Krukowski, Thomas P. v. CIR ( 2002 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 00-3946
Thomas P. Krukowski and Ermina A. Krukowski,
Petitioners-Appellants,
v.
Commissioner of Internal Revenue,
Respondent-Appellee.
Appeal from the United States Tax Court.
No. 7765-98--David Laro, Judge.
Argued May 17, 2001--Decided February 5, 2002
Before Harlington Wood, Jr., Kanne, and
Rovner, Circuit Judges.
Kanne, Circuit Judge. In 1994, the
Commissioner of the Internal Revenue
Service issued a deficiency notice to
Thomas and Ermina Krukowski. The notice
informed the Krukowskis that they had
misclassified certain rental income as
passive income on their 1994 federal
income tax return. The Krukowskis
challenged the deficiency charge, but the
Tax Court granted summary judgment in
favor of the Commissioner. On appeal, the
Krukowskis argue (1) that they are
entitled to characterize the particular
rental activity as a passive activity,
(2) that the Secretary of the Treasury’s
regulation recharacterizing the rental
activity as a nonpassive activity is
invalid, and finally, (3) that this
particular rental activity should be
treated as a single activity with their
other rental activity, and this single
activity should be characterized as a
passive activity. For the reasons stated
herein, we affirm.
I. History
The Krukowskis own two buildings in
Milwaukee, Wisconsin. They lease these
buildings and earn rental income from the
leases. Housed in one of the buildings is
S.R. & F.C., Inc., a health club wholly
owned by Thomas Krukowski ("Club
Building"). The other building houses
Krukowski & Costello, S.C., a law firm
("Law Firm Building"). Thomas Krukowski
is an attorney with Krukowski & Costello,
S.C., and in 1994, served as its
president and sole shareholder.
Additionally, he received all of his
earned income that year from his law
practice with Krukowski & Costello, S.C.
On March 1, 1987, Thomas Krukowski and
Krukowski & Costello, S.C., executed a
five-year lease for the Law Firm
Building. The lease contained a renewal
clause that provided:
Option to Renew
Lessor grants to Lessee three (3)
consecutive options to renew this Lease,
each for a term of three (3) years, at a
rental to be mutually agreed to by Lessor
and Lessee prior to the commencement of a
renewal term with respect to that renewal
term, with all other terms and conditions
of the renewal lease to be the same as
those herein. To exercise this option,
Lessee must:
(1) give Lessor written notice of the
intention to do so at least 60 days
before initial term expires, and
(2) agree with Lessor on rental for
renewal period at least 30 days before
initial term expires.
In Lessor’s sole discretion, failure to
comply with either (1) or (2) above shall
cause the option to renew to become null
and void.
On December 27, 1991, Thomas Krukowski
and Krukowski & Costello, S.C. signed a
renewal for the Law Firm Building. The
renewal provided that "[t]he term of the
Lease will be extended from March 1, 1992
until February 28, 1995 and all other
terms and conditions of the Lease shall
remain the same including the monthly
rent of $17,500."
On their 1994 federal income tax return,
the Krukowskis reported a passive income
of $175,149 from the Law Firm Building
and a passive loss of $69,100 from the
Club Building. The Krukowskis offset
their gain from the Law Firm Building
with the loss from the Club Building. The
Commissioner of the Internal Revenue
Service issued a notice of deficiency to
the Krukowskis on March 11, 1998.
TheCommissioner determined that the net
income from the Law Firm Building was
nonpassive income because the property
was rented to a corporation in which
Thomas Krukowski "materially
participate[d]." For this reason, the
Commissioner found that the Krukowskis
should not have used the passive loss
from the Club Building to offset the
nonpassive income from the Law Firm
Building.
As part of the Tax Reform Act of 1986,
Internal Revenue Code sec. 469 was
enacted. See I.R.C. sec. 469. Section 469
was intended to limit the financial
incentive to structure traditional tax
shelters. Prior to this enactment,
taxpayers could use passive activity
losses to offset nonpassive activity
income, thereby sheltering active income
from taxation. Now, however, sec. 469
prohibits the deduction of passive
activity losses, except insofar as the
losses are used to offset passive
activity income. Section 469(c)(1)
defines a passive activity as "any
activity (A) which involves the conduct
of any trade or business, and (B) in
which the taxpayer does not materially
participate." I.R.C. sec. 469(c)(1).
The Krukowskis do not dispute the
Commissioner’s finding that Thomas
Krukowski materially participated in
Krukowski & Costello, S.C. Rather, in
support of their contention that the
income for the Law Firm Building should
be treated as passive, the Krukowskis
assert three arguments on appeal. First,
they argue that they are entitled to
transitional relief under Treasury
Regulation sec. 1.469-11(c)(1)(ii) and
are allowed to characterize the income
from the Law Firm Building as passive
because it arises from a written binding
contract entered into prior to February
19, 1988. See Treas. Reg. sec. 1.469-
11(c)(1)(ii). Second, they argue that
because sec.sec. 469(c)(2) and (4) state
that "any rental activity" is to be
treated as a "passive activity," the
generalized power of the Secretary to
recharacterize some passive activities as
nonpassive under sec. 469(l) does not
include the power to effectively repeal
sec.sec. 469(c)(2) and (4). Therefore,
they argue that the Secretary’s
regulation that recharacterizes the
rental income from the Law Firm Building
as nonpassive is invalid. Finally, the
Krukowskis argue that, pursuant to
Treasury Regulation sec. 1.469-4(c)(1),
the rental activities of both buildings
should be treated as a single, passive
activity.
II. Analysis
Each of the Krukowskis’ arguments on
appeal presents a question of law. These
questions of law, we review de novo. See
Connor v. Commissioner, 218 F.3d 733, 736
(7th Cir. 2000); L & C Springs Assocs. v.
Commissioner, 188 F.3d 866, 869 (7th Cir.
1999).
A. Written Binding Contract Exception
The Krukowskis contend that the 1987 Law
Firm Building lease was extended by the
agreement signed in 1991. Because the
1991 agreement is merely an extension of
the 1987 lease, the Krukowskis argue that
they are entitled to transitional relief
under Treasury Regulation sec. 1.469-
11(c)(1)(ii). Section 1.469-11(c)(1)(ii)
allows taxpayers to characterize leasing
agreements as passive when the agreement
was a "written binding contract entered
into before February 19, 1988." See
Treas. Reg. sec. 1.469-11(c)(1)(ii). We
disagree with the Krukowskis’
characterization of the 1991 agreement.
We conclude that in 1991, when the
Krukowskis exercised the renewal option
contained in the 1987 lease, they entered
into a new leasing agreement, and did not
merely extend the original 1987 lease.
In addition to being entered into prior
to February 19, 1988, "[t]o qualify for
exemption from passive activity
characterization [under sec. 1.469-
11(c)(1)(ii)], a lease must be in writing
and it must be binding. At a minimum, for
a lease to be binding on a party, it must
be enforceable under applicable state
law." Connor, 218 F.3d at 740. Because
the lease at issue involves Wisconsin
property, we apply Wisconsin law. See id.
Under Wisconsin law, a new lease
agreement is required in order to validly
exercise an option to renew a lease
agreement. See Seefeldt v. Keske, 111
N.W.2d 574, 575 (Wis. 1961). Conversely,
a new lease agreement is not required
where the option being exercised merely
extends the original lease. See Connor,
218 F.3d at 740; Seefeldt, 111 N.W.2d at
576.
The 1987 lease was a five-year lease,
expiring in 1992. The renewal option in
the 1987 lease provided the lessee with
"three (3) consecutive options to renew
[the 1987] Lease, each for a term of
three (3) years, at a rental to be
mutually agreed to by Lessor and Lessee
prior to the commencement of a renewal
term with respect to that renewal term."
(Emphasis added). This provision is
unambiguous and is plainly referred to by
the parties as an option to renew.
Furthermore, since both parties had to
"mutually agree" on a new rental price,
the 1991 agreement was a new agreement
and not merely an extension of the
original agreement. See St. Regis
Apartment Corp. v. Sweitzer, 145 N.W.2d
711, 713-14 (Wis. 1966) (finding that
"the period of the lease [did] not
include the period of time covered by the
automatic renewal clause" because both
the lessee and the lessor could prevent
renewal by giving notice); Milwaukee
Hotel Wis. Co. v. Aldrich, 62 N.W.2d 14,
16 (Wis. 1953) ("The rule of law that a
lease for three years and three
additional years if the lessee chooses to
continue it, is a lease of itself for six
years.") (emphasis added); Sheppard v.
Rosenkrans, 85 N.W. 199, 200 (Wis. 1901)
(explaining that "[t]his is so because,
if the tenant makes the election, he
still holds under the original demise;
there is no further act to be done by the
lessor.") (quotation omitted). Here, the
lessee did not possess a unilateral right
to bind the lessor to an extension of the
original lease. Cf. Milwaukee Hotel Wis.
Co., 62 N.W.2d at 16. Rather, the parties
had to mutually agree on the rental
amount before the lease would be renewed.
The fact that the parties chose to
maintain the same rental price does not
alter the fact that the parties were free
to agree to a different amount. Thus, in
1994, the Krukowskis received rental
income from the Law Firm Building
pursuant to a lease agreement entered
into in 1991. Consequently, the
Krukowskis are not entitled to
transitional relief under Treasury
Regulation sec. 1.469-11(c)(1)(ii).
B. Treasury Regulation sec. 1.469-
2(f)(6)
Second, the Krukowskis note that
sec.sec. 469(c)(2) and (4) state that
"any rental activity" is to be treated as
a "passive activity." Thus, they argue
that the generalized power of the
Secretary to recharacterize some passive
activities as nonpassive does not include
the power to recharacterize rental
activity as nonpassive. Therefore, they
assert that Treasury Regulation sec.
1.469-2(f)(6), which recharacterizes the
rental income from the Law Firm Building
as nonpassive, is invalid. Treasury
Regulation sec. 1.469-2(f)(6) provides in
pertinent part that:
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]s rented for use in a trade or
business activity . . . in which the
taxpayer materially participates . . .
for the taxable year . . . .
(the "Self-Rental Rule"). We find this
argument to be unpersuasive, as have the
First and Fifth Circuits. See Sidell v.
Commissioner, 225 F.3d 103, 107 (1st Cir.
2000); Fransen v. United States, 191 F.3d
599, 601 (5th Cir. 1999).
Section 496(l) authorizes the Secretary
to "prescribe such regulations as may be
necessary or appropriate to carry out
provisions of [Section 469], including
regulations which specify what
constitutes an activity, material
participation, or active participation"
and regulations "requiring net income or
gain from a limited partnership or other
passive activity to be treated as not
from a passive activity." I.R.C. sec.
469(l) (emphasis added). Under Chevron
U.S.A., Inc. v. Natural Resources Defense
Council, 467 U.S. 837, 844, 104 S. Ct.
2778, 81 L. Ed. 2d 694 (1984), this
legislative regulation should be upheld
unless it is "arbitrary, capricious, or
manifestly contrary to statute." "[I]f
the plain meaning of the text of the
statute . . . supports . . . the
regulation, the inquiry ends." See United
States v. Dierckman, 201 F.3d 915, 923
(7th Cir. 2000) (quotation omitted).
Section 469(l) is a broad grant of
authority. See Sidell, 225 F.3d at 107.
The plain language of sec. 469(l) clearly
states that the Secretary can treat
"other passive activity" as nonpassive.
I.R.C. sec. 469(l); see also Sidell, 225
F.3d at 107; Fransen, 191 F.3d at 600-01.
Furthermore, the regulation comports with
Congress’s goal of eliminating tax
shelters. See Sidell, 225 F.3d at 107. In
fact, this type of regulation was
specifically anticipated by Congress. The
House Conference Report states:
The conferees intend that this authority
be exercised to protect the underlying
purpose of the passive loss provision,
i.e., preventing the sheltering of
positive income sources through the use
of tax losses derived from passive
business activities . . . . Examples of
where the exercise of such authority may
. . . be appropriate include the
following . . . (2) related property
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 . . . .
(Emphasis added). See H.R. Rep. No. 99-
841, at 147 (1986), reprinted in 1986
U.S.S.C.A.N. 4075, 4235; see also Sidell,
225 F.3d at 107-08. Because we find that
the Self-Rental Rule is within the
Secretary’s authority to enact and that
it furthers Congress’s goal of
eliminating tax shelters, we reject the
Krukowskis’ challenge to the rule’s
validity.
The Krukowskis also argue that sec.
469(l) unconstitutionally delegates
legislative power to the Secretary. We do
not agree. In Whitman v. American
Trucking Associations, 531 U.S. 457, 458,
121 S. Ct. 903, 149 L. Ed. 2d 1 (2001),
the Supreme Court reconfirmed that a
delegation is constitutional so long as
Congress provides "an intelligible
principle" to which the Secretary is
directed to conform. In Whitman, the
"intelligible principle" directed the EPA
to set ambient air quality standards at a
level "requisite to protect the public
health." Id. at 472-73. Similarly, the
Secretary is directed to "prescribe such
regulations as may be necessary or
appropriate to carry out provisions" of
Section 469, including regulations that
"specify what constitutes an activity,
material participation, or active
participation" and regulations "requiring
net income or gain from a limited
partnership or other passive activity to
be treated as not from a passive
activity." I.R.C. sec. 469(l). We find
the principle in this case to be at least
as intelligible as the principle recently
upheld in Whitman, and therefore, it is a
constitutional delegation.
C. Single Activity Treatment
Finally, the Krukowskis argue that,
pursuant to Treasury Regulation sec.
1.469-4(c)(1), the rental of both
buildings should be treated as a single
activity. "To make an election, a
taxpayer must clearly notify the
Commissioner of the taxpayer’s intent to
do so." See Kosonen v. Commissioner, T.C.
Memo 2000-107 (2000). Because the
Krukowskis did not elect to treat the
rental activities as a single activity on
their 1994 Income Tax Return, they cannot
now claim that the activities should be
grouped as a single activity for purposes
of this dispute. See id.
III. Conclusion
For the foregoing reasons, we AFFIRM the
tax court’s decision dismissing the
Krukowski’s claims.