Private Letter Ruling 201232023 (April 4, 2012)
It is not uncommon for corporations that have made an election to be taxed under Subchapter S of the Internal Revenue Code to inadvertently terminate their status as S corporations through error or neglect of their shareholders or management. Therefore, understanding the S election requirements is an important part of CPA exam study. For example, the S status will terminate when an ineligible shareholder acquires stock, a second class of stock is issued, or a corporation with accumulated earnings and profits has excessive passive investment income for a specified period. Under procedures described in Treasury Regulations §1.1362-4(c), a corporation that believes that the termination or invalidity of its election was inadvertent may request a determination from IRS that the termination or invalidity of its election was inadvertent. Such requests are legion, an indication that S status missteps are commonplace and therefore become CPA and Enrolled Agent jobs to correct.
In at least one situation, however, the shareholders of an S corporation inadvertently maintained the corporation’s S status. The case involved Code §1362(d)(3)(A), which provides that an S election will be terminated whenever the corporation has accumulated earnings and profits (from years during which it was a C corporation) at the close of each of 3 consecutive taxable years, and has gross receipts for each of such taxable years more than 25% of which are passive investment income. The term “passive investment income”, which is vital knowledge in CPA review courses, means gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities.
The S corporation in question did, in fact, have accumulated earnings and profits from years in which it had been a C corporation. Furthermore, the corporation engaged extensively in rental activity. For three years in a row, the corporation’s gross receipts were generated in large part through these rental activities, such that more than 25% of its gross income in each of these years consisted of rental income. Dutifully, the corporation’s (now former) accountant attached a statement to the corporation’s Form 1120S, indicating that the corporation’s S election had terminated because of excess passive investment income.
As it turns out, however, the corporation, through its shareholder and officers, had provided a variety of services with respect to the leasing of the rental property. These services included inspecting, maintaining, and repairing the building, including the roofs, canopies, external walls, windows, floors, foundations, guttering and downspouts, plumbing, painting and internal light fixtures. Additionally, shareholders were responsible for inspecting, maintaining and repairing all common areas, including the parking lots, sidewalks, curbs and external light fixtures, and maintenance of the property grounds, including landscaping, garbage removal and snow and ice removal. The corporation negotiated leases, renewals and other agreements with tenants, collected rents, monitored compliance with lease terms, addressed tenant complaints and requests and advertised available commercial space, soliciting new tenants as applicable.
The regulations provide that, for purposes of an S corporation’s passive investment income, the term “rents” does not include income derived in the active trade or business of renting property. This crucial factor from study for CPA licensing escaped notice by the corporation’s accountant. Rents received by a corporation are deemed to be derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. These services may be provided by officers, shareholders, or may be outsourced.
Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation).
In this case, it was clear that the officers and shareholders of the corporation had, in fact, provided significant services with respect to leasing the property, and therefore the rental income was not passive investment income under Code §1362(d)(3)(A). Not only was the accountant incorrect in his or her analysis, the attempt to acknowledge the termination of the S election was faulty, as it did not comply with the requirements for an effective S corporation election revocation set forth in §§ 1.1362-2(a)(1) and 1.1362-6(a)(3) of the regulations.
Instead of the S election, the corporation terminated its arrangement with the accountant and sought a Private Letter Ruling, which confirmed that, despite the best efforts of the former accountant to establish the termination of the S election, the efforts of the shareholders resulted in the election remaining intact. The time arrived to find a new accountant with thorough expertise about S corporations from courses for CPA study.
Question
Excessive passive investment income under Code §1362(d)(3)(A) will operate to terminate a corporation’s S election only if
a. The corporation has any amount of passive investment income
b. The passive investment income constitutes more than 25% of the corporation’s gross income in any one year
c. The passive investment income constitutes more than 25% of the corporation’s gross income in three consecutive years
d. The passive investment income constitutes more than 25% of the corporation’s gross income in three consecutive years in which the corporation also had accumulated earnings and profits from years in which it was a C corporation
Correct Answer: d
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
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