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Rental income not PII.

The IRS has been consistent in issuing letter rulings favorable to S corporations in determining the character of rental income as active trade or business income and not passive investment income (PII). If an S corporation has C corporation earnings and profits, PII must be closely monitored. When PII exceeds 25% of gross receipts in any year, a corporate-level tax at the highest rate is imposed on the excess net PII, thereby subjecting such income to two levels of tax. If such status continues for three consecutive years, the S election is terminated.

The most recent favorable ruling is Letter Ruling 9937037, which addresses the income of qualified subchapter S subsidiaries (QSubs) engaged in the business of renting various types of personal property. Historically, the company and several wholly owned subsidiaries comprised a consolidated-return group for Federal income tax purposes. When the company elected S status under Sec. 1362(b), it also elected to treat the wholly owned subsidiaries as QSubs. The subsidiaries engaged in the active rental of personal property.

Regs. Sec. 1.1362-2(c)(5)(ii)(B)(2) provides that "rent" does not include rents derived in the active trade or business of renting property only if, based on all the facts and circumstances, a 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. Letter Rulings 9536007 and 9536008 addressed rental income allocated to S corporations with significant services and expenses incurred by trustees being provided by a subsidiary, which did not classify the rental income as PII for the passthrough entity.

A number of remedies available in the planning stage allow corporations to structure leases so as to provide significant services and incur substantial costs. The requirement that the receipts from passive sources be reduced to below 25% must be met every year to avoid corporate-level tax. There is always the option to distribute accumulated earnings and profits from subchapter C years as taxable dividends to shareholders.

Because inadvertent terminations can cause adverse tax consequences, the Service has been reasonable in allowing adjustments that retain S status. Rev. Proc. 98-55 provides guidance on termination relief. When the facts and circumstances fail to meet the requirements of Sec. 1362(d) (3), it is up to the IRS to determine the status of the corporation after the terminating event. The committee reports accompanying Sec. 1362(f) explain the correction process. Appropriate adjustments should be consistent with the treatment of the corporation as an S corporation. The issue of "rents" being classified as active trade or business income or PII indeed depends on the facts, but it does not appear that this relief is available when the facts do not support nonpassive status. Reclassifying an ineligible shareholder after the fact seems an easier adjustment.

Because the Small Business Job Protection Act of 1996 allowed for more parent-subsidiary relationships, advisers should review the annual 25% gross receipts test and apply the facts and circumstances of passthrough entities to determine the character of income derived from rents. Failing the test for three years will trigger S election termination at the beginning of the following year.

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Article Details
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Title Annotation:passive investment income; S corporations
Author:White, George L.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Dec 1, 1999
Previous Article:Late election relief under Rev. Procs. 97-48 and 98-55.
Next Article:Final SRLY Regs.: effective date provision bears watching.

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