An S Corporation Doesn't Change the Self-Rental Rules

If you own a trade or business, are actively participating in the management, and that trade or business rents property from another entity you own, you need to be aware of a recent U.S. Tax Court decision.

According to Internal Revenue Code Section 469, the term "passive activity," with certain exceptions, includes any rental activity, regardless of the level of activity by a taxpayer in managing such rental activity. Consequently, rental income typically offsets passive losses generated by other activities.

However, there is another rule under Section 469 that says if income is generated from the rental of property to a trade or business in which the taxpayer materially participates, such income should be "recharacterized" from being passive activity income to being treated as income from a nonpassive activity. This rule is known as the "self-rental rule," and it prevents "self-rental" income from offsetting passive losses.

U.S. Tax Court Case

But, what if the rental property creating the income is owned by an S corporation and not directly by the taxpayer, does the self-rental rule still apply?

That was the question answered in the U.S. Tax Court case Williams vs. Commissioner of the IRS, filed on April 16, 2015.

While there have been numerous cases wherein the loss limitations of Section 469 have been applied to an individual, Mr. and Mrs. Williams thought their case was distinguishable because the owner of the property (that was rented to a business in which Mr. Williams materially participated) was an S corporation.

The Williams argued that Section 469 was not intended by Congress to apply to activities conducted through an S corporation, because only individuals, estates, trusts, closely held C corporations and personal service companies are the taxpayers listed as subject to the passive activity loss limitations. They also argued that the lessor of the property, being an S corporation, could never materially participate in the trade or business renting the property, thereby failing one of the tests for making the income subject to recharacterization from passive to nonpassive.

While the Tax Court agreed with the Williams that Section 469 does not specifically refer to S corporations, it concluded Section 469 does not need to identify S corporations, because the allowable shareholders report the S corporation's pass-through income and are taxpayers to whom Section 469 applies. For that same reason, the Tax Court found that the test of material participation is made at the pass-through shareholder level, and due to the material participation of Mr. Williams in the trade or business renting the property, the material participation test was met.

Accordingly, the Tax Court said that income received by the Williams from renting property held in a 100 percent-owned S corporation to a wholly owned regular corporation (C corporation), used by such C corporation in a trade or business in which Mr. Williams materially participated, should be recharacterized from passive to nonpassive income.

No Offset Allowed

The net effect of the Tax Court decision was that the passive income claimed on the originally filed return, now being nonpassive, could not offset other passive losses. While those unused passive losses remain available for future use, additional tax, and resulting penalty, if any, and interest, were due in the adjustment years.

Contact your Eide Bailly representative with questions about self-rentals or if you need to discuss a current rental structuring to avoid the self-rental rule.