S-corporations – Time to Roll In your Rental-Income Benjamins

In Private Letter Ruling 201725022 (the “PLR”), the IRS determined that rental income an S-corporation received from its operations is not passive investment income that would subject the S-corporation to termination. 

In the PLR, the taxpayer was an S-corporation active in the business of acquiring, developing, leasing and managing commercial real estate, primarily medical office suites and clinics.  The taxpayer received rental income in connection with such operations. 

An S-corporation with accumulated earnings and profits will be subject to the highest level of corporate tax if more than 25% of its annual gross receipts are derived from passive investment income.  If such threshold is exceeded for 3 consecutive years, the S-election will be automatically terminated.  Internal Revenue Code § 1362(d)(3).  Rental income is generally included as passive investment income.

With respect to this passive investment income limitation, “rents” means amounts received for the use of, or the right to use, property (whether real or personal) of the corporation but does not include rents derived in the active trade or business of renting property.  Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(1)-(2).  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 – which are not generally incurred in connection with net leases. 

In determining whether the S-corporation taxpayer’s rental income was passive investment income, the IRS considered all facts and circumstances and analyzed the services provided by the taxpayer with respect to the property and its tenants, the frequency of such services, and who assisted the taxpayer with the services and in what capacity.    The IRS identified services provided by the taxpayer in connection with soliciting tenants, negotiations of leases for initial terms and renewals, and services related to space design such as renovations or build-outs.  The taxpayer provided such services with the assistance of an independent leasing agent and an independent space planner.  The IRS also identified services provided by the taxpayer to the building and the tenants under the terms of the taxpayer’s standard lease agreements with tenants, including the obligation to maintain or repair interior and exterior items for each tenant’s respective space as well as common areas.  Such services were provided by the taxpayer through its employees, agents, and agents’ employees. 

In addition, the IRS noted specific services provided by the taxpayer to the building and the tenants such as, for example, daily walk-through inspections to report new issues in real-time, routine inspection, cleaning, maintaining, and repairing as needed of common areas, building interiors and exteriors, plumbing and sewer lines, and lighting, weekly trash removal, seasonal snow removal and ice control, regular maintenance of grounds and lawn care, periodic pest control, and annual roof treatments.  These services were provided by the taxpayer through an employee or independent contractor or worker of the taxpayer pursuant to specific requests for service and in connection with routine inspection and upkeep.

Based on all of the facts and circumstances, the S-corporation taxpayer provided significant services in conducting an active business of renting property.  The IRS identified these significant services as part of its ruling that the rental income received by the S-corporation taxpayer was not passive investment income.

The PLR highlights an important issue for S-corporations in the business of acquiring, developing, leasing and managing real estate – providing significant services in the rental business.  S-corporations should be aware of the facts of this ruling to prevent passive investment income tax and/or termination.  The termination of a corporation’s S-election causes that corporation to immediately become a C-corporation and the corporation or successor corporation cannot re-elect S-corporation status for 5 years.

This blog was written by Kendra H. Merchant at Miles & Stockbridge.

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