S Corporation Rental Income Not Passive Except When It Is

Originally Published on forbes.com on July 31st,2011

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Private Letter Ruling 201118011

A C corporation is a taxable entity.  Distributions that it makes to its shareholders are also, generally, taxable to them.  People who don’t want to pay tax twice on the same income will make an S election.  The shareholders are taxed on whatever the earnings are regardless of distributions.  Distributions of those earnings will generally not be taxable.  It’s pretty easy if the corporation made the election effective day one of its existence.  Former C corporations have other problems.  If too much (more than 25%) of its income is “passive” the corporation pays a tax on that income.  If that continues for three years, it loses its S election.

Included in passive income is “rents”, but not all rents.  If the corporation is doing enough to manage the property then the rent is not passive.  The corporation in this ruling was doing enough:

X employs b full-time employees who directly perform services relating to the Properties. X also contracts with independent contractors to provide various services. X, through its employees or through the independent contractors, provides certain services with respect to the Properties, including: property inspection, common area maintenance and repair, including carpeting and painting; janitorial and cleaning services; maintenance and repair of building structural components, including roofs and facades; upkeep and repair of building systems (heating, air conditioning, plumbing, water and sewer, electrical and lighting); parking lot maintenance; landscape maintenance; snow removal; trash collection; pest control; providing security personnel; and the approval and supervision of capital improvements. X, Sub 1, Sub 2, and LLC or independent contractors also perform leasing and administrative functions, including: purchasing and developing new properties; negotiating and drafting individual leases; showing properties to prospective tenants; andhiring and supervising personnel assigned to perform theproperty management functions.

So the rental income of an S corporation that actively manages the real estate is not passive ? That is what the ruling says, but be sure not to make that statement in isolation.  It is valid for the S corporation sting tax and not losing an S election because of “passive” income.  There is also Code Section 469, the passive actvity loss rules. Those rules require us to put our trade or business activities into different buckets.  Losses from an activity in the passive bucket are suspended unless there is income from other activities in the same bucket (Losses are released when an activity is entirely disposed.)  Under those rules rental activities are “per se” passive.  There are, of course, exceptions to that rule involving items rented for very short periods or where the rental includes a lot of additional service, but that is not what is going on in this situation.  So the activity will still be “passive” for purposes of the passive activity loss rules.