Cal Interiors Inc. v. Comm'r ( 2004 )

CAL INTERIORS INCORPORATED, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Cal Interiors Inc. v. Comm'r

No. 8052-01; No. 8053-01; No. 10869-01; No. 10870-01

United States Tax Court

T.C. Memo 2004-99; 2004 Tax Ct. Memo LEXIS 99; 87 T.C.M. 1226;

April 7, 2004, Filed

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">*99 Court held that recharacterization rule was valid. Judgment entered in favor of respondent.

CAL INTERIORS INCORPORATED, ET AL.,

Edward B. Simpson and John Gigounas, for petitioners.

Andrew R. Moore, for respondent.

Laro, David

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LARO

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioners petitioned the Court to redetermine the following Federal income tax deficiencies and accuracy-related penalties under section 6662(a):

Cal Interiors Inc., docket No. 8052-01

Fiscal Year Ended    Deficiency    Sec. 6662(a)   April 30, 1997     $ 43,156     $ 8,631.20

S & C Dent Corp., docket No. 8053-01

Fiscal Year Ended    Deficiency    Sec. 6662(a)   April 30, 1997     $ 5,298      $ 1,059.60

Cal Interiors Inc., docket No. 10869-01

Fiscal">*100 Year Ended    Deficiency    Sec. 6662(a)   April 30, 1998     $ 21,496      $ 4,299.20

  April 30, 1999      17,837      $ 3,567.40



Gary & Dolores Beecher, docket No. 10870-01

   Year    Deficiency   Sec. 6662(a)    1997    $ 150,774    $ 30,154.80

   1998     72,822     14,564.40

   1999     63,961     12,792.20

The cases resulting from these petitions are now before us consolidated for purposes of trial, briefing, and opinion.

Following concessions by the parties, we are left to decide whether the recharacterization rule of section 1.469-2(f)(6), Income Tax Regs., is valid as applied to net income realized by Gary and Dolores Beecher (collectively, the Beechers) on the rental of space in their home to two wholly owned C corporations (collectively, the corporations); the Beechers materially participated in the business activities of the corporations. We hold that the recharacterization rule of the regulations is valid. Unless otherwise stated, section references are to the applicable versions of the Internal Revenue Code. Rule references">*101 are to the Tax Court Rules of Practice and Procedure.

             FINDINGS OF FACT

Many facts were stipulated. We incorporate herein by this reference the parties' stipulation of facts and the exhibits submitted therewith. We find the stipulated facts accordingly. The Beechers are husband and wife, and they resided in Woodside, California, when their petition was filed with the Court. The principal place of business of the other two petitioners (i.e., the corporations) also was in Woodside, California, when their petitions were filed.

Cal Interiors, Inc., is a C corporation wholly owned by Gary Beecher. Its business is the repair of automobile interiors. S & C Dent Corp. is a C corporation wholly owned by Dolores Beecher. Its business is the removal of dents from automobiles. Both of the Beechers work full time in the businesses of the corporations, and each corporation's business office (office) is located in the Beechers' home. The corporations pay rent to the Beechers for use of the space in which the office is located.

On their 1997, 1998, and 1999 Federal income tax returns, the Beechers reported the income and expenses of six rental properties.">*102 For the respective years, the net income of one of these properties; i.e., the office, was reported as $ 39,307, $ 23,387, and $ 22,160. Each of the other five rental properties reported a net loss such that the combined losses of the five properties in each year exceeded the net income from the office.

                OPINION

Respondent determined that the Beechers' net income from their rental of the office was nonpassive income under the recharacterization rule of section 1.469-2(f)(6), Income Tax Regs., 2004 Tax Ct. Memo LEXIS 99">*103 Petitioners' sole argument is that the recharacterization rule is invalid for two reasons. First, petitioners assert, the recharacterization rule is arbitrary, capricious, and contrary to the statute. Second, petitioners assert, the recharacterization rule improperly negates their "bona fide business purpose" for renting the office to the corporations.

">*104 We disagree with petitioners' argument that the recharacterization rule is invalid. As to the first assertion, petitioners note correctly that this Court has declared the recharacterization rule valid. See Krukowski v. Commissioner, 114 T.C. 366">114 T.C. 366 (2000) (Court-reviewed), ^{279 F.3d 547">279 F.3d 547 (7th Cir. 2002); Schwalbach v. Commissioner, 111 T.C. 215">111 T.C. 215 (1998); Shaw v. Commissioner, T.C. Memo. 2002-35; Sidell v. Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d 103">225 F.3d 103 (1st Cir. 2000); Connor v. Commissioner, T.C. Memo. 1999-185, affd. 218 F.3d 733">218 F.3d 733 (7th Cir. 2000). Petitioners also note correctly that so have three Courts of Appeals, namely, the First, Fifth, and Seventh. See Krukowski v. Commissioner, 279 F.3d 547">279 F.3d 547 (7th Cir. 2002), affg. 114 T.C. 366">114 T.C. 366 (2000); Sidell v. Commissioner, 225 F.3d 103">225 F.3d 103 (1st Cir. 2000), affg. T.C. Memo. 1999-301; Connor v. Commissioner, 218 F.3d 733">218 F.3d 733 (7th Cir. 2000), affg. T.C. Memo. 1999-185; Fransen v. United States, 191 F.3d 599">191 F.3d 599 (5th Cir. 1999). According to petitioners, all">*105 of these cases were wrongly decided for the reasons argued by the taxpayers there. We disagree. Given the detailed and exhaustive analysis set forth in those cases in rejection of the arguments made by the taxpayers there, we see no need to repeat that analysis herein. Suffice it to say that the recharacterization rule of section 1.469-2(f)(6), Income Tax Regs., is a legislative regulation that was properly promulgated by the Secretary pursuant in part to the specific grant of authority stated in section 469(l) that allows him to prescribe all necessary or appropriate regulations to carry out the provisions of section 469, including regulations: (1) Defining the terms "activity" and "material participation", sec. 469(l)(1), and (2) "requiring net income or gain from a * * * passive activity to be treated as not from a passive activity", sec. 469(l)(3).}

We also disagree with petitioners' second assertion. First, from a factual point of view, we are unable to agree with petitioners that the instant case is distinguishable from the cases cited above. Whereas petitioners state on brief that here, unlike there, "it is crystal clear that the rental activity was">*106 not contrived as a tax shelter", they have directed us to no evidence in support of that statement. Nor have they directed us to any evidence to support their related statement on brief that the rental of the office served a bona fide business purpose in that "It was reasonable that Cal Interiors and [S& C] Dent should pay a fair rental for the [office] space", given that the Beecher's [sic] spent their personal funds to construct office space". Contrary to petitioners' belief, the taxpayers in those other cases also presumably used their personal funds to purchase the property that was the subject of the rentals there.

Moreover, from a legal point of view, we read nothing in the statute or in the legislative history thereunder that would require the Secretary to condition the recharacterization rule on the absence of a bona fide purpose for a "self-rental" such as we have here. In fact, we and the Courts of Appeals that have considered the validity of the recharacterization rule have read the statute and the underlying legislative history to support a contrary conclusion that the Secretary was authorized by Congress to apply the recharacterization rule to all self-rentals in">*107 which there is material participation by the taxpayer. As we stated in 114 T.C. 366">Krukowski v. Commissioner, supra at 369-370: The [recharacterization] rule is tied directly to the following passage set forth by the conferees in their report as to the Secretary's regulatory authority under section 469:

     Regulatory authority of Treasury in defining non-passive

   income. -- The conferees believe that clarification is desirable



   regarding the regulatory authority provided to the Treasury with



   regard to the definition of income that is treated as portfolio



   income or as otherwise not arising from a passive activity. 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 where the exercise of such authority may (if the

   Secretary so determines) be appropriate include the following

   * * * (2) related party leases or sub-leases, with respect to

   property used in a business">*108 activity, that have the effect of

   reducing active business income and creating passive income

   * * *. [H. Conf. Rept. 99-841 (Vol. II), at II-147, 1986-3 C.B.

   (Vol. 4) 1, 147.]

As the Court of Appeals for the First Circuit stated in Sidell v. Commissioner, 225 F.3d 103">225 F.3d at 107:

     The authority given to the Secretary, as illustrated by the

   statutory text, is quite broad. The statute empowers him to



   promulgate any regulations that he deems "necessary or

   appropriate" to further the goals of section 469.

   Importantly, this includes the explicit power to treat what



   normally would be passive income as nonpassive if he believes

   that such a shift is warranted.

As the Court of Appeals for the Fifth Circuit stated in 191 F.3d 599">Fransen v. United States, supra at 600-601:

     Here, the parties dispute the scope of passive activity the



   IRS may treat as non-passive. The point of uncertainty lies with

   the word "other" in section 469(l)(3). The Fransens

   suggest that "other" refers to activity not elsewhere

   defined in section 469 as passive. Grammatically, ">*109 however, the

   more persuasive reading of the provision is that a regulation

   may treat any kind of passive activity as non-passive. The

   phrase "or other" appears to refer back to "limited

   partnership" and thus to include any passive activity other

   than a limited partnership.

     The legislative history supports this view: it provides

   examples of situations in which the Secretary may treat

   activities defined as passive under section 469(c), including

   rental activity, as non-passive. The report includes these

   examples as illustrations rather than as an exclusive list. See

   H.R. Conf. Rep. No. 99-841, at 147 (1986), reprinted in 1986

   U.S.C.C.A.N. 4075, 4235.

     The Fransens suggest that the regulation defeats the

   statutory purpose of privileging rental income. The statute,

   however, does not seek to privilege rental income by generally



   classifying it as passive. Instead, the purpose animating the



   statute is to foreclose tax shelters. See STAFF OF THE JOINT



   COMM. ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF

   1986, ">*110 99th CONG., at 209-210 (J. Comm. Print 1987). In most

   cases, a classification of income as passive achieves this

   result. Tellingly, professional real estate lessors sought and

   obtained an exception from the passive designation in the 1993

   amendments because a non-passive classification would be more

   favorable to them. See I.R.C. section 469(c)(7); Scott P. Greiner,

   The Real Estate Professional's Tax Relief Act of 1993, 23 COLO. LAW. 1317, 1318 (1994).

     In some cases, however, the opposite is true: the treatment

   of income as passive may create a shelter opportunity. The

   inclusion of section 469(l) allows for such situations by granting

   the IRS the authority to treat income as non-passive. See H.R.

   Conf. Rep. No. 99-841, at 147 (1986), reprinted in 1986

   U.S.C.C.A.N. 4075, 4235. Here, the IRS identified self-rentals

   as such a case and promulgated the regulation at issue.

See also Connor v. Commissioner, 218 F.3d 733">218 F.3d at 738 (" the purpose of the passive activity loss regulations * * * is to assess accurately whether a taxpayer is involved">*111 in the active management of a trade or business in such a fashion that passive activity treatment would be inaccurate"). Although petitioners observe correctly that both the legislature and the judiciary have referred to the combating of "tax shelters" as one of the reasons for the enactment of section 469, we, unlike petitioners, do not read that term to require a finding of a specific intent to reduce taxes. Instead, we read that term plainly in the context of the setting at hand to include any transaction that, but for the recharacterization rule, would allow taxpayers to use passive losses to offset rental income received from a wholly owned business in which they actively participate.

We hold once again that the recharacterization rule is valid. In so doing, we have considered all of petitioners' arguments for a contrary holding and, to the extent not discussed above, find those arguments to be without merit or irrelevant. To reflect the foregoing,

An appropriate order will be issued.

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Footnotes

• 1. Cases of the following petitioners are consolidated herewith: S & C Dent Corporation, docket No. 8053-01; Gary and Dolores Beecher, docket No. 10870-01.↩

• 2. The recharacterization rule of sec. 1.469-2(f)(6), Income Tax Regs., provides:

       (f)(6) 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 (within

       the meaning of sec. 1.469-5T↩) for the taxable year; * * *

• 3. Although the Court in Krukowski v. Commissioner, 114 T.C. 366">114 T.C. 366 (2000), affd. 279 F.3d 547">279 F.3d 547 (7th Cir. 2002), was split as to whether the taxpayers qualified under sec. 1.469-11(b)(1), Income Tax Regs., for transitional relief from application of the recharacterization rule, 114 T.C. 366">id. at 376 (Beghe, J., concurring in part and dissenting in part), the Court held unanimously that the recharacterization rule is a valid regulation, id. Here, petitioners challenge only the validity of the recharacterization rule. Because their years in issue are 1997, 1998, and 1999, they make no claim to transitional relief under sec. 1.469-11(b)(1), Income Tax Regs. Only taxable years beginning before Oct. 4, 1994, qualify for transitional relief under that section. Id.↩