Rental income not PII.

• Author: White, George L.
• Position: Passive investment income; S corporations

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...