When Is Rental Real Estate an Active Business?

By Robert Willens


October 11, 2010

With lease accounting due to go through major changes over the next year, it is a good time to review other real estate rental issues, particularly those having to do with tax-free divestitures. In a private-letter ruling issued by the Internal Revenue Service last year, the agency delineates between situations that meet the “active business” requirements and those that don’t, for purposes of spin-offs.

Before looking into the private-letter ruling, let’s examine a similar situation to give the guidance some context. Consider a case in which one company, Pro Corp. (ProCorp), which is engaged in the active conduct of a trade or business, owns all of the stock of Sigma Corp. In turn, Sigma owns an office building and uses an independent contractor to manage the property. The independent contractor provides the following services:

• supplies and supervises janitors and maintenance personnel;
• collects rents;
• pays bills;
• advertises for tenants;
• negotiates leases; and
• handles tenant complaints.

The president of ProCorp — who is also an officer of Sigma — devotes some time to the operation of the building. He visits the building periodically to ensure the maintenance is done properly; he attends to all matters concerning zoning, building permits, and other local laws affecting the building; and he approves the leases negotiated and the repair contracts.

For valid business reasons, ProCorp distributes to its shareholders all of its stock in Sigma. The distribution does not qualify as a tax-free spin-off because the active business requirement is not met: Sigma is not engaged in the active conduct of a trade or business (see Revenue Ruling 86-125).

The Internal Revenue Code — specifically Section 355(b) — requires that both the distributing corporation (ProCorp) and the controlled corporation (Sigma) be engaged in the active conduct of a trade or business immediately after the distribution. To meet Section 355(b) requirements, each corporation must be engaged in entrepreneurial endeavors of “such a nature,” and to such an extent, as to qualitatively distinguish its operations from “mere investments.” In addition, the business activity has to be activity of the corporation itself, and not of independent contractors.

In the ProCorp case, however, the operational and management activity of the rental business is largely performed by independent contractors. Although some of Sigma’s activities could be considered managerial or operational, these activities are not different from those a prudent investor would be expected to undertake, and are not enough to qualitatively distinguish Sigma’s operations from mere investments. Accordingly, Sigma is not engaged in the active conduct of a trade or business.

However, if the corporation itself (through its employees) directly performs active and substantial management and operational functions, the corporation will be considered engaged in the active conduct of a trade or business. As a result, the IRS issued guidance last year in a private-letter ruling, LTR 200943019, to explain the distinction.

The letter noted that Delta Corp., an “S” corporation, is engaged in the rental real estate business consisting of owning and managing Building No. 1 and Building No. 2. Delta’s employees are engaged in the following activities:

• advertising for tenants;
• preparing leases for tenants;
• collecting rent;
• cleaning and maintaining common areas;
• paying bills;
• maintaining books and records;
• evicting tenants; and
• making repairs.

Delta’s stock is owned by Mr. C and Mr. D. Serious disagreements have developed between the two owners concerning the operation of Delta. In response, Delta will form subsidiaries (Sub1 and Sub2) and transfer Building No. 1 to Sub1 and Building No. 2 to Sub2. Delta will also distribute the Sub1 stock to Mr. C in exchange for his stock in Delta, and distribute the Sub2 stock to Mr. D in exchange for, and in retirement of, his stock in Delta.

The IRS ruling notes that the separation is a “good” split-up, primarily because the active business requirement is met. Indeed, both Sub1 and Sub2 are engaged in the active conduct of a trade or business. Further, in each instance the corporation itself, through its employees, is performing active and substantial management and operational functions. Thus, in contrast to Revenue Ruling 86-125, the business activities in the Delta case were activities of the corporation itself and not the activities of persons outside of the corporation, such as independent contractors.1

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

1 See also LTR 200946009. In the ruling, X Corp. (X) is an “S” corporation. X owns and manages real estate. X owns, operates, and manages a total of “e” commercial properties. X provides various services, including routine maintenance, negotiation of tenant leases, maintenance of common areas, resolution of tenant complaints, and management of all finances relating to its properties. X also maintains a staff of “f” employees. Section 1362(d)(3)(A)(i) provides that an “S” election shall be terminated whenever the corporation has (i) accumulated earnings and profits at the close of each of three consecutive taxable years and (ii) gross receipts for each of such taxable years more than 25% of which are “passive investment income.” The term passive investment income includes gross receipts derived from rents. Rents, in turn, refer to amounts received for the use of property. However, rents do not include rents derived in the active trade or business of renting property: rents are so derived only if the corporation provides “significant services” or incurs “substantial costs” in the rental business. The ruling concludes that the rental income X receives is not passive investment income. Rather, X’s activities, performed by its employees, place it squarely in the active trade or business of renting property.

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