S Corporations and Rental Income
Avoiding Tax Penalties and Other Risks

By Robert S. Barnett

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OCTOBER 2006 - An S corporation can lose its tax-favored S status if it fails to carefully monitor passive rental income. This risk occurs when an S corporation has prior accumulated earnings and profits at the close of three consecutive tax years and when passive investment income exceeds 25% of gross receipts [see IRC section 1362(d)(3)(A)(i)]. The loss of S corporation status can result in adverse tax consequences. Corporate earnings would be subject to a two-tier tax along with gains from the sale of corporate assets. Gains from the sale of capital assets would be taxed at corporate tax rates. In addition, the personal holding company tax and the excess earning tax penalty might apply.

Even worse for an unsuspecting S corporation, IRC section 1375 provides for a tax on the excess net passive income, computed at the highest corporate income tax rate of 35%. To avoid the imposition of the section 1375 tax and the potential loss of S corporation status, many S corporations distribute their accumulated earnings and profits at the reduced dividend rate of 15% (through 2008). If that is not possible, a recent private letter ruling (PLR 200527013) highlights how, with proper planning, an S corporation’s rental income can escape classification as passive investment income.

Rental Income

Rent is defined as amounts received for the use of property, or for the right to use property, whether real or personal. Recent rulings have provided that rent does not always include receipts from the active conduct of a trade or business. The test is based on all of the relevant facts and circumstances. Under Treasury regulations section 1.1362-2(c)(5)(ii)(B)(2), rent will not be deemed passive for these purposes if the corporation provides significant services or incurs substantial costs in the rental business.

In PLR 200527013, the IRS described how an S corporation that owned rental farmland would avoid these tax penalties. Based on several factors, the IRS determined that the business activities amounted to the conduct of an active trade or business and, therefore, the rents would not be classified as passive investment income. These activities included participation in critical farming operations, such as crop patterning, fertilization, insect and weed control, and soil and water usage. Company personnel were significantly involved with a tenant’s farming operations, including paying many operating expenses for the property. This led the IRS to conclude that the taxpayers’ activities constituted the active conduct of a trade or business. Therefore, the rental income was not deemed to be passive investment income as defined under IRC section 1375.

The same analysis has also been applied to an S corporation that owns a rental building. In PLR 200339042, the IRS concluded that rental income from commercial buildings was not passive investment income. The company in that favorable ruling similarly performed many of the management activities with respect to the property. Services were provided by both company employees and outside contractors under the direction and supervision of company personnel. These services included: common area cleaning and maintenance; inspection and maintenance of the building foundation, roof, and electrical system; maintenance and repair of the plumbing and HVAC systems; interior and exterior lighting for the office property; interior and exterior painting; repair and maintenance of the parking lots; janitorial services; window washing; landscaping and lawn care; snow removal; trash removal; pest control; utilities for the office property; supervision and compensation of outside vendors and service providers; and emergency response and property access for public safety purposes. The company also performed customary management leasing and administrative functions and was active in the negotiation and resolution of tenant issues and complaints.

Under Treasury Regulations section 1.1362-2(c)(5)(ii)(B), the determination as to whether significant services are performed or substantial costs are incurred in a rental business is determined based upon all the facts and circumstances. These factors include, but are not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses (other than depreciation) incurred.

Section 6166

A similar issue arises with respect to obtaining IRC section 6166 benefits for an estate holding S corporation stock, because, as described below, the rental activity must be considered a trade or business. Owners of rental properties must carefully plan their estate tax liquidity. Under IRC section 6166, an executor can elect to extend payment of that portion of the estate tax attributable to a closely held business interest. If a sufficient portion of the estate consists of a closely held business, then the estate can benefit by receiving a tax deferral period and, thereafter, by paying its estate tax in 10 installments. The rules also include favorable interest provisions. Utilizing the safety net of section 6166, estates can avoid selling assets at a fire sale in order to pay the tax.

The IRC section 6166 election is made by attaching an election notice to a timely filed estate tax return. The notice must include the factors which led the executor to conclude that the estate qualifies for relief, and specify that the property interests represent active trade or business interests. Section 6166 also contains certain statutory requirements beyond the scope of this article.

PLR 200340012

PLR 200340012 presents a good analysis of these issues and factors. According to this ruling, the level of activity is what distinguishes a trade or business under IRC section 6166. Merely managing rental properties and collecting rental income on a net lease basis is not enough activity for a rental property to distinguish itself under section 6166. When determining a decedent’s level of activity, an analysis similar to that discussed above for S corporations is undertaken. The activities of agents and employees are taken into account; however, the activities of third parties, such as independent contractors or lessees, that are neither agents nor employees of the decedent or of a partnership are not taken into account. To receive the benefits provided in IRC section 6166, it is important to properly structure leasing activities.

In PLR 200340012, the IRS looked at the level of business activity. Although the decedent’s activities included those normally associated with merely managing investment assets (such as collecting rents, paying taxes, and making mortgage payments), the decedent also actively participated in the management and operation of those properties. The decedent, his son, and the part-time employees personally provided repair and maintenance services. If they could not perform a necessary, major repair to the properties, independent contractors were hired.

Although using independent contractors can weigh against a determination that an active trade or business exists, a sufficient proportion of the activities of the decedent, his son, and the part-time employees were devoted to the performance of other substantial services. The IRS therefore concluded that the decedent’s activities met the scope of activity required to qualify under section 6166.

Success for an S Corporation

Tax advisors can assist and advise individuals regarding the optimal structure for real estate and rental activities. By meeting the active business tests, an S corporation can retain several tax benefits. It can avoid corporate taxes on excessive passive income, as well as the loss of its S corporation status. In addition, qualifying for IRC section 6166 will help the executor preserve estate liquidity and proceed with an orderly estate administration. The deferral of tax payments will help the estate avoid a forced asset sale.


Robert S. Barnett, Esq., CPA, is a partner in Capell Barnett Matalon & Schoenfeld LLP whose practice is located in Jericho, N.Y. He is a member of the NYSSCPA’s Closely Held and S Corporations, Estate Planning, and Personal Financial Planning committees.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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