Realty rental S Corporations: those with excess passive investment income and C earnings and profits face a dilemma.

• Author: Lux, Michael S.

Those With Excess Passive Investment Income and C Earnings and Profits Face a Tax Dilemma

S corporations that still have subchapter C earnings and profits (CE&P) at the close of the S corporation's tax year, and gross receipts from passive investment income that are more than 25% of total gross receipts, face two tax problems. 1. A yearly tax on "excess net passive income" under Sec. 1375. 2. The risk of losing their S status when passive investment income exceeds 25% of gross receipts for three consecutive tax years.(1) A lost election (unless it is ruled by the IRS to be inadvertent under Sec. 1362(f) and Prop. Regs. Sec. 1.1362-5) will result in the inability of the corporation to reelect S status for five years without IRS permission.(2) As a practical matter, such permission is rarely granted when there is less than a 50% change in stock ownership.(3)

Passive investment income is defined under Sec. 1362(d)(3)(D), and generally includes items such as royalties, rents, dividends, interest, annuities, and gains from the sale or exchange of stock or securities. Thus, S corporations with CE&P whose only or predominate business is rental activities face a critical tax dilemma. This is particularly so for realty rental operations, as this article will explain.

New Proposed Regulations

On Apr. 16, 1992, the IRS released revised proposed regulations under Sec. 1362 dealing with the definition of "passive investment income."

These proposed regulations contain new and favorable provisions regarding the definition of passive investment interest, royalty and related income from gross receipts derived in the ordinary course of certain trades or businesses. The new proposed regulations replace portions of Prop. Regs. Sec. 1.1362-3, released in December 1988. The new proposed regulations also provide for favorable taxpayer elections including an election to have them apply to open years prior to their proposed effective date of tax years beginning after Dec. 31, 1992.

Rental Income Under

the New Proposed Regulations

Unfortunately, rental income seems not to have benefited under the new proposals.

Under new Prop. Regs. Sec. 1. 1362-3(d)(5)(ii)(B), rents are defined as "amounts received for the use of, or right to use, property (whether real or personal) of the corporation." However, "rents" do not include payments received for the use of or for the right to use property if the corporation also provides significant services to the user or occupant for the payments. Examples of payments not treated as rents include payments for the use of rooms or other quarters in hotels, boarding houses, apartment houses, tourist homes, motor courts or motels if significant services are rendered to the occupant.

Generally, significant services are considered rendered to the occupant if they are primarily for the occupant's convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. Maid service supplied by a hotel is an example of significant services rendered to the occupant; in contrast, the furnishing of heat and light, the cleaning of common areas (such as public entrances, exits, stairways and lobbies), the collection of trash, and similar activities, are not significant services rendered to the occupant. Payments for the use of entire private residences or living quarters in duplex or multiple housing units, or offices in an office building or similar property, generally are rents. Payments for the parking of automobiles ordinarily are not rents. Payments for the warehousing of goods or for the use of personal property generally are rents unless significant services are rendered in connection with the payments.

The language in this definition of rents is similar to the language used in the earlier proposed regulations and the old but still relevant Regs. Sec. 1.1372-4(b)(5) under old Sec. 1372.(4) The providing of "significant services" remains the key concept to get a rental operation out of the...