1999 Tax Ct. Memo LEXIS 347 | Tax Ct. | 1999
Decision with respect to the deficiencies for 1993 and 1994 will be entered for respondent; decision with respect to the accuracy-related penalty under section 6662(a) with respect to 1994 will be entered for petitioners.
Respondent recharacterized the income petitioner husband
received from the rental of property to his wholly owned C
corporation from passive to nonpassive, pursuant to the
attribution rule of
so-called self-rented property rule contained in
2(f)(6), Income Tax Regs. As a consequence of this
recharacterization, petitioners were able neither to reduce
such rental income by losses from other rental properties nor to
use certain rehabilitation credits.
1. HELD: Pursuant to
properly promulgated the attribution and self-rented property
rules. The self-rented property rule (by virtue of the
attribution rule) is valid insofar as it recharacterizes rental
income received by a controlling shareholder from a C
corporation from passive to nonpassive. See Schwalbach v.
2. HELD FURTHER: The transitional relief provided 1999 Tax Ct. Memo LEXIS 347">*348 in sec.
1.469-11(b), Income Tax Regs., is of no benefit to petitioners
in determining their 1993 and 1994 tax liability because sec.
1.469-4,
1992), PS-1-89,
activities of a C corporation are or are not attributable to the
corporation's shareholder.
3. HELD FURTHER: Respondent properly disallowed
rehabilitation credits claimed by petitioners for 1993 and 1994
because once their net rental income for those years is
recharacterized as nonpassive, the limitation on passive
activity credits mechanically disallows the claimed credits.
MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined deficiencies and an accuracy-related penalty under section 6662(a) with respect to petitioners' Federal income taxes, as follows:
Penalty
_______
Year Deficiency Sec. 6662(a)
____ __________ ____________
1993 $ 103,728 1999 Tax Ct. Memo LEXIS 347">*349 ---
1994 41,621 $ 8,324
The deficiencies stem from respondent's recharacterizing the income Chester F. Sidell (Mr. Sidell) received from the rental of properties to his wholly owned C corporation from passive to nonpassive. Respondent now concedes the accuracy-related penalty under section 6662(a) for 1994.
The issues for decision are: (1) Whether respondent's recharacterization of the rental income Mr. Sidell received from his wholly owned C corporation was proper; and if so, (2) whether respondent properly disallowed the rehabilitation credits petitioners claimed for those years.
All section references are to the Internal Revenue Code as in effect for the years in issue.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits submitted therewith are incorporated herein by this reference.
Petitioners, husband and wife, resided in Framingham, Massachusetts, at the time they filed their petition contesting respondent's determinations. For both years in issue, petitioners filed joint Federal income tax returns.
ACQUISITION OF RENTAL PROPERTIES
Mr. Sidell was the sole beneficiary of five trusts: The Manche Realty 1999 Tax Ct. Memo LEXIS 347">*350 Trust, CFS Realty Trust, FLS Realty Trust, GES Realty Trust, and RMS Realty Trust. All five trusts are nominee trusts under Massachusetts law and constitute grantor trusts for Federal income tax purposes. All income, deductions, and credits of these trusts were reported as pass-through items on petitioners' 1993 and 1994 Federal income tax returns.
On November 8, 1985, Manche Realty Trust acquired title to the land and building known as the Everett Mill Cotton Weaving House (the Everett Mill property), located at 181-183 Canal Street, Lawrence, Massachusetts. The Everett Mill property is located in a National Register historical district. Immediately after its purchase in 1985, the Everett Mill property was leased to KGR, Inc. (KGR), Mr. Sidell's wholly owned corporation. At the time of its acquisition, the Everett Mill property was in poor condition.
On July 6, 1992, Mr. Sidell executed an agreement for the acquisition of the land and building known as Kunhardt Mill, located at 60 Island Street, Lawrence, Massachusetts. The Kunhardt Mill property is a historic mill dating back to the late 1800's and is located across the street from the Everett Mill property in the same National Register 1999 Tax Ct. Memo LEXIS 347">*351 historical district. On October 14, 1992, CFS Realty Trust (rather than Mr. Sidell) took title to the Kunhardt Mill property. At the time of its acquisition, the Kunhardt Mill property needed substantial repair. After its acquisition, the Kunhardt Mill property was leased to KGR. The property was subsequently renovated and thereafter used as KGR's corporate headquarters.
On February 23, 1993, FLS Realty Trust acquired the land and building located at Canal, Mill, and Methuen Streets, Lawrence, Massachusetts (the FLS Realty Trust property). This property was subsequently leased to KGR to alleviate a parking shortage around KGR's offices.
On July 14, 1993, and May 16, 1994, respectively, GES Realty Trust and RMS Realty Trust acquired properties located near the Everett Mill, Kunhardt Mill, and FLS Realty Trust properties. These properties were acquired in anticipation of future expansion of KGR's business; they were not rented to KGR during the years in issue.
KGR
KGR, incorporated in Massachusetts, has its principal place of business in Lawrence, Massachusetts. For Federal income tax purposes it is a subchapter C corporation. KGR is engaged in the business of manufacturing women's and 1999 Tax Ct. Memo LEXIS 347">*352 children's apparel under private labels for such customers as Nordstrom, Talbots, and Dillards.
During the years in issue, petitioner was the president, treasurer, and sole director of KGR. With the exception of its retail sales operation, which was managed by Mrs. Sidell, Mr. Sidell managed every facet of KGR's day-to-day activities.
REHABILITATION OF EVERETT MILL/KUNHARDT MILL PROPERTIES
On May 16, 1986, Mr. Sidell submitted a historical preservation application to the U.S. Department of the Interior requesting certification that the Everett Mill property was a "certified historic structure". Certification was subsequently granted by the National Park Service (Park Service). Thereafter, in 1989 and 1990, substantial rehabilitation, repairs, and modifications were made to the Everett Mill property. Petitioners claimed rehabilitation credits for the rehabilitation expenditures in 1989 and 1990. The rehabilitation credits for these years were allowed and are not at issue in this case.
Seeking similar tax treatment for the Kunhardt Mill property, and concurrently with its acquisition, Mr. Sidell (on behalf of CFS Realty Trust) instituted a major rehabilitation project with respect to the 1999 Tax Ct. Memo LEXIS 347">*353 property. After repairs and renovations had begun on the Kunhardt Mill property, Mr. Sidell submitted a historic preservation certification application on March 23, 1993, to the U.S. Department of the Interior seeking a determination that the work previously done on the property conformed with its "Standards for Rehabilitation". After Mr. Sidell completed the rehabilitation project, the Park Service preliminarily determined that the work performed on the Kunhardt Mill property was eligible for "certified rehabilitation" status. Subsequently, on September 23, 1994, Mr. Sidell submitted a "Historic Preservation Certification Application Request for Certification of Completed Work" to the Park Service. Rehabilitation costs totaling $ 1,701,988 in 1993 and $ 84,435 in 1994 were incurred with regard to the rehabilitated Kunhardt Mill property. 11999 Tax Ct. Memo LEXIS 347">*354 An additional $ 200,000 was incurred in related costs associated with obtaining "qualified rehabilitation" status.
PETITIONERS' 1993 AND 1994 FEDERAL INCOME TAX RETURNS
Petitioners timely filed their 1993 and 1994 Federal income tax returns. On their returns, petitioners reported the following net rental income:
Property Net Rental Income/(Loss)
________ ________________________
1993 1994
____ ____
Manche/Everett Mill property $ 122,139 $ 45,936
CFS/Kunhardt Mill property 138,451 (5,335)
FLS property (42,758) 57,894
GES property (2,272) (25,315)
RMS property N/A (11,855)
_______ ________
Rental activities with net income 260,590 103,830
Rental activities with net loss (45,030) (42,505)
_______ ________
Net rental income 215,560 61,325
Petitioners also claimed rehabilitation credits of $ 85,361 in 1993 and $ 24,284 in 1994 with regard to the Kunhardt Mill property renovations.
NOTICE OF DEFICIENCY
In the notice of deficiency dated March 11, 1998, respondent recharacterized the positive 1993 income from the Everett Mill and Kunhardt Mill properties and the positive 1994 income 1999 Tax Ct. Memo LEXIS 347">*355 from the Everett Mill and FLS Realty Trust properties from passive to nonpassive pursuant to
OPINION
Central to the dispute in this case is the validity of the so-called self-rented property rule contained in
Property rented to a nonpassive activity. -- An amount
of the taxpayer's gross rental activity income for the
taxable year from an item of property equal to the net
rental activity income for the year from that item of
property is treated as not from a passive activity if the
property --
(i) Is rented for use in a trade or
business activity * * * in which the taxpayer
materially participates * * * for the taxable
year.
Pursuant to this 1999 Tax Ct. Memo LEXIS 347">*356 rule, and by virtue of the attribution rule of
As a consequence of this recharacterization, petitioners were neither able to reduce such rental income by the losses from other rental properties nor able to utilize certain rehabilitation credits.
Pursuant to
The passive activity rules reflect Congress' concern over the widespread use of tax shelters that allowed taxpayers to avoid paying tax on unrelated income. See
It was envisioned that by promulgating regulations regarding "related party leases or sub-leases", the Secretary would be acting consistently with
In the absence of regulations, a taxpayer
could derive passive activity gross income
from an active business in which tangible
property is used by renting the property to an
entity conducting the activity (or by causing
an entity holding the property to rent the
In successive attempts to define the scope of the self- rented property rule, numerous sets of regulations were promulgated. In both sets of temporary regulations, promulgated on 1999 Tax Ct. Memo LEXIS 347">*362 February 25, 1988, and May 12, 1989, respectively, activities conducted through a C corporation were excluded from being attributed to the taxpayer/shareholder for purposes of determining "material participation". See
On May 15, 1992,
In 1994, the proposed regulations issued in 1992 were replaced by the final version of
A commentator requested clarification on whether activities conducted through a C corporation 1999 Tax Ct. Memo LEXIS 347">*364 may be grouped with activities not conducted through the C corporation. The final regulations clarify that in determining whether a taxpayer materially or significantly participates in an activity, a taxpayer may group that activity with activities conducted through C corporations that are subject to
See
The final regulations were generally made effective for taxable years beginning after May 10, 1992. See
The parties disagree as to the proper characterization of the rental income from the Everett Mill, Kunhardt Mill, and FLS Realty Trust properties.
Petitioners seek to have the income Mr. Sidell 1999 Tax Ct. Memo LEXIS 347">*365 received in 1993 and 1994 from the rental of these properties characterized as income from a passive activity in order to use (1) passive losses from the rental of other properties, and (2) rehabilitation credits (claimed on their 1993 and 1994 returns) with respect to renovations made to the Kunhardt Mill property.
Respondent relies on the self-rented property rule contained in
Petitioners challenge respondent's 1999 Tax Ct. Memo LEXIS 347">*366 determinations, making three arguments. First, petitioners assert that
Second, petitioners argue that even if the application of the self-rented rule to a closely held C corporation is deemed valid, attribution/recharacterization cannot apply to any taxable year beginning before October 4, 1994, when the final regulations (discussed infra) were adopted. Thus, petitioners contend that 1999 Tax Ct. Memo LEXIS 347">*367 they may determine their 1993 and 1994 tax liability under the proposed regulations promulgated in 1992 (
Finally, petitioners assert that, assuming arguendo the rental income from the Everett Mill, Kunhardt Mill, and FLS Realty Trust properties is properly 1999 Tax Ct. Memo LEXIS 347">*368 recharacterized as nonpassive (or active) income under
Petitioners maintain a distinction between recharacterizing income, on the one hand, and recharacterizing the underlying activity, on the other. In this regard, petitioners contend that
STANDARD OF REVIEW OF
Petitioners invite us to invalidate a portion 1999 Tax Ct. Memo LEXIS 347">*369 of a regulation,
The starting point in determining the deference given to a regulation is whether the regulation is legislative or interpretive in nature. See
Congress authorized the Secretary to promulgate "such regulations as may be necessary or appropriate to carry out provisions of
ANALYSIS OF PARTIES' ARGUMENTS
Petitioners maintain in their validity argument that the self- rented property rule cannot apply to reclassify their rental income as nonpassive because KGR's business activities cannot be attributed to Mr. Sidell for purposes of determining "material participation". We disagree. Mr. Sidell's transaction with KGR is the epitome of a self-renting transaction. Mr. Sidell is the sole shareholder of KGR and manages its operations in various capacities. 81999 Tax Ct. Memo LEXIS 347">*372 At the same time that Mr. Sidell materially participated in KGR's operations, through his grantor trusts he rented several pieces of real property to KGR. KGR used the leased property in conducting its apparel business. By being in effect both the lessor and lessee of the properties in question, Mr. Sidell established the amounts of rent, and, unless the resulting rental income is deemed nonpassive, he could have used all of his passive losses to offset that income.
Moreover, there is ample legislative history and proper delegation under
In 1999 Tax Ct. Memo LEXIS 347">*373 enacting
The petitioners' assertion that no abuse potential
is present in the present case because they own no "tax
shelters" begs the 1999 Tax Ct. Memo LEXIS 347">*374 question. Furthermore, the unquestioned
legitimate business needs that prompted the purchases of the
various properties that caused petitioners to incur losses do
not mean that the petitioners' case is not the sort against
which the strictures of
The self-rental rule as a matter of administrative
convenience is a bright line rule. The rule does not
look to a taxpayer's motives in structuring transactions.
We are persuaded by respondent's responses to petitioners' assertions.
Consequently, we conclude that the self-rented property rule in
We now turn our attention to petitioners' proposed regulation argument. The taxpayers in
As in Connor, petitioners herein assert that the proposed regulations promulgated in 1992 did not specifically disavow the provisions in the temporary regulations issued in 1989, which provided that "a taxpayer's activities do not include operations that a taxpayer conducts through one or more entities (other than pass through entities)." 10
It is abundantly clear that Proposed Regulation sec.
1.469-4 was not intended to, and in fact did not change
the rule from the * 1999 Tax Ct. Memo LEXIS 347">*377 * * Temporary Regulations that a
taxpayer's activities did not include those conducted
through a C corporation. Consequently, it is clear that
under Proposed Regulation
property rule does not apply to the rental of property to
a C corporation.
Petitioners' proposed regulation argument is founded upon the transitional relief set forth in
We are mindful that:
(1) The 1992 proposed regulations eliminated the specific
statement found in
Tax Regs.,
which stated:
For purposes of applying
regulations thereunder, a taxpayer's activities do not
include operations that the taxpayer conducts through one
or more entities (other than passthrough entities).
(2) The preamble to the 1992 proposed regulations states:
This document proposes to replace section
1.469-4T with a new
will provide a modified definition of the term
activity.
and
(3) The preamble to the final regulations, 59 Fed. Reg.
50485, 50486 (Oct. 4, 1994),
The final regulations clarify that in determining
whether a taxpayer materially or significantly
participates in an activity, a taxpayer may group that
activity with activities 1999 Tax Ct. Memo LEXIS 347">*379 conducted through C corporations
that are subject to
service and closely held C corporations). [Emphasis added.]
It is inferable from the elimination of the aforementioned statement in the temporary regulations of 1989 and the preamble to the proposed regulations of 1992 that the Secretary did not intend in those proposed regulations to adhere to the position previously taken in the temporary regulations. As we noted in
Because the proposed regulations are silent as to whether the activities of a C corporation are or are not attributable to the corporation's shareholders, the 1992 proposed regulations are of no benefit to petitioners in determining their 1993 and 1994 tax liability.
Finally, we turn our attention to petitioners' credit argument. A passive activity credit is defined as "the amount 1999 Tax Ct. Memo LEXIS 347">*380 * * * by which * * * the sum of the credits from all passive activities allowable for the taxable year under subpart D of part IV of subchapter A * * * exceeds the regular tax liability of the taxpayer for the taxable year allocable to all passive activities."
In determining the existence and amount of a passive activity credit, the regular tax liability allocable to all passive activities must be ascertained. The regular tax liability allocable to passive activities is defined in
(d) Regular tax liability allocable to
passive activities -- (1) In general. -- For
purposes of paragraph (a)(2) of this section,
the taxpayer's regular tax liability allocable
to all passive activities for the taxable year
is the excess (if any) of --
(i) The taxpayer's regular tax
liability for such taxable year;
over
(ii)The amount of such regular
tax liability determined by reducing
the 1999 Tax Ct. Memo LEXIS 347">*381 taxpayer's taxable income for
such year by the excess (if any) of
the taxpayer's passive activity
gross income for such year over the
taxpayer's passive activity
deductions for such year.
Thus, in order to utilize a tax credit allocated to a passive activity, a taxpayer must have passive income in excess of passive deductions. See
In reaching our conclusions herein, we have considered all other arguments presented and, to the extent not discussed above, find them to be irrelevant or without merit.
To reflect the foregoing and respondent's concession,
Decision with respect to the deficiencies for 1993 and 1994 will be entered for respondent; 1999 Tax Ct. Memo LEXIS 347">*382 decision with respect to the accuracy-related penalty under section 6662(a) with respect to 1994 will be entered for petitioners.
Footnotes
1. The record does not enable us to account for the discrepancy between the stipulated amounts of rehabilitation costs for 1993 ($ 1,701,988) and 1994 ($ 84,435) and the amounts reflected on petitioners' Federal tax returns for 1993 ($ 1,734,163) and 1994 ($ 89,725).
2.
Sec. 1.469-4(a), Income Tax Regs. , provides, among other things, that for grouping a taxpayer's trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitations rules ofsec. 469 , a taxpayer's activities include those conducted through C corporations that are subject tosec. 469↩ .3. In
Schwalbach v. Commissioner, 111 T.C. 215">111 T.C. 215 (1998), the taxpayer husband (Dr. Schwalbach) practiced dentistry and was employed by a personal service corporation (Associated Dentists) he owned equally with another dentist. Dr. Schwalbach owned a building that he rented to Associated Dentists for use in its dentistry practice. The taxpayers reported $ 50,556 in 1994 as the net income from the rental of the building to Associated Dentists. The taxpayers attempted to offset this income with certain losses derived from unrelated activities, namely: (a) A rental loss from a commercial building apparently rented to an unrelated tenant; (b) a passive loss from an investment in an S corporation unrelated to the dentistry practice; and (c) a passive loss from an investment in a partnership also unrelated to the dentistry practice. In the aggregate, the losses claimed totaled $ 18,115. The Commissioner applied the self-rented property rule and thereby disallowed the losses. We sustained the Commissioner's determination.4. In
Fransen v. United States, 1998 U.S. Dist. LEXIS 16611">1998 U.S. Dist. LEXIS 16611 , 82 A.F.T.R.2d (RIA) 6621,98-2 U.S. Tax Cas. (CCH) P 50776">98-2 U.S. Tax Cas. (CCH) P50776 (E.D. La. 1998), the taxpayer husband was the sole shareholder of Fransen & Hardin, a personal service corporation. The taxpayers leased a building (in which each had an undivided one-half interest) to Fransen & Hardin. The taxpayers reported $ 29,902 of net rental income which they sought to offset with passive activity losses from other activities in the aggregate amount of $ 32,606. The taxpayers argued thatsec. 1.469-2(f)(6), Income Tax Regs. , "flatly contradicts the plain language of the statute it purports to enforce: the statute deems rental activity income passive with a minor exception, and the regulation's allowance of recharacterization of that income as non-passive renders the regulation invalid."5. We note that the preamble further states:
the Conference Report accompanying the Act states that
it would be appropriate for the Service to exercise its
regulatory authority under
sec. 469(l)(3) in the caseof "related party leases or sub-leases, with respect to
property used in a business activity, that have the
effect of reducing active business income and creating
passive income." H. Conf. Rept. 99-841, 99th Cong., 2d
Sess., Vol. II, at 147 (1986) [
53 Fed. Reg. 5725 (Feb.25, 1988).] property to the taxpayer). It would be
inconsistent with the purposes of
section 469 to treat rental income as passive activity gross income in such
cases * * *↩
6. Proposed regulations adopting the definition of "activity" for purposes of applying the limitations on passive activity losses and passive activity credits as set forth in the second set of temporary regulations were issued concurrently (i.e., May 12, 1989) with the promulgation of the second set of temporary regulations. See PS-001-89,
54 Fed. Reg. 20606 (May 12, 1989) ,1 C.B. 1057">1989-1 C.B. 1057↩ .7.
Sec. 7805(e)(2)↩ provides: "Any temporary regulation shall expire within 3 years after the date of issuance of such regulation."8. Petitioners acknowledge that Mr. Sidell materially participated in KGR. However, they argue that there is a distinction between materially participating in KGR and materially participating in the activities of KGR. Petitioners cite no authority to support this distinction. Regardless of any distinction, Mr. Sidell's day-to-day management of KGR's only line of business would constitute material participation in all the activities of KGR, which consequently would trigger the self- rented property rule. See
sec. 1.469-5T(a), Temporary Income Tax Regs. ,53 Fed. Reg. 5686, 5700 (Feb. 25, 1988) ,T.D. 8175, 1 C.B. 191">1988-1 C.B. 191↩ , 234.9. In
Connor v. Commissioner, T.C. Memo 1999-185">T.C. Memo 1999-185 , the taxpayer husband practiced dentistry and was employed by a professional service corporation in which he was a shareholder. (Until Oct. 31, 1993, the corporation was known as Michael F. Connor, D.D.S., S.C.; after that date, the corporation was known as Drs. Connor & McKeever, S.C.). The professional service corporation leased the building (the Rochester Street building) in which it conducted its business activities from taxpayer wife. The taxpayers reported net income from the rental of the Rochester Street building as $ 10,503 and $ 15,937 in 1993 and 1994, respectively. They reported losses from the rental of another property and losses from a partnership, which they used to offset the rental income from the Rochester Street building. The Commissioner determined that the rental profits from the Rochester Street building constituted nonpassive income and consequently could not be used to offset the taxpayers' passive losses. We sustained the Commissioner's determination.10. At trial, petitioners introduced over respondent's objection a multitude of Internal Revenue Service internal documents and memoranda purporting to show intent on the part of the drafters of
sec. 1.469-4, Proposed Income Tax Regs. ,57 Fed. Reg. 20802 (May 15, 1992), to maintain the exclusion on attribution of activities from C corporations. We find these documents to be of little probative value inasmuch as they do not state the final position of either the Commissioner or the Secretary. SeeConnecticut Gen. Life Ins. Co. v. Commissioner, 109 T.C. 100">109 T.C. 100 , 109 T.C. 100">110 (1997), affd.177 F.3d 136">177 F.3d 136 (3d Cir. 1999). Normally, such internal memoranda are not binding on the Secretary and cannot be used to determine intent. See109 T.C. 100">109 T.C. at 109-111 (observing that material from administrative work files generally reflects only personal views of various Government representatives, not official statements of the Commissioner or the Secretary);Armco, Inc. v. Commissioner, 87 T.C. 865">87 T.C. 865 , 867-868↩ (1986).