Rental real estate and sec. 1375.

Because Sec. 1375 imposes a corporate tax on excess "passive investment income" generated by an S corporation that retains subchapter C earnings and profits, many taxpayers have avoided putting rental real estate into an S corporation. According to the regulations, excess passive investment income includes (with some special exceptions) gross receipts from royalties, rents, dividends, interest, annuities and gains from the sale or exchange of stock and securities. For the purposes of this definition, however, Regs. Sec. 1.1362-2(c)(5)(ii)(B) carved out an exception for rents derived in the active trade or business of renting property if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Unfortunately, the IRS has not given any guidelines to taxpayers as to what constitutes "significant services" or substantial costs."

For insight into the Service's attitude on this point, letter rulings are currently taxpayers' only resource. Surprisingly, the IRS has adopted fairly liberal definitions of the terms "significant services" and "substantial costs." Significant services A starting point is that the lessor provides the basic services required to maintain the property in a condition for occupancy. Examples of services in this category would be janitorial services, cleaning, snow removal, garbage collection, grounds maintenance and minor to moderate repairs. However, the rendering of significant services is a threshold somewhere beyond this performance of basic services. Letter Rulings 9411015 and 9404010 are noteworthy in that the "extra" services the corporations provided were modest, such as coordination and supervision of capital improvements, mediation of tenant disputes, and regular safety, zoning and signage inspections. Nevertheless, the corporations still received nonpassive status for their rents.

Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2) states that the number of persons employed to provide services is one factor in determining whether a corporation performs significant services. In Letter Ruling 9341010, the Service emphasized that the taxpayer performed every aspect of the operational and managerial functions associated with these properties directly without the use of independent contractors. However, in several subsequent rulings (including Letter Rulings 9422049, 9421007 and 9404010), the taxpayer received nonpassive status despite the use of subcontractors (although their duties were limited to daily maintenance and management of routine transactions, such as the collection of rents, marketing of vacant space and coordination of repairs with other contractors). In all instances, the taxpayer maintained control over the management. In addition, all arrangements made by subcontractors were subject to approval by the taxpayer. Also, the taxpayers handled all disbursements related to the properties directly. In fact, in no instance were subcontractors given financial authority beyond collecting rent.

Substantial costs

The only detail Regs. Sec. 1.1362-2(c)(5)(B) gives as to substantial costs is that it is based on facts and circumstances, including the types and amounts of cost and expenses incurred other than depreciation. In addition, generally, substantial costs are not incurred in connection with net leases. However, in Letter Ruling 9404016, the Service held that rents from a net lease of personal property were not deemed "passive investment income." The IRS determined that the taxpayer's large employee compensation and office rental expenses amounted to substantial costs even though the rental was a net lease. This ruling is also important because the taxpayer did not provide significant services. Thus, the Service applied significant services and substantial costs tests separately and only required one be met.

Related parties

The fact that a taxpayer leases some of its rental space to a related tenant has not precluded taxpayers from receiving nonpassive status for its rents. For example, in Letter Ruling 9404010, the primary tenant of one of two rental properties was a related party and rents from both the related and unrelated parties were not considered to be passive income.

The IRS's liberal ruling policy on the exclusion of rents in the computation of excess passive investment income may allow some corporations to restructure their rental real estate activities to avoid passive classification and thereby make an S election practicable.