AUTO AND TRUCK LEASING RECEIPTS ARE NOT RENTS FOR WORTHLESS STOCK DEDUCTION PURPOSES IF SIGNIFICANT SERVICES ARE PERFORMED.

Rev. Rul. 88-65

ISSUE

If significant services are performed by a corporation in connection with the leasing of automobiles and trucks, are the amounts received under the leases "rents" within the meaning of section 165(g)(3)(B) of the Internal Revenue Code?

FACTS

P is a domestic corporation that owns all the outstanding stock of S. S is in the business of operating automobile and truck rental agencies. S derives its gross receipts solely from the leasing of automobiles and trucks on a daily basis for periods that ordinarily do not exceed one week. At its own expense, S performs or arranges for all necessary maintenance and repair services to its leased vehicles. In addition, S pays all applicable state and local taxes and maintains liability insurance coverage to protect against claims for damage caused by its automobiles and trucks.

In 1988, the stock of S became worthless. In its federal income tax return for that tax year, P claimed an ordinary loss deduction for worthless securities under section 165(g)(3) of the Code.

Section 165(a) of the Code provides that a deduction shall be allowed for any loss sustained during the tax year that is not compensated for by insurance or otherwise.

Section 165(g)(1) of the Code provides that if any security that is a capital asset becomes worthless during the tax year, the loss resulting therefrom shall be treated as a loss from the sale or exchange, on the last day of the tax year, of a capital asset.

Section 165(g)(3) of the Code provides that, for purposes of section 165(g)(1), any security in a corporation affiliated with a taxpayer that is a domestic corporation shall not be treated as a capital asset. For this purpose, a corporation shall be treated as affiliated with a taxpayer only if (A) stock possessing at least 80 percent of the voting power of all classes of its stock and at least 80 percent of each class of its nonvoting stock is owned directly by the taxpayer, and (B) more than 90 percent of the aggregate of the corporation's gross receipts for all tax years has been from sources other than royalties, rents (except rents derived from rental of properties to employees of the corporation in the ordinary course of its operating business), dividends, interest (except interest received on the deferred purchase price of operating assets sold), annuities, and gains from sales or exchanges of stocks and securities.

Section 1.165-5(b) of the Income Tax Regulations provides that if any security that is not a capital asset becomes wholly worthless during the tax year, the loss resulting therefrom may be deducted under section 165(a) as an ordinary loss.

The legislative history of section 165(g)(3) of the Code and its predecessors indicates that Congress intended that an ordinary loss deduction for worthless securities be allowable only when the subsidiary is an operating company as opposed to an investment or holding company. See S. Rep. No. 91-1530, 91st Cong., 2d Sess. 2 (1970), 1971-1 C.B. 617, 618; S. Rep. No. 77-1631, 77th Cong., 2d Sess. 46 (1942), 1942-2 C.B. 504, 543.

The term "rents," as used in section 165(g)(3)(B) of the Code, is not defined or discussed in the Code, the legislative history of section 165 or its predecessor provisions, or the underlying regulations. Section 165(g)(3)(B), however, groups rents with other types of investment income (royalties, dividends, interest, annuities, and gains from sales or exchanges of stock and securities).

The types of investment income specified in section 165(g)(3)(B) of the Code are similar to the types of passive income specified in section 1244(c)(1)(C), regarding the definition of "section 1244 stock," and section 1362(d)(3)(D)(i), concerning the passive investment income limitation of S corporations. They are also similar to the types of passive income specified in former section 1372(e)(5)(C), the predecessor to section 1362(d)(3)(D)(i).

Under section 1244(c)(1)(C) of the Code and former section 1372(e)(5)(C), a distinction is made between amounts received from the active conduct of a business and passive or investment income. Section 1.1244(c)-1(e)(1)(iii) of the regulations provides that payments "for the use of personal property do not constitute rents if significant services are rendered in connection with such payments." Rev. Rul. 65-40, 1965-1 C.B. 429, and Rev. Rul. 76-469, 1976-2 C.B. 252, relying on former section 1.1372-4(b)(5)(iv) of the regulations, hold that income from the leasing of motor vehicles is not considered rents for purposes of former section 1372(e)(5) of the Code where "significant services" are performed by the lessors. The services described in these rulings are similar to the maintenance and repair services that S performs in the instant case.

In furtherance of the congressional purpose evidenced by the legislative history of section 165(g)(3) of the Code, it is appropriate to distinguish between active and passive rental income in the same manner as provided for in the regulations under section 1244 and former section 1372. Thus, because S performs significant services with respect to the property it leases, the amounts received from the operation of its automobile and truck rental agencies are not rents for the purpose of section 165(g)(3)(B).

The ownership requirements under section 165(g)(3)(A) of the Code are met because S is wholly owned by P. In addition, the gross receipts test of section 165(g)(3)(B) is satisfied because the amounts received by S under the leases are not rents. As a result, S is affiliated with P, and P is allowed an ordinary loss deduction for the worthless stock of S.

HOLDING

If significant services are performed by a corporation in connection with the leasing of automobiles and trucks, the amounts received under the leases are not rents within the meaning of section 165(g)(3)(B) of the Code.

DRAFTING INFORMATION

The principal author of this revenue ruling is Robert N. Deitz of the Corporation Tax Division. For further information regarding this revenue ruling contact Mr. Deitz on (202) 377-9589 (not a toll- free call.