Rentals Not Treated as Passive Investment Income for S Corporation Purposes

Rentals Not Treated as Passive Investment Income for S Corporation Purposes

In PLR 201725022, a corporation received rental income from its leasing of offices for medical and related services.  The taxpayer intended the rental income from its maintenance-related operations as non-passive investment income under section 1362(d)(3)(c)(i).

 

X was incorporated as a C corporation. X had accumulated earnings and profits. X intended to elect to be an S corporation. X was in the business of acquiring, developing, leasing and managing commercial real estate, concentrating in medical office suites and clinics.

 

X owned a parcel of land situated on two contiguous lots. X acquired this parcel of land and at the time of acquisition, it was partially developed as a plaza containing various buildings and commercial office space. X later constructed another building and a separate two-story building. All the property was converted into medical suites.

 

All of the suite space comprising was leased for use as medical offices and/or related services.

 

X contracted with an independent leasing agent to assist in soliciting prospective tenants, 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, drafted and negotiated letters of intent to lease available suite spaces. Once letters of intent were accepted, X, with the assistance of the independent leasing agent, prepared lease agreements and renewals with prospective tenants.

 

X, through its employees, its agents, and the agents’ employees, provided services in maintaining and repairing of the buildings, common areas, and grounds. X utilized a standard lease agreement for its tenants, and under the lease agreement X had the obligation to provide certain services with respect to the leasing of space and to maintain or repair 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, X provided services to its tenants by daily walk-through inspections to report on water breaks, lighting outage, vandalism, damage to building exteriors and certain interior spaces; sweeping, cleaning and maintaining the common areas 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.

Issue Before the IRS

The IRS had to decide if the rental income was active or passive. Additionally, if the income was passive could the corporation elect S status.

As S election is terminated whenever the corporation (1) has accumulated earnings and profits at the close of each of three consecutive taxable years, and (2) has gross receipts for each of such taxable years more than 25 percent of which are passive investment income.

Section 1362 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 1.1362-2(c)(5)(iii)B)(i) of the Income Tax Regulations provides that “rents” means amounts received for the use of, or the right to use, property (whether real or personal) of the corporation.

Section 1.1362-2(c)(5)(ii)(B)(2) 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 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).

The Bottom Line

The IRS concluded that the rental income X receives from its operations described above was not passive investment income under section 1362(d)(3)(C)(i).

Similarly Temp. Reg. § 1.469-1T(e)(3)(ii)(C) provides that if a taxpayer provides “extraordinary personal services … in connection with making such property available for use by customers,” then the activity is not treated as rental property.  The term “extraordinary personal services” includes those services that “are provided in connection with making property available for use by customers … [where] the use by customers of the property is incidental to their receipt of such services, Temp. Reg. § 1.469-1T(e)(3)(v).  Unfortunately, this Regulation does not contain an example that is directly on point.  However, in a Tax Court case, Arsaf F. Al Assaf, 89 TCM 694, T.C. Memo. 2005-14, the court agreed with the taxpayer that the personal services provided were extraordinary.  As result the activity was not considered rental.  In that fact pattern, a limited liability company (LLC) owned an office building and provided substantial support services to its tenants who leased the space to obtain the services.  Thus, the court concluded that the lessees’ payments to the LLC were principally for the services, not for the leased space. After avoiding classification as a rental activity, the activity was found to be not passive because the taxpayer’s participation exceeded 500 hours per year.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Frank Brunetti, at 201-806-3364.

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Frank Brunetti has been practicing law for over thirty years in the areas of estate and wealth preservation, tax planning for business entities and complex tax matters. He is admitted to the New Jersey and New York Bars as well as the United States Tax Court. Mr. Brunetti provides representation in federal and state tax matters, IRS controversies, estate and business planning and guidance for the preparation of wills and trusts as well as the administration of estates. For more information, please visit Frank Brunetti's full biography at Scarinci Hollenbeck

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