Section 1362(d)(3)(A)(i) of the Internal Revenue Code provides that an election to be taxed as an S Corporation under Section 1362(a) is terminated if 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 of more than 25% of which are passive investment income.

In this situation, an S Corporation owned rental properties. The S Corporation was concerned that its election would be terminated if its rental income was deemed passive. The S Corporation sought a ruling that the income was not passive due to the nature of the services it rendered to the tenants. Such services included:

1. Negotiating leases, renewals and other tenant agreements;
2. Marketing available units for rental;
3. Recruiting and approving new residential and commercial leases;
4. Communicating with tenants on management and operation issues;
5. Maintenance of the properties;
6. Supervising development and construction;
7. The handling of legal and accounting issues through the normal course of business.

In Private Letter Ruling (PLR) 200833003 the IRS ruled that the rental income from the properties was not passive investment income under Section 1362(d)(3)(C)(i). Such ruling cited Reg. 1.1362-2(c)(5)(ii)(B)(2), which provides that the definition of “rents” does not include rents derived in the active trade or business of renting property.

Rents received by a corporation are derived in an active trade or business of renting property only if, based on all the current facts and circumstances, the corporation provides significant service or incurs substantial costs in such rental business. The facts and circumstances will determine whether significant services are/were performed or substantial costs are incurred.

This ruling shows that the passive investment income rules of Section 1362 are independent from the passive activity rules in Section 469. Thus, the corporation’s rental activity would have remained passive for purposes of Section 469 unless there was an exception.