United States: Passive Activity Self-Rental Rule Applies To S Corporations

If you own property and a business, there is an obvious temptation to lease that property to the business. However, be careful—you risk triggering the self-rental rule and catching the eye of the IRS. One creative couple tried to get around this by using an S corporation to lease their property to their business; however, their effort fell flat.

Self-Rental Rule in a Nutshell

The Internal Revenue Code (IRC) generally prohibits taxpayers from deducting passive activity losses (PALs). It defines "passive activity" as any trade or business in which the taxpayer does not materially participate. Rental real estate activities generally are considered passive activities regardless of whether the taxpayer materially participates.

A PAL is the amount by which the taxpayer's aggregate losses from all passive activities for the year exceed the aggregate income from all of those activities. A PAL can usually only be used to offset passive income (although the IRC does provide a few exceptions).

The self-rental rule in IRC Section 469 applies when you rent property to a business in which you or your spouse materially participates. Under the rule, any rental losses are still considered passive, but the rental income is deemed nonpassive.

That means your rental profits cannot be offset by passive losses, and the rental losses generally can offset only passive income. You essentially suspend the tax benefits from current rental losses unless you have passive income.

Real-Life Example of the Negative Consequences

A couple in Texas owned two businesses: BEK Real Estate Holdings, an S corporation, and BEK Medical, Inc., a C corporation where the husband worked full-time. The S corporation leased commercial real estate to the C corporation. Neither the husband nor the wife materially participated in BEK Real Estate or otherwise engaged in a real property business.

In 2009 and 2010, BEK Real Estate had net rental income of $53,285 and $48,657, respectively, solely from the rental of property to BEK Medical. The couple reported those amounts as passive income on their 2009 and 2010 tax returns. They offset the income with passive losses from other businesses. The IRS, however, reclassified the rental income as nonpassive and disallowed the passive losses they claimed against the rental income for 2009 and 2010.

As a result, they owed more than $26,000 in taxes on the rental income for the two tax years.

They appealed to the U.S. Tax Court. When the court ruled in favor of the IRS, the couple appealed to the Fifth Circuit Court of Appeals.

An Unusual Challenge

The couple argued that the self-rental rule did not apply because Sec. 469 does not define "taxpayer" to include S corporations. And, they claimed, even if it did, BEK Real Estate did not materially participate in BEK Medical.

The Fifth Circuit Court acknowledged that Sec. 469 does not refer to S corporations at all: "The statute specifically applies to 'taxpayers' who are individuals, estates, trusts, closely-held C corporations and personal service corporations." However, the appellate court agreed with the Tax Court that the provision did not need to specifically refer to S corporations because S corporations are merely pass-through entities; the individual shareholders in an S corporation are the ultimate taxpayers, not the entity.

Therefore, the Fifth Circuit found that an S corporation is nit really a taxpayer. And, because S corporations do not pay taxes directly, Sec. 469 had no need to include them in its list of potential "taxpayers."

The material participation argument regarding the S corporation's level of participation also failed. The couple were the taxpayers, so the proper focus was not on the S corporation but on the couple. The husband, who worked full-time for the C corporation, indisputably materially participated in its business.

Check Yourself

Renting property to a business in which you materially participate can be a lose-lose proposition when it comes to your taxes. Your financial advisor can help you devise a more beneficial arrangement.

Sidebar: A Potential Reprieve from the Self-Rental Rule

You may be able to avoid the negative tax repercussions of Internal Revenue Code (IRC) Section 469's self-rental rule by "grouping." The IRC allows you to group your separately owned rental building with your business to treat them as one activity for purposes of the passive loss rules if they constitute an "appropriate economic unit." The regulation determines this based on factors such as common ownership and control, types of activities and location. As long as you materially participate in the business (and the business is not a C corporation) the rental activity will not be treated as passive.

To take advantage of this option, you must own both the rental property and the business. You could also use grouping if the rental activity is "insubstantial" (a term undefined by the regulations) in relation to the business activity.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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