S Corp Rental

Originally published on Passive Activities and Other Oxymorons on January 28th, 2011.
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Private Letter Ruling 201050002

There must have been a time when it was a good idea to have real estate in a C corporation.  It was well before my time, though and that is starting to be a while ago.  My career commenced in the waning days of the Internal Revenue Code of 1954.  Even then, before they had assassinated that indomitable old soldier General Utilities, it was not a good idea. It still happens though and they are still around here and there.  One way to deal with the problem is an S election.  Then you just have to wait ten years, although maybe it will be seven or five, if you are lucky.

The only problem is that an S corporation cannot have "passive income" greater than 25% of its gross receipts if it has accumulated earnings and profits.  If it does it is subject to an entity level tax and if the condition continues for three years it is bounced out of S status.  One solution to the problem, which I discussed in an earlier post is to purge earnings and profits.  Then there is the more risky, but also more entertaining, "DUH" approach outlined in PLR 201042010.  Purging earnings and profits can be expensive though, PLR 201050002 points to another possibility.

Included in "passive income" for purposes of the S corporation excise (Section 1375) is rent.  Rent is also considered a per se passive activity under the passive activity loss rules of  Section 469. Interest and dividends on the other hand are explicitly passive income under 1375 and explicitly not passive income under 469.  I could explain why this "makes sense", but I prefer, in this case, to stick with my "It is what it is. Deal with it." philosophy.

It turns out however that there is rent and there is rent. I have little doubt that the operation outlined in this PLR would be a rental activity for 469 purposes, but it is not considered passive income under Section 1375.  Here are the facts :

Company was incorporated under the laws of State on Date 1, and elected under § 1362(a) to be an S corporation effective Date 2. Company owns, leases, and manages commercial rental real estate. In addition, Company owns an interest in Entities all of whom own, rent, and operate commercial office and industrial buildings and apartment and multi-family residential buildings. Company is actively involved in the management of each of the Entities. None of the Entities have hired employees or other management companies to handle the day-to-day business of operating the properties owned by them.

With respect to the wholly-owned properties, Company is actively involved in performing all of the leasing and administrative functions for maintaining the properties, including repair and maintenance services. Company has A employees and multiple independent contractors involved in the day-to-day activities associated with its commercial real estate.

With respect to each of the properties owned by the Entities, Company performs varying services. For example, Company may be responsible for management, financing, tenant negotiations, cash flow decision making, remodeling decisions, lease approval and negotiations, major development approval, mortgage and sale negotiations, advertising, repairs and maintenance, capital improvements, services for snowplowing, lawn care, trash removal, overseeing construction, and bookkeeping.

For the tax year ending in Year, Company collected approximately $B in gross rents and paid or incurred approximately $C in relevant operating expenses (other than depreciation).

The ruling goes on to explain the relevant regulation.

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 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).

The problem with applying this strategy is that there is no bright line test.  If it fits your facts you may really have no alternative to getting a ruling if you want peace of mind.