are often complicated by requests for concessions and renegotiation of the leasing rate. Renewals often require significant time and attention by X.
X, through its employees, its agents, and the agents’ employees, provides certain services in maintaining and repairing of the buildings, common areas, and grounds of M. X utilizes a standard lease agreement for its tenants, and under the lease agreements X has the obligation to provide certain services with respect to the leasing of space within M and to maintain or repair the following items: the heat and air conditioning systems, plumbing, hot water heaters, exterior lighting, signs, lawn care and gardening, roofs and exterior walls, exterior walkways, courtyards, parking areas, electricity, water and sewer, drainage, and garbage pickup.
In addition, the following specific services are provided to M and its tenants by an employee or independent contractor/worker of X: daily walk-through inspections of M to report on water breaks, lighting outage, vandalism, damage to building exteriors and certain interior spaces; sweeping, cleaning and maintaining the common areas of M such as sideways, walkways, and parking lot; routine periodic inspection of building exteriors and interiors, including foundations, roofs, exterior lighting, grounds, and parking lot and engaging in maintenance and repairs as needed; treating the roofs of the buildings for moss growth yearly; recoating and resurfacing the parking lot; routine and periodic maintenance of the numerous heating and air conditioning units; renovating vacant suites for leasing; routine and periodic maintenance of the plumbing and sewer lines, and their repair and replacement as needed; maintenance, repair and replacement of exterior lighting and selected interior lighting; janitorial services for selected units and common areas; exterior window washing; regular maintenance of grounds and lawn care, and landscaping services when necessary; seasonal snow removal and ice control; weekly trash removal; periodic pest and vermin control; and emergency response and property access for public safety.
The IRS notes that, under Reg. §1.1362-2(c)(5)(ii)(B)(2), a rental would need to meet the following criteria to be deemed part of a trade or business of renting real estate:
Rents received by a corporation are derived in the active trade or business of renting property only if, based on all of 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 of 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).
In this case the IRS ruled that the corporation’s services and costs incurred were significant enough to treat the rental as derived in the active trade or business of leasing. Thus, the rental would not generate the S corporation §1362 style of “passive income.”
One important item to note is that, even though the word “passive” is used in IRC §1362(d)(3), that definition is not the same as the one found at IRC §469 and the corporation was not asking for a finding that any income or loss would not be required to be treated as passive under §469 by any of the shareholders. This is one of many unfortunate cases where Congress uses the same word to have different and, at times contradictory, meanings in different provisions of the law.