Farm lease receipts are not passive investment income for S corporation purposes

Plain-English summary

An S corporation that owned farmland received income under both a sharecropping arrangement and a rental lease. The corporation shared specified farming costs and crop risks under the sharecropping arrangement, and it paid substantial property, irrigation, insurance, tax, and maintenance costs under the rental lease. The IRS ruled that receipts from both arrangements were not passive investment income under IRC § 1362(d)(3)(C)(i). This meant those receipts would not count toward the passive-income test that can terminate an S election when a corporation also has accumulated earnings and profits. The ruling did not decide whether the corporation otherwise qualified for S status or whether the rental activity was passive under IRC § 469.

Ruling snapshot

• Question: Do the corporation's sharecropping and farmland rental receipts count as passive investment income under the S corporation termination rules?
• Outcome: Approved. The IRS ruled that receipts from both lease arrangements were not passive investment income.
• Key authorities: IRC § 1362(a), (d)(3); Treas. Reg. § 1.1362-2(c)(5)(ii)(B)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201722019 Third Party Communication: None
Release Date: 6/2/2017 Date of Communication: Not Applicable
Index Number: 1362.00-00, 1362.02-00,
1362.02-03 Person To Contact:
-----------------------, ID No. ----------------
---------------------- Telephone Number:
------------------------------------------- ----------------------
------------------------------ Refer Reply To:
---------------------------------- CC:PSI:B03
PLR-136392-16
Date:
March 02, 2017

Legend

X = ----------------------
------------ -----------------

Y = -------------------

Date 1 = ------------------------

Date 2 = ------------------ -----

Date 3 = --------------

State = --------------

Property = -----------------------

Year = -------

m = --------------

n = --------

o = ------

p = ------
PLR-136392-16 2

Dear ------ --------:

   This letter responds to your letter dated October 28, 2016, submitted on behalf of

X, requesting a ruling that the revenue received by X from Property under the
Sharecropping Lease Arrangement and the rental income received by X from Property
from its Rental Lease Arrangement were not passive investment income under
§ 1362(d)(3)(C)(i) of the Internal Revenue Code (Code).

                                     FACTS

    X was incorporated under State law on Date 1 and elected to be an S corporation

effective Date 2. X has accumulated earnings and profits of m.

    X is engaged in the business of farming and owns n acres in State. X has leased

the land for sharecropping (Sharecropping Lease Arrangement) continuously beginning
in Date 3. Beginning in Year, the land was leased to Y. Pursuant to the Sharecropping
Lease Arrangement, all taxes, assessments or charges levied or assessed on products
of the land must be paid by X and Y based in proportion to the percentage of crops to
which X and Y are entitled. X and Y each pay one half of the actual cost of fertilizer and
soil conditioner. X pays the cost of the power and fuel necessary to operate the
drainage pumping plants as well as the cost of maintaining the irrigation and drainage
canals and irrigation pipe line. X is also responsible for paying box rent and the
grower’s share of the state inspection fee. Any processing expenses incurred with the
preparation of crops for sale, which are related to X’s share of the crops, are paid by X.
X also determines the percentage of Property to be farmed and the types of crops to be
planted. Further, X is at risk for crop yields and marketing.

    In Year, X signed a new lease agreement (Rental Lease Arrangement) with Y for

lease of Property. Under the lease, X’s expenses are between o% and p% of X’s rental
income. X is responsible for providing and maintaining insurance on all improvements
and fixtures owned by X. Further, X pays the costs and expenses associated with the
repair, maintenance and replacement of the irrigation drainage pumps as well as the
insurance, water reclamation tax, water rights fees, water coalition dues and property
taxes.

                             LAW AND ANALYSIS

  Section 1362(a)(1) provides that, except as provided in § 1362(g), a small

business corporation may elect, in accordance with § 1362, to be an S corporation.
PLR-136392-16 3

   Section 1362(d)(3)(A)(i) provides that an election under § 1362(a) terminates

whenever the corporation (I) has accumulated earnings and profits at the close of each
of 3 consecutive taxable years, and (II) has gross receipts for each of such taxable
years more than 25 percent of which are passive investment income.

   Section 1362(d)(3)(C) provides that, except as otherwise provided in

§ 1362(d)(3)(C)(i), the term “passive investment income” means gross receipts derived
from rents, royalties, dividends, interest, and annuities.

    Section 1.1362-2(c)(5)(ii)(B)(1) of the Income Tax Regulations provides that

“rents” means amounts received for the use of, or the right to use, property (whether
real or personal) of the corporation.

    Section 1.1362-2(c)(5)(ii)(B)(2) provides that “rents” does not include rents

derived in the active trade or business of renting property. Rents received by a
corporation are derived in the 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. 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).

                                 CONCLUSION

  Based on the facts submitted and representations made, we conclude the

revenue received by X under the Sharecropping Lease Arrangement and the rental
income received by X under the Rental Lease Arrangement were not passive
investment income under § 1362(d)(3)(C)(i).

   Except as expressly provided herein, we express or imply no opinion concerning

the federal tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion concerning
whether X is otherwise eligible to be an S corporation for federal tax purposes. Further,
the passive investment rules of § 1362 are independent of the passive activity rules of
§ 469; unless an exception under § 469 applies, the rental activity remains passive for
purposes of § 469.
PLR-136392-16 4

  These rulings are directed only to the taxpayer who requested it. Section

6110(k)(3) of the Code provides that it may not be used or cited as precedent.

    Under a power of attorney on file with this office, we are sending a copy of this

letter to your authorized representative.

  The rulings contained in this letter are based upon information and

representations submitted by the taxpayer and accompanied by a penalty of perjury
statement executed by an appropriate party. While this office has not verified any of the
material submitted in support of the ruling requests, they are subject to verification on
examination.

                                   Sincerely,



                                   Bradford R. Poston
                                   Senior Counsel, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Passthroughs & Special Industries)

Enclosures (2)
A copy of this letter
A copy for § 6110 purposes