Corporations and Rental Income
Avoiding Tax Penalties
and Other Risks
Robert S. Barnett
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.
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.
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.
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.
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.
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.
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.
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.
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
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.
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.
for an S Corporation
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
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