Hillman v. IRS

ON PETITION FOR REHEARING
PUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
DAVID H. HILLMAN; SUZANNE 
HILLMAN,
Petitioners-Appellees,
v.  No. 00-1915
INTERNAL REVENUE SERVICE,
Respondent-Appellant.

Appeal from the United States Tax Court.
(Tax Ct. No. 97-19893)
Argued: February 28, 2001
Decided: July 30, 2001
Before WILKINS and WILLIAMS, Circuit Judges, and
HAMILTON, Senior Circuit Judge.
Reversed and remanded by published opinion. Senior Judge Hamilton
wrote Parts I and II of the opinion, in which Judge Wilkins and Judge
Williams joined. Judge Williams wrote Part III of the opinion, in
which Judge Wilkins joined. Senior Judge Hamilton wrote a dissent-
ing opinion with respect to Part III.
COUNSEL
ARGUED: Kenneth L. Greene, Tax Division, UNITED STATES
DEPARTMENT OF JUSTICE, Washington, D.C., for Appellant. Ste-
2 HILLMAN v. INTERNAL REVENUE SERVICE
fan F. Tucker, VENABLE, BAETJER, HOWARD & CIVILETTI,
L.L.P., Washington, D.C., for Appellees. ON BRIEF: Paula M. Jung-
hans, Acting Assistant Attorney General, Howard T. Perelmuter, Tax
Division, UNITED STATES DEPARTMENT OF JUSTICE, Wash-
ington, D.C., for Appellant. David E. Sellinger, Susan Edlavitch,
Damon W.D. Wright, VENABLE, BAETJER, HOWARD & CIVI-
LETTI, L.L.P., Washington, D.C., for Appellees.
OPINION
HAMILTON, Senior Circuit Judge:
I.
In mid-July 1997, David and Suzanne Hillman (the Hillmans)
received written notice from the Commissioner of the United States
Internal Revenue Service (the Commissioner) that a deficiency
existed in the amount of federal income taxes they had paid for tax-
able years 1993 and 1994. According to the notice, the Hillmans still
owed the government $294,556.00 in federal income taxes for taxable
year 1993 and $309,696.00 in federal income taxes for taxable year
1994. The Hillmans contested the full amounts of these deficiencies
by filing a timely petition for redetermination in the United States Tax
Court (the Tax Court). At the time the Hillmans filed their petition,
they were residents of Bethesda, Maryland.
The parties submitted this case to the Tax Court on the following
stipulated facts. During taxable year 1993, David Hillman was the
sole shareholder of Southern Management Corporation (SMC), a cor-
poration taxed under Subchapter S of the Internal Revenue Code (IRC).1
During taxable year 1994, David Hillman owned 94.43 percent of
SMC’s stock.
1
Shareholders of a corporation taxed under Subchapter S of the IRC
may elect a passthrough taxation system, under which the corporation’s
profits pass through directly to its shareholders on a pro rata basis and
are reported on each shareholder’s individual federal income tax returns.
26 U.S.C. § 1366(a)(1)(A).
HILLMAN v. INTERNAL REVENUE SERVICE 3
SMC provided real estate management services to approximately
ninety entities, including joint ventures, limited partnerships, and
Subchapter S corporations, which were involved in real estate rental
activities.2 At all times relevant to the issues in this appeal, David
Hillman owned, either directly or indirectly, interests in each of these
entities (the Passthrough Entities). The general partner of each limited
partnership was either David Hillman or an upper tier partnership or
Subchapter S corporation in which he owned an interest.
During taxable years 1993 and 1994, the Hillmans did not partici-
pate in the activities of the Passthrough Entities. The Hillmans did,
however, participate in the activities of SMC by performing real
estate management services SMC had contracted to perform for the
Passthrough Entities. Indeed, David Hillman materially participated
in SMC’s real estate management activity in excess of 500 hours.3
The Hillmans reported as income the compensation paid to them
for their real estate management services offered through SMC for
taxable years 1993 and 1994. In computing their taxable income for
1993 and 1994, the Hillmans deducted the total amounts of the man-
agement fee expenses of the Passthrough Entities for taxable years
1993 and 1994 from the gross income they received during those
years through SMC for providing the management services that gave
rise to the management fee expenses. The notice of deficiency disal-
lowed this deduction, thus resulting in the claimed tax deficiencies at
issue in this appeal.
On April 18, 2000, the Tax Court entered a final decision fully in
favor of the Hillmans. The Tax Court accompanied its final decision
with a published opinion holding the Hillmans properly deducted the
2
For purposes of federal income tax liability, joint venturers and part-
ners are taxed under a passthrough taxation system. 26 U.S.C. § 701-04,
761(a). Thus, each joint venturer or partner is individually taxed on his
distributive share of joint venture or partnership income. Id.3
During taxable years 1993 and 1994, SMC also conducted other oper-
ations in addition to real estate management services, such as recre-
ational services, medical insurance plan underwriting, credit/collection
services, and a maintenance training academy. The Hillmans did not
materially participate in any of these other operations of SMC.
4 HILLMAN v. INTERNAL REVENUE SERVICE
management fee expenses of the Passthrough Entities from their
related management fee income for purposes of lowering the amounts
of their taxable income for taxable years 1993 and 1994. The Com-
missioner filed a timely appeal. We have appellate jurisdiction pursu-
ant to 26 U.S.C. § 7482(a)(1).
Judge Wilkins and Judge Williams join in this part of the opinion.
II.
In this appeal, we are presented with the following question of law:
May the Hillmans legally deduct their passive management fee
expenses from their related nonpassive management fee income for
purposes of lowering their taxable income for taxable years 1993 and
1994? We review this question of law de novo. Balkissoon v. Com-
missioner, 995 F.2d 525, 527 (4th Cir. 1993).
The Commissioner insists this question is easily answered by
applying the plain language of IRC § 469(a),4 which prohibits individ-
uals, estates, trusts, closely held C corporations, and personal service
corporations from deducting passive activity losses or passive activity
credits from nonpassive gains in an effort to lower taxable income. 26
U.S.C. § 469(a). Specifically, IRC § 469(a) provides:
(a) Disallowance.—
(1) In General.—If for any taxable year the taxpayer is
described in paragraph (2), neither—
(A) the passive activity loss, nor
(B) the passive activity credit, for the taxable
year shall be allowed.
(2) Persons described.—The following are described in
this paragraph:
4
All references to IRC § 469 are to the version in effect during taxable
years 1993 and 1994.
HILLMAN v. INTERNAL REVENUE SERVICE 5
(A) any individual, estate, or trust,
(B) any closely held C corporation, and
(C) any personal service corporation.
Id. For purposes of IRC § 469, the term "passive activity" is defined
as an activity involving the conduct of a trade or business in which
the taxpayer does not materially participate. Id. § 469(c)(1). With cer-
tain exceptions not relevant here, rental activity is a passive activity.
Id. § 469(c)(2). Also for purposes of IRC § 469, the term "passive
activity loss" is defined as "the amount (if any) by which—(A) the
aggregate losses from all passive activities for the taxable year,
exceed (B) the aggregate income from all passive activities for such
year." Id. § 469(d)(1). The Commissioner points out that the some-
what harsh result of applying IRC § 469(a) in a self-charged or wash
transaction is tempered by IRC § 469(b), which provides that "any
loss or credit from an activity which is disallowed under subsection
(a) shall be treated as a deduction or credit allocable to such activity
in the next taxable year." Id. § 469(b).
The Hillmans do not dispute, nor could they, that straightforward
application of the plain language of IRC § 469(a) prohibits them from
deducting the management fee expenses of the Passthrough Entities
for taxable years 1993 and 1994 from their related management fee
income for those same respective years.5 However, the Hillmans take
the position that the plain language of IRC § 469(a) should not so
apply. The Hillmans’ position is based upon their argument that,
when IRC § 469(l)(2) is read together with certain portions of IRC
§ 469’s legislative history, it is clear that Congress directed the Secre-
tary of the Treasury (the Secretary) to issue a regulation excepting
self-charged management fees resulting in no accretion of the taxpay-
er’s actual wealth from operation of IRC § 469(a), and the Secretary’s
failure to comply with this direction does not prevent them from
avoiding operation of IRC § 469(a). The Tax Court’s reasoning in
5
Indeed, the Hillmans do not dispute that under a straightforward
application of the plain language of IRC § 469, the management fee
expenses at issue are passive activity losses and the related management
fee income at issue resulted from nonpassive activity.
6 HILLMAN v. INTERNAL REVENUE SERVICE
support of its ruling in favor of the Hillmans essentially tracks this
argument made by the Hillmans.
IRC § 469(l)(2), relied upon by the Hillmans, provides that the Sec-
retary "shall prescribe such regulations as may be necessary or appro-
priate to carry out provisions of [IRC § 469], including regulations—
. . . which provide that certain items of gross income will not be taken
into account in determining income or loss from any activity (and the
treatment of expenses allocable to such income) . . . ." 26 U.S.C.
§ 469(l)(2). The following excerpt from the House Conference Report
for the Tax Reform Act of 1986 is the legislative history of IRC § 469
upon which the Hillmans rely:
Self-charged interest.—A further issue with respect to
portfolio income arises where an individual receives interest
income on debt of a passthrough entity in which he owns an
interest. Under certain circumstances, the interest may
essentially be "self-charged," and thus lack economic signif-
icance. For example, assume that a taxpayer charges $100
of interest on a loan to an S corporation in which he is the
sole shareholder. In form, the transaction could be viewed
as giving rise to offsetting payments of interest income and
passthrough interest expense, although in economic sub-
stance the taxpayer has paid the interest to himself.
Under these circumstances, it is not appropriate to treat
the transaction as giving rise both to portfolio interest
income and to passive interest expense. Rather, to the extent
that a taxpayer receives interest income with respect to a
loan to a passthrough entity in which he has an ownership
interest, such income should be allowed to offset the interest
expense passed through to the taxpayer from the activity for
the same taxable year.
***
The conferees anticipate that Treasury regulations will be
issued to provide for the above result. Such regulations may
also, to the extent appropriate, identify other situations in
which netting of the kind described above is appropriate
HILLMAN v. INTERNAL REVENUE SERVICE 7
with respect to a payment to a taxpayer by an entity in
which he has an ownership interest. Such netting should not,
however, permit any passive deductions to offset non-
passive income except to the extent of the taxpayer’s alloca-
ble share of the specific payment at issue.
H.R. Conf. Rep. No. 99-841, at II-146-47 (1986). The Secretary has
promulgated no permanent regulations exempting self-charged items
of income and expenses from operation of IRC § 469(a), and has only
issued one proposed regulation in this regard. That proposed regula-
tion deals only with the self-charged interest situation specifically dis-
cussed in the just quoted legislative history of IRC § 469 and the
reverse of that situation (i.e., when a passthrough entity loans money
to its owner). Prop. Treas. Reg. § 1.469-7, 56 Fed. Reg. 14,034 (April
5, 1991).
We hold IRC § 469(a) prohibits the Hillmans from legally deduct-
ing their passive management fee expenses from their related nonpas-
sive management fee income for purposes of lowering their taxable
income for taxable years 1993 and 1994. The threshold problem with
the Hillmans’ position is that nothing in the plain language of IRC
§ 469 suggests that an exception to IRC § 469(a)’s general prohibition
against a taxpayer’s deducting passive activity losses from nonpassive
activity gains exists where, as in the present case, the taxpayer essen-
tially paid a management fee to himself. The general rule is that
unless there is some ambiguity in the language of a statute, a court’s
analysis must end with the statute’s plain language (the Plain Mean-
ing Rule). Caminetti v. United States, 242 U.S. 470, 485 (1917)
("[T]he rules which are to aid doubtful meanings need no discussion"
when the statutory language is clear and unambiguous.); United States
v. Morison, 844 F.2d 1057, 1064 (4th Cir. 1988) ("[W]hen the terms
of a statute are clear, its language is conclusive and courts are not free
to replace that clear language with an unenacted legislative intent."
(internal quotation marks and alteration marks omitted)).
The Hillmans’ argument calling for us to ignore the plain language
of IRC § 469(a) implicates two extremely narrow exceptions to the
Plain Meaning Rule. The first exception applies when literal applica-
tion of the statutory language at issue produces an outcome that is
demonstrably at odds with clearly expressed congressional intent to
8 HILLMAN v. INTERNAL REVENUE SERVICE
the contrary. Sigmon Coal Co. v. Apfel, 226 F.3d 291, 304 (4th Cir.
2000). The second exception implicated by the Hillmans’ argument
applies when literal application of the statutory language at issue "re-
sults in an outcome that can truly be characterized as absurd, i.e., that
is so gross as to shock the general moral or common sense . . . ." Id.(internal quotation marks omitted). If either of these exceptions apply,
"then we can look beyond an unambiguous statute and consult legisla-
tive history to divine its meaning." Id. Again, the instances in which
either of these exceptions to the Plain Meaning Rule apply "are, and
should be, exceptionally rare." Id.When considering the applicability in the case before us of the first
described exception to the Plain Meaning Rule, we must consider
whether clearly expressed congressional intent exists to the effect that
taxpayers such as the Hillmans are exempt from operation of IRC
§ 469(a) in a self-charged or wash transaction involving passive man-
agement fee expense and related nonpassive management fee income.
Unfortunately for the Hillmans, no such clearly expressed congressio-
nal intent exists. First, no statutory language, including the statutory
language of IRC § 469(l)(2), is of help to the Hillmans in this regard.
Second, the legislative history of IRC § 469 does not clearly express
the congressional intent the Hillmans need in order to prevail on their
argument. Indeed, the only situation the legislative history of IRC
§ 469 specifies that deserves exception from operation of IRC
§ 469(a) is one involving self-charged interest. H.R. Conf. Rep. No.
99-841, at II-146 (1986). Moreover, the legislative history further
states, without qualification, that the Secretary has discretion to iden-
tify other situations in which offsetting otherwise prohibited under
IRC § 469(a) will be allowed. H.R. Conf. Rep. No. 99-841, at II-146-
47 (1986). Without clearly expressed congressional intent, contrary to
the result produced by literally applying the plain language of IRC
§ 469(a) to the factual situation presented in this case, the Hillmans
cannot avail themselves of the first described exception to the Plain
Meaning Rule.
The Hillmans also cannot avail themselves of the second described
exception to the Plain Meaning Rule—that literal application of the
statutory language at issue produces an absurd result. Literal applica-
tion of the plain language of IRC § 469(a) to the factual situation
before us does not produce a result that is so gross as to shock our
HILLMAN v. INTERNAL REVENUE SERVICE 9
general moral or common sense. In this regard, we point out that the
somewhat harsh result created by literally applying IRC § 469(a) to
the wash transaction at issue here is considerably tempered by the fact
that IRC § 469(b) allows the Hillmans to carry forward the passive
management fee expenses for taxable years 1993 and 1994 to subse-
quent taxable years as deductions allocable to the activity of the Pass-
through Entities for those next years. We do note, however, that we
see no reason why the factual situation before is not deserving of
exemption from operation of IRC § 469(a) as proposed by the Secre-
tary with regard to an interest payment in a self-charged transaction,
see Prop. Treas. Reg. § 1.469-7, 56 F.R. 14,034 (April 5, 1991). But,
this is an inequity in the United States Tax Code that only Congress
or the Secretary (as the holder of delegated authority from Congress)
has the authority to ameliorate.
In summary, we hold that IRC § 469(a) prohibits the Hillmans
from legally deducting their passive management fee expenses from
their related nonpassive management fee income for purposes of low-
ering their taxable income for taxable years 1993 and 1994.
Judge Wilkins and Judge Williams join in this part of the opinion.
WILLIAMS, Circuit Judge:
III.
Accordingly, we reverse the decision of the Tax Court and remand
for the Tax Court to consider the alternative argument raised below
by the Hillmans.6
(Text continued on page 11)
6
The Tax Court specifically declined to address the Hillmans’ alterna-
tive argument:
Because of our conclusion that petitioners are entitled to self-
charged treatment with respect to the management fees, we find
it unnecessary to address their alternative argument that the part-
nerships properly reported two activities to petitioner (or to the
upper tier partnerships or S Corporations).
Hillman v. Commissioner, 114 T.C. 103, 115 n.9 (2000).
10 HILLMAN v. INTERNAL REVENUE SERVICE
If, as the dissent suggests, the Hillmans had failed to raise a substan-
tive legal argument in their briefs and, instead, waited to raise it until oral
argument, I might agree that the argument is waived. Instead, however,
the issue is one of relief — whether the Hillmans have lost the opportu-
nity to have the district court address the argument that was specifically
preserved by the Tax Court when it ruled in their favor on one of the
bases they presented at trial.
Federal Rule of Appellate Procedure 28(a)(10) requires that the appel-
lant’s brief contain "a short conclusion stating the precise relief sought."
Rule 28(b) requires the appellee’s brief to "conform to the requirements
of Rule 28(a)(1)-(9) and (11)" but patently omits the requirement that the
appellee’s brief conform with Rule 28(a)(10). Charles Alan Wright et al.,
Federal Practice and Procedure § 3974.2 (1999) ("[A]ppellate Rule
28(b) provides that it shall conform to the requirements of paragraphs (1)
to (9) and (11) of Rule 28(a) for the brief of the appellant . . . . The one
conspicuous omission from the listing in Rule 28(b) . . . is the paragraph
that requires an appellant’s brief to contain a short conclusion stating the
precise relief sought." (internal quotation marks omitted)). Therefore, it
was the Commissioner’s burden and not the Hillmans’ to request the
appropriate relief. As a result, the Hillmans should not now be penalized
for that which they were not required to do in the first instance.
Moreover, the dissent conflates the Hillmans’ failure to request relief
with failure to raise a substantive legal argument. As the dissent notes,
this Court normally considers arguments not raised in the appellant’s
opening brief to be waived. See Edwards v. City of Goldsboro, 178 F.3d
231, 241 n.6 (4th Cir. 1999) ("Federal Rule of Appellate Procedure
28(a)(9)(A) requires that the argument section of an appellant’s opening
brief must contain the appellant’s contentions and the reasons for them,
with citations to the authorities and parts of the record on which the
appellant relies. . . . Failure to comply with the specific dictates of this
rule with respect to a particular claim triggers abandonment of that claim
on appeal." (internal citations and quotation marks omitted)). Likewise,
Rule 28(b) requires Rule 28(a)(9) compliance by appellees at the risk of
abandonment of an argument. Here, however, the Hillmans did not fail
to raise a substantive legal argument; instead, at oral argument, the Hill-
mans informed this Court of the appropriate relief should their argument
on the merits fail. Specifically, the Hillmans asked that the case be
remanded for resolution of an argument raised before the Tax Court upon
which the Tax Court had reserved ruling. The Hillmans’ request for alter-
HILLMAN v. INTERNAL REVENUE SERVICE 11
Judge Wilkins joins in this part of the opinion.
REVERSED AND REMANDED
HAMILTON, Senior Circuit Judge, dissenting in part:
Remand of this case in order for the Tax Court to address the Hill-
mans’ alternative argument is inappropriate. Accordingly, I dissent
from Part III of the court’s opinion.
Federal Rule of Appellate Procedure 28(b) provides, inter alia, that
an appellee’s brief must conform to the requirements of Federal Rule
of Appellate Procedure 28(a)(5) and (a)(9)(A). Thus, an appellee’s
brief must contain a statement of all issues presented for review, Fed.
R. App. P. 28(a)(5), and argument with respect to each of those issues
consisting of the appellee’s "contentions and the reasons for them,
with citations to the authorities and parts of the record on which" the
appellee relies, Fed. R. App. P. 28(a)(9)(A). This court has previously
deemed a claim abandoned on appeal where the appellant failed to
comply with Federal Rule of Appellate Procedure 28(a)(9)(A) with
respect to that claim. Edwards v. City of Goldsboro, 178 F.3d 231,
241 n.6 (4th Cir. 1999). This result only makes sense, given that with-
out negative consequences to a party’s failure to comply with Federal
Rule of Appellate Procedure 28, the requirements of the rule would
be hollow.
native relief does not constitute a substantive legal argument. Further,
granting the Hillmans’ request for a remand does not countenance "sand-
bagging" this Court or the Commissioner. Neither does it require this
Court or the Commissioner to consider complex legal issues requiring
detailed analysis without proper notice. Accordingly, we conclude that
the Hillmans’ failure to specify in their briefs the alternative relief they
desired does not prevent us from granting such relief. Cf. Hernandez v.
Starbuck, 69 F.3d 1089, 1093 (10th Cir. 1995) ("Because the appellant
comes to the court of appeals as the challenger, he bears the burden of
demonstrating the alleged error and the precise relief sought . . . . Though
Fed. R. App. P. 28(b) requires the appellee’s brief to contain arguments
addressing the issues raised by the appellant, we have never character-
ized the appellee’s obligation in terms of a categorical imperative.").
12 HILLMAN v. INTERNAL REVENUE SERVICE
Here, the Hillmans, as appellees, did not include their alternative
argument in the "Issues Presented" section of their appellate brief; nor
did they address the argument in the "Argument" section of their
appellate brief. Rather, they merely requested, for the first time at oral
argument, that in the event the panel rejected the legal basis upon
which the Tax Court ruled in their favor, the panel remand the case
for the Tax Court to consider their alternative argument that they
made below, but which the Tax Court expressly did not reach. Under
Federal Rule of Appellate Procedure 28(b) and Edwards, 178 F.3d at241 n.6, such a belated request is insufficient to preserve the Hill-
mans’ alternative argument for appellate review, and, a fortiori,
remand. As for the substantive legal argument/relief distinction made
by the majority, common sense dictates that if the Hillmans waived
their right to have this court consider their alternative argument on
appeal, they have also waived their right to have the district court
now, following resolution of the appeal, consider it in the first
instance.
For these reasons, I would reverse the Tax Court’s decision without
honoring the Hillmans’ unpreserved request for a remand.