Thomas P. and Ermina A. Krukowski v. Commissioner

114 T.C. No. 25UNITED STATES TAX COURT
THOMAS P. AND ERMINA A. KRUKOWSKI, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7765-98. Filed May 22, 2000.
P was the sole shareholder of two C corporations.
One corporation operated a health club; the other
operated a law firm for which P worked as an attorney.
P realized a loss renting a building to the health
club, and he realized income renting a building to the
law firm. P’s 1994 Federal income tax return reported
that the loss and income were both “passive” under sec.
469, I.R.C., and that the loss offset part of the
income. R disallowed the offset because, R determined,
the recharacterization rule of sec. 1.469-2(f)(6),
Income Tax Regs., deemed the income nonpassive. Held:
The recharacterization rule is valid. Held, further,
the written binding contract exception of sec. 1.469-
11(c)(1)(ii), Income Tax Regs., is inapplicable to the
facts herein. Held, further, the transitional rule of
sec. 1.469-11(b)(1), Income Tax Regs., does not operate
to avoid application of the recharacterization rule.
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Victor A. Kornis, for petitioners.
Christa A. Gruber, for respondent.
OPINION
LARO, Judge: This case is before the Court on cross-motions
for summary judgment. Respondent determined a $28,184 deficiency
in petitioner's 1994 Federal income tax and a $5,637 accuracy-
related penalty under section 6662(a). Petitioner, while
residing in Greendale, Wisconsin, petitioned the Court to
redetermine respondent’s determination.
Following respondent’s concession that petitioner is not
liable for the accuracy-related penalty, we must decide whether
petitioner may offset the income and loss that he realized on his
separate rental activities.1 We hold he may not. Unless
otherwise stated, section references are to the Internal Revenue
Code applicable to 1994. Rule references are to the Tax Court
Rules of Practice and Procedure. We refer to Thomas P. Krukowski
as the sole petitioner.
Background
Petitioner is the president and sole shareholder of two
subchapter C corporations. One corporation (the health club)
1
Petitioner asserts that he treated the separate rental
activities as a single activity under sec. 1.469-4(c)(1), Income
Tax Regs. The record does not support this assertion. To the
contrary, the record reveals that petitioner treated his rental
activities as separate activities.
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operates a health club. The other corporation (the law firm)
operates a law firm. Petitioner actively works for the law firm
as an attorney.
Petitioner rents a building (the club) to the health club,
and he rents a second building (the office building) to the law
firm. Petitioner’s 1994 Federal income tax return reported that:
(1) He realized a $69,100 loss on the rental of the club, (2) he
realized income of $175,149 on the rental of the office building,
(3) the rental of the club and the rental of the office building
were separate passive activities under section 469, and (4) the
loss from one activity offset an equal amount of the income from
the other activity, resulting in the inclusion in petitioner’s
1994 taxable income of $106,049 of rental income. Respondent
determined that the rental income could not partially be offset
by the rental loss; respondent determined that the income was
recharacterized as nonpassive income under section 1.469-2(f)(6),
Income Tax Regs.,2 because petitioner materially participated in
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
(continued...)
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the law firm’s business activity. Respondent determined that
petitioner’s 1994 taxable income includes $175,149 (rather than
the reported $106,049) of rental income.
Petitioner leased the office building to the law firm on
March 1, 1987, pursuant to a written, 5-year lease (the 1987
lease) that provided for monthly rent of $17,500. The 1987 lease
contained the following renewal provision:
24. 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, petitioner and the law firm executed a
document entitled “Lease Renewal” (the 1991 lease), pursuant to
2
(...continued)
participates (within the meaning of sec. 1.469-5T)
for the taxable year * * * [Sec. 1.469-2(f)(6),
Income Tax Regs.]
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the option provision in the 1987 lease. The 1991 lease provided
in full:
Lease Renewal
Lease Renewal made this 27 day of December 1991
between Thomas P. Krukowski, of Greendale, Wisconsin,
herein referred to as "Lessor" and Krukowski &
Costello, S.C., of Milwaukee, Wisconsin, herein
referred to as "Lessee".
Pursuant to Paragraph 24 entitled "Option to
Renew" in the Lease dated March 1, 1987 between Lessor
and Lessee (the "Lease"), Lessee hereby gives written
notice of its intention to exercise the first three
year option to renew the Lease.
The 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 $17,500.00.
LESSEE:
KRUKOWSKI & COSTELLO, S.C.
BY: s/
Timothy G. Costello, Secretary
Agreed to and Accepted this 27 day of December 1991
s/
Thomas P. Krukowski, Lessor
Discussion
The parties agree that we may decide this case by way of
summary judgment because, they assert, the dispositive issues are
purely legal. We agree that our decision herein turns entirely
on legal determinations, and, hence, that we may decide this case
summarily. Summary judgment is appropriate where, as here, "the
pleadings, answers to interrogatories, depositions, admissions,
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and any other acceptable materials, together with the affidavits,
if any, show that there is no genuine issue as to any material
fact and that a decision may be rendered as a matter of law."
Rule 121(b); see P & X Mkts., Inc. v. Commissioner, 106 T.C. 441,
443 (1996), affd. without published opinion 139 F.3d 907 (9th
Cir. 1998); see also Anderson v. Liberty Lobby, Inc., 477 U.S.
242, 247-251 (1986).
Petitioner challenges the ability of the Commissioner to
apply the recharacterization rule to the rental income from the
office building. Petitioner argues primarily that the
recharacterization rule is invalid because it conflicts with
explicit statutory text as to the characterization of income
derived from a rental activity. Petitioner observes that section
469(c)(2) and (4) provides that a rental activity is generally
passive and that the recharacterization rule provides that
certain rental income is nonpassive.
We disagree with petitioner that the recharacterization rule
is invalid. The recharacterization rule is a legislative
regulation, see Schwalbach v. Commissioner, 111 T.C. 215, 220
(1998) (the Secretary had to comply with the Administrative
Procedure Act (APA), 5 U.S.C. sec. 553(b) and (c) (1994), when he
prescribed sec. 1.469-2(f)(6), Income Tax Regs., because the
rules contained therein are legislative rather than
interpretative); see also Fransen v. United States, 191 F.3d 599,
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600 (5th Cir. 1999); thus, it is invalid only if it is arbitrary,
capricious, or manifestly contrary to the statute, see Chevron,
U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S.
837, 844 (1984); see also McKnight v. Commissioner, 99 T.C. 180,
183 (1992).
The rechacterization rule is not arbitrary, capricious, or
manifestly contrary to the statute.3 It was prescribed 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 limited partnership or other
passive activity to be treated as not from a passive activity”,
sec. 469(l)(3). The 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
3
The Court of Appeals for the Fifth Circuit has so
concluded. See Fransen v. United States, 191 F.3d 599 (5th Cir.
1999).
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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
activity, that have the effect of reducing active
business income and creating passive income * * *. [H.
Conf. Rept. 99-841, at 147, 1986-3 C.B. (Vol. 4) 1,
147.]
Petitioner also argues that the recharacterization rule is
inapplicable to this case by virtue of section 1.469-
11(c)(1)(ii), Income Tax Regs., which provides that the rule does
not apply to income “attributable to the rental of * * * property
pursuant to a written binding contract entered into before
February 19, 1988.” Petitioner asserts that the office building
lease in effect during 1994 was the 1987 lease, or, in other
words, that he leased the office building to the law firm during
1994 pursuant to a pre-February 19, 1988, written binding
contract. We disagree. As discussed below, we conclude that the
office building lease in effect during 1994 was the 1991 lease
and, moreover, that the 1991 lease and the 1987 lease are
separate contracts.
Applicable State (Wisconsin) law characterizes the 1991
lease as a renewal (as opposed to an extension) of the 1987
lease, which, in turn, means that the 1991 lease is a contract
separate from the 1987 lease. See Seefeldt v. Keske, 111 N.W.2d
574, 575-576 (Wis. 1961). We look at three critical factors to
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determine whether a contract is renewed or extended under
Wisconsin law and conclude therefrom that the 1991 lease is a
renewal of the 1987 lease.
First, the language used in both leases by the parties
thereto leads to the conclusion that the 1991 lease is a renewal
of the 1987 lease. See id. at 576-577. The leases refer several
times to a renewal; they refer only once to an extension.
Second, the parties’ conduct leads to the same conclusion.
See id. The 1991 lease was signed by an officer of the law firm
(other than petitioner) as “Lessee”, and it was signed by
petitioner as “Lessor”, under the heading “Agreed to and
Accepted”. If the parties to the leases had intended that the
lessee could extend the 1987 lease at its option, petitioner’s
signature and agreement would have been unnecessary.
Third, the fact that petitioner, as the office building’s
lessor, had to perform a further act to lengthen the term of the
1987 lease also leads to the conclusion that the 1987 lease was
renewed through the 1991 lease. Compare Milwaukee Hotel Wis. Co.
v. Aldrich, 62 N.W.2d 14 (Wis. 1953) (lease providing for initial
term of 3 years could be extended at lessee’s option for 3 more
years at rent stated in lease; held, lease is a 6-year lease
because no further act required of lessor once lessee makes
election), with St. Regis Apt. Corp. v. Sweitzer, 145 N.W.2d 711(Wis. 1966) (2-year lease automatically renews for 2 more years
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if neither party gives contrary notice; held, lease is 2-year
lease because either party can prevent renewal by giving notice).
See also Sheppard v. Rosenkrans, 85 N.W. 199 (Wis. 1901).
Petitioner, as lessor, had to agree with the lessee/law firm as
to the rent that would be payable for any additional rental
period after the first 5 years. Moreover, if they were unable to
reach such an agreement at least 30 days before the 5-year period
expired, petitioner possessed the sole discretion to declare the
option to renew null and void.
We also bear in mind that the absence in the 1987 lease of
an agreed-upon rent for the renewal period made the 1987 lease
unenforceable for any period after the 5-year period expired.
See Wis. Stat. Ann. sec. 704.03(1) (West 1998) (Wisconsin statute
of frauds provides that a lease for more than a year, or a
contract to make such a lease, is unenforceable unless it sets
forth the amount of rent or other consideration). In fact, an
enforceable contract for the additional period did not exist
until December 27, 1991, when the parties agreed on a rent for
the renewal period and created a writing memorializing that new
agreement. See Borkin v. Alexander, 132 N.W.2d 587 (Wis. 1965);
Ratcliff v. Aspros, 35 N.W.2d 217 (Wis. 1948).
Petitioner also argues that he is not subject to the
recharacterization rule by virtue of section 1.469-11(b)(1),
Income Tax Regs., which allows taxpayers, at their option, to use
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certain proposed regulations to ascertain their tax liability for
years ending after May 10, 1992, and beginning before October 4,
1994. See sec. 1.469-11(b)(1), Income Tax Regs. These proposed
regulations (the 1992 proposed regulations) were prescribed by
the Secretary in 1992 to define the word “activity” for purposes
of the passive loss rules. Notice of Proposed Rulemaking, PS-1-
89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992).
Petitioner argues that the 1992 proposed regulations preclude a
shareholder from participating in the activities of a C
corporation, which, petitioner concludes, means that the
recharacterization rule cannot be applied to his 1994 income from
the office building.
We disagree with petitioner’s assertion that section 1.469-
11(b)(1), Income Tax Regs., precludes taxpayers from
participating in activities conducted by C corporations. Our
conclusion is driven by a plain reading of the relevant text;
namely, section 469(a)(2)(A) and (h)(1) and section 1.469-
2(f)(6)(i), Income Tax Regs. See Commissioner v. Soliman, 506
U.S. 168, 174 (1993); Crane v. Commissioner, 331 U.S. 1, 6
(1947); Venture Funding, Ltd. v. Commissioner, 110 T.C. 236, 241-
242 (1998), affd. without published opinion 198 F.3d 248 (6th
Cir. 1999). Section 469(a)(2)(A) provides in relevant part that
the passive activity rules apply to “any individual”. Section
469(h)(1) provides in relevant part that an individual is treated
as materially participating in an activity when he or she “is
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involved in the operations of the activity on a basis which is *
* * regular, * * * continuous, and * * * substantial”.4 Section
1.469-2(f)(6)(i), Income Tax Regs., provides in relevant part
that rental income is recharacterized as nonpassive income if the
underlying property “Is rented for use in a trade or business
activity * * * in which the taxpayer materially participates”,
sec. 1.469-2(f)(6)(i), Income Tax Regs.
Nowhere in section 469 or the regulations thereunder do we
read, as petitioner asks us to hold, that an individual’s
“regular”, “continuous”, and “substantial” involvement in the
operations of an activity is not treated as materially
participating in that activity when the activity is operated by a
C corporation. Petitioner correctly observes that the Secretary
had set forth such an exception in two sets of temporary
regulations that he had prescribed before 1992. In 1988, the
Secretary prescribed section 1.469-5T(f)(1), Temporary Income Tax
Regs., 53 Fed. Reg. 5686, 5726 (Feb. 25, 1988), (the 1988
4
Although we understand the words “regular”, “continuous”,
and “substantial” to support a finding that petitioner materially
participated in the law firm’s business activity, we note that
petitioner also meets the definition of the term “material
participation” as set forth in the applicable regulations. Sec.
1.469-5T(a) and (d), Temporary Income Tax Regs., 53 Fed. Reg.
5686 (Feb. 25, 1988) (an individual materially participates in an
activity if, inter alia, he or she participates in an activity
for more than 500 hours in the taxable year, he or she
participates in the activity for more than 100 hours in the
taxable year and no other individual spends more time in the
activity, or the activity involves the performance of legal
services and the individual had materially participated in the
activity during any 3 years prior to the year in question).
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temporary regulations), providing that “any work done by an
individual * * * in connection with an activity in which the
individual owns (directly or indirectly, other than through a C
corporation) an interest at the time the work is done shall be
treated for purposes of this section as participation of such
individual in the activity.” One year later, in 1989, the
Secretary prescribed section 1.469-4T(b)(2)(ii)(B), Temporary
Income Tax Regs., 54 Fed. Reg. 20527, 20543 (May 12, 1989) (the
1989 temporary regulations), providing that “For purposes of
applying section 469 and the regulations thereunder, a taxpayer’s
activities do not include operations that a taxpayer conducts
through one or more entities (other than passthrough entities).”
As part of the regulatory project underlying the 1989
temporary regulations, the Secretary also amended the 1988
temporary regulations (the amended 1988 temporary regulations) to
delete the parenthetical exception “(directly or indirectly,
other than through a C corporation)” from section 1.469-5T(f)(1),
Temporary Income Tax Regs. Sec. 1.469-5T(f)(1), Temporary Income
Tax Regs. On May 15, 1992, the Secretary finalized the amended
1988 temporary regulations as section 1.469-5(f)(1), Income Tax
Regs. (the 1992 final regulations), leaving them virtually
unchanged in their final form. Two years later, in 1994, the
Secretary finalized a substantially revised version of the 1992
proposed regulations as section 1.469-4, Income Tax Regs. (the
1994 final regulations).
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The 1988 temporary regulations (prior to the 1989 amendment)
and the 1989 temporary regulations are not applicable to the year
at bar.5 The applicable rules are found in: (1) The 1992
proposed regulations, (2) the 1992 final regulations, and (3) the
1994 final regulations. The 1994 final regulations do not help
petitioner’s cause because they provide specifically that “A
taxpayer’s activities include those conducted through C
corporations that are subject to section 469”.6 Sec. 1.469-4(a),
Income Tax Regs. Nor are the 1992 final regulations of any help
to petitioner; as mentioned above, the parenthetical exception
“(directly or indirectly, other than through a C corporation)”
does not appear in those regulations. The 1992 proposed
regulations also do not help petitioner’s cause; the 1992
proposed regulations do not contain the exception set forth in
the 1989 temporary regulations.
Petitioner looks to the fact that the 1992 proposed
regulations did not affirmatively and expressly disavow the
exception set forth in the 1989 temporary regulations, and he
discerns therefrom that the exception continued to exist in 1992.
5
For completeness, we note that the Secretary allowed the
1989 temporary regulations to expire on May 11, 1992, under the
sunset provision of sec. 7805(e)(2). See 57 Fed. Reg. 20803 (May
15, 1992).
6
Neither party disputes that the corporation operating the
law firm is a C corporation subject to sec. 469. See sec. 1.469-
1T(b)(4) and (5), Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5701 (Feb. 25, 1988) (a C corporation is subject to sec. 469 if
it is a “Personal service” or “Closely held” corporation.
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We disagree. The fact that the Secretary did not re-prescribe
that exception as part of the 1992 proposed regulations is
persuasive evidence that he revoked the exception at that time.
See Keppel v. Tiffin Sav. Bank, 197 U.S. 356, 373 (1905) ("it
cannot in reason be said that the omission * * * gives rise to
the implication that it was the intention of Congress to reenact
it."); Independent Ins. Agents of Am., Inc. v. Clarke, 955 F.2d
731, 735 (D.C. Cir. 1992) (“Under traditional rules of statutory
construction, * * * material omitted on reenactment is deemed
repealed.”), revd. on other grounds sub nom. United States Natl.
Bank v. Independent Ins. Agents of Am., Inc., 508 U.S. 439(1993). See generally Singer, Sutherland Statutory Construction,
sec. 23.28, at 413 (5th ed. 1993). As we observed in Schwalbach
v. Commissioner, 111 T.C. 215, 228 (1998): “Although the * * *
[1992 proposed regulations were] silent on this rule, including
whether the Commissioner was considering abandoning it, we read
nothing in * * * [those] regulations that would lead us to
believe that the Commissioner was proposing to retain the rule.”
The facts of Schwalbach v. Commissioner, supra, are similar
to the facts at bar. There, the taxpayers challenged the
Commissioner’s application of the recharacterization rule to
income they had realized in 1994 on their rental of property to a
corporation owned by 2 shareholders, one of whom was one of the
taxpayers. The taxpayers argued primarily that the
recharacterization rule was invalid because the Secretary did not
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comply with the APA when he prescribed section 1.469-4(a), Income
Tax Regs.; if the Secretary had not complied with the APA, the
taxpayers argued, then the recharacterization rule was invalid as
applied to them. We concluded that the Secretary met the APA’s
requirements; in so doing, we analyzed the statutory text,
relevant legislative history, and various regulations prescribed
under section 469.
The taxpayers in Schwalbach also advanced an alternative
argument that is the same argument that petitioner advances
herein. The taxpayers in Schwalbach argued on brief:
in the event it is redetermined the provisions of
Treas. Reg. Sec. 1.469(d)(5) [sic] apply, the
provisions of Treas. Reg. Sec. 1.469-4T(b)(2)(ii)(B)
should be available to petitioners through 1994 due to
the continued confusion with respect to provisions of
the May, 1992, proposed regulations and the absence of
a definitive statement as regards a non-passthrough
entity not conducting passive activities through
itself. See, effective date and transition rules under
Treas. Reg. Sec. 1.469-11(b)(1).
We rejected this argument summarily, holding that nothing in
section 1.469-11, Income Tax Regs., allowed us to apply the
exception appearing in the pre-1992 regulations under which a
taxpayer would not be considered to be a material participant of
an activity conducted through a C corporation. See Schwalbach v.
Commissioner, supra at 230. We stated:
we decline petitioners' invitation to allow them to
apply the rules of section 1.469-4T(b)(ii)(B),
Temporary Income Tax Regs., 54 Fed. Reg. 20543, in lieu
of the rules stated in section 1.469-4(a), Income Tax
Regs. Simply put, the effective date and transition
rules related to the regulatory rules under section 469
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do not allow them to use it [i.e., the only rule stated
in sec. 1.469-4T(b)(ii)(B), Temporary Income Tax Regs.,
45 Fed. Reg. 20543 (May 12, 1989), namely, that “a
taxpayer's activities do not include operations that
the taxpayer conducts through one or more entities
(other than passthrough entities).”]. See sec.
1.469-11, Income Tax Regs. [Id.]
Although we recognize that section 1.469-11(b)(1), Income Tax
Regs., does not explicitly reference section 1.469-4T(b)(ii)(B),
Temporary Income Tax Regs., but, instead, allows taxpayers to use
the rules set forth in the 1992 proposed regulations, we believe
that this distinction is meaningless under the facts herein.
Whereas section 1.469-4T(b)(ii)(B), Temporary Income Tax Regs.,
contains an explicit rule under which a taxpayer is not
considered to participate in a C corporation’s activities,
petitioner effectively asks the Court to imply the same rule in
the 1992 proposed regulations by virtue of the fact that those
regulations are silent as to the inapplicability of such a rule.
We decline to do so. Accord Sidell v. Commissioner, T.C. Memo.
1999-301; Connor v. Commissioner, T.C. Memo. 1999-185.
We conclude that petitioner may not offset part of the
income that he realized on his rental of the office building to
the law firm, by the loss that he realized on his rental of the
club to the health club. We have considered all arguments in
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this case 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, and decision will be
entered for respondent.
Reviewed by the Court.
COHEN, WELLS, RUWE, COLVIN, CHIECHI, FOLEY, VASQUEZ, and
THORNTON, JJ., agree with this majority opinion.
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BEGHE, J., concurring in part and dissenting in part: I
agree with the majority that section 1.469-2(f)(6), Income Tax
Regs. (popularly known as the self-rental rule, and referred to
by the majority and hereinafter as the recharacterization rule),
as in effect interpreted by the final 1994 activity regulation,
section 1.469-4(a), Income Tax Regs., is a valid regulation. I
also agree that petitioners are not entitled to effective date
relief from the recharacterization rule under the pre-1988
written binding contract exception of section 1.469-11(c)(1)(ii),
Income Tax Regs. However, I respectfully dissent from the
majority’s conclusion that petitioners are not entitled, under
section 1.469-11(b)(1), Income Tax Regs., to transitional relief
from application of the recharacterization rule for 1994 to the
net rental income from Mr. Krukowski’s C corporation law firm.
The key question is whether shareholders did materially
“participate” in the “activities” of their C corporations under
the regulatory law applicable to 1994. The majority conclude
that shareholders did so participate, under their “plain reading”
of section 469 and the recharacterization rule and their
interpretation of the “silent” 1992 proposed regulations that
flows therefrom. I disagree.
I. The Majority’s “Plain Reading” of Section 469 and the
Recharacterization Rule Is Unprecedented and Incorrect
The majority’s plain meaning approach to this case is
unprecedented, in several disquieting respects. To begin with,
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neither party argued that the statutory text and the
recharacterization rule suffice to answer the question in issue.
Instead, the parties’ arguments were based on their respective
analyses of the applicable provisions of the several successive
sets of regulations the Commissioner has issued under section
469, interpreting the terms “participation” or “activity”.
More particularly, the parties have agreed that the 1994
final regulations, and the 1992 proposed regulations, are the
governing law. As discussed in more detail below, the 1994 final
activity regulation clearly provides that shareholders
participate in the activities of their C corporations; that
regulation generally applies to 1994. See sec. 1.469-11(a)(1),
Income Tax Regs. (sec. 1.469-4, Income Tax Regs., applies for
taxable years ending after May 10, 1992). However, the 1994
final regulations also contain a transitional rule applicable to
the year in issue. Section 1.469-11(b)(1), Income Tax Regs.,
provides that taxpayers may apply the 1992 proposed regulations
to 1994 if they so choose, instead of the 1994 final activity
regulation otherwise applicable. In other words, the 1994 final
regulations make the 1992 proposed regulations applicable to the
year in issue.
For this reason, the parties believed that the crucial issue
was whether shareholders participate in C corporation activities
under the 1992 proposed regulations, and they made their
arguments accordingly.
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The majority’s “plain reading” of section 469 and the
recharacterization rule is also inconsistent with our precedent.
In Schwalbach v. Commissioner, 111 T.C. 215 (1998), Sidell v.
Commissioner, T.C. Memo. 1999-301, and Connor v. Commissioner,
T.C. Memo. 1999-185, we considered the application of the
recharacterization rule to C corporation shareholders. None of
these opinions relied on the plain meaning of section 469 or of
the recharacterization rule. To the contrary, all three opinions
treated the 1994 final regulations (and the 1992 proposed
regulations made applicable thereby) as the governing law.
Our Schwalbach decision is a striking example of the
importance we have attributed to the 1994 final activity
regulation in this context. In Schwalbach, respondent applied
the recharacterization rule to a C corporation shareholder. The
taxpayers’ primary argument was that this application was
invalid, because: (1) The 1994 final regulation defining
“activity” was a prerequisite to the application of the
recharacterization rule to a C corporation shareholder; and (2)
the recharacterization rule and the 1994 final activity
regulation were invalid for failure to comply with the notice and
comment procedures of the Administrative Procedure Act, 5 U.S.C.
sec. 553(b) and (c) (1994). See Schwalbach v. Commissioner,
supra at 219.
In the course of Schwalbach’s detailed analysis of the
protracted regulatory process that ultimately gave rise to the
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1994 final activity regulation, we never questioned that that
regulation was a prerequisite to the application of the
recharacterization rule. Indeed, if shareholders clearly
participated in C corporation activities under the plain meaning
of the statute and the recharacterization rule, as the majority
now contend, Schwalbach’s analysis and upholding of the 1994
final “activity” regulation would be dictum.7
Most importantly, the majority’s plain meaning approach is
fundamentally inconsistent with the repeated efforts the
Commissioner has found it necessary to exert, through issuance of
different regulations, simply to interpret and apply the
assertedly “plain” language of section 469.
As the majority correctly observe, section 469 defines
“material participation” generally. Sec. 469(h). That section,
however, neither defines a taxpayer’s “activities”, nor expressly
7
Of course, in Sidell v. Commissioner, T.C. Memo. 1999-301,
and Connor v. Commissioner, T.C. Memo. 1999-185, we did conclude
that sec. 1.469-2(f)(6), Income Tax Regs. (the recharacterization
rule), could be applied to C corporation shareholders where the
regulations promulgated in T.D. 8565, 1994-2 C.B. 81, 59 Fed.
Reg. 50485 (Oct. 4, 1994) (the 1994 final regulations), and the
regulations promulgated in Notice of Proposed Rulemaking, PS-1-
89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992) (the 1992
proposed regulations), applied. I believe those decisions should
no longer be followed. As I explain in the text below, the 1992
proposed regulations, properly interpreted, prevent shareholder
participation in C corporation activities.
In any event, the majority rely little on Sidell and Connor
for their conclusion; perhaps this is because the majority’s view
of the governing law is so fundamentally different from the views
expressed in those opinions.
- 23 -
states whether a taxpayer can “participate” in the activities of
entities he owns. Nor does the recharacterization rule, which
uses these terms, provide a definition of either of them.
If I were writing on a clean slate, before the Commissioner
had issued any relevant regulations defining “material
participation” or “activity”, I might conclude that a shareholder
could participate in the activities of his C corporations, under
a plausible interpretation of the statute.8 However, the slate
was far from clean during the year in issue. As discussed in
more detail below, on at least four separate occasions--in 1988,
1989, 1992, and 1994–-the Commissioner issued temporary,
proposed, or final regulations interpreting “activity” or
“participation” for purposes of section 469.
Of course, the mere existence of these detailed and often
contradictory versions of the regulations is compelling evidence
that the meaning of section 469 is anything but plain.9 Above
8
I’m not sure, however, that even in the absence of
regulations I would agree with the majority that attributing C
corporation activities to the shareholder is a foregone
conclusion under either the statute or the recharacterization
rule. Both the tax common-law rule of Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943), and the necessity of statutory
stock ownership attribution rules in other areas, e.g., secs.
267, 318, and 544, would give me pause, even if they wouldn’t bar
this approach.
9
One of the section 469 regulations–-the temporary
“activity” regulation promulgated in 1989–-alone occupied over 20
pages of the Federal Register. See sec. 1.469-4T, Temporary
Income Tax Regs., 54 Fed. Reg. 20527, 20542-20565 (May 12, 1989).
As described in the text infra p. 34, the Commissioner allowed
(continued...)
- 24 -
all, however, the content of these successive regulations
demonstrates that the majority’s “plain meaning” interpretation
of the statute and the recharacterization rule is incorrect.
The majority conclude that shareholders participate in C
corporation activities under the plain meaning of section 469 and
the recharacterization rule. The fatal flaw of this conclusion
is that the Commissioner reached the opposite conclusion in the
section 469 regulations–-not once but twice.
In 1988 and 1989, the Commissioner was faced with the same
statutory language. And yet, during those years the Commissioner
interpreted that language--in temporary regulations having the
force of law--to conclude that shareholders did not participate
in C corporation activities. See the discussion of the 1988 and
1989 temporary regulations infra pp. 30-34.
The majority do not argue (or even dare to suggest) that the
express nonparticipation (or nonattribution) rules set forth in
the temporary regulations were invalid interpretations of the
statute. Moreover, none of the parties litigating (or courts
considering) the application of the recharacterization rule to C
corporation shareholders has ever argued or concluded that the
temporary regulations were invalid in this respect. The
9
(...continued)
this regulation to “sunset” under sec. 7805(e), partly as a
result of public criticism that it was overly long and complex,
burdensome for small taxpayers, and mechanically inflexible. See
Schwalbach v. Commissioner, 111 T.C. 215, 224 (1998).
- 25 -
Commissioner’s inclusion of express nonattribution rules in two
sets of temporary regulations therefore completely refutes the
majority’s conclusion that shareholders participate in C
corporation activities under the plain language of section 469
and the recharacterization rule.
II. The Silence of the 1992 Proposed Regulations Is Not
Dispositive
The majority correctly note that the Commissioner allowed
the relevant portions of the temporary regulations to “sunset” in
1992. See infra p. 34. At the same time, the Commissioner
promulgated the 1992 proposed regulations, which apply to the
year in issue. See id.Unlike the temporary regulations, the 1992 proposed
regulations say nothing about shareholder participation in C
corporation activities. The majority conclude, because the 1992
proposed regulations do not expressly preclude such
participation, that shareholders participate in C corporation
activities even when the proposed regulations apply. Once again,
I disagree.
The majority’s interpretation of the “silent” 1992 proposed
regulations rests on their conclusion that shareholders
participate in C corporation activities under the plain meaning
of the statute and the recharacterization rule. As explained
above, the majority’s plain reading is incorrect; their
interpretation of the 1992 proposed regulations is therefore also
- 26 -
incorrect. The silence of the 1992 proposed regulations simply
does not require (or as explained below, even permit) us to reach
the majority’s result.
III. The Silence of the 1992 Proposed Regulations Must Be
Interpreted in Light of the Prior and Subsequent
Regulations
In essence, the majority view section 469 and the
recharacterization rule as self-executing and as mandating a rule
of shareholder participation in C corporation activities unless
another rule expressly bars such participation. Consistent with
this view, the majority conclude that the silent 1992 proposed
regulations cannot constitute the necessary bar.
My view is different. I see section 469-–particularly as
implemented by the recharacterization rule--as an ambiguous
statute, which the Commissioner reasonably interpreted, in
temporary regulations having the force of law--not once but
twice-–as precluding shareholder participation in C corporation
activities.
Of course, the Commissioner later adopted a contrary
interpretation. However, the Commissioner did not publicly
announce this contrary interpretation until 1994, when he issued
the 1994 final regulations. This announcement came more than 6
years after the 1988 temporary regulations, and almost at the end
of 1994, the taxable year in issue. See Schwalbach v.
Commissioner, 111 T.C. at 226, where we stated that “up until the
[1994] final regulations, the Commissioner had not publicly taken
- 27 -
the position that an individual’s activities could include
activities conducted through a C corporation.”
I agree that the Commissioner is entitled to change his
mind; we so decided in Schwalbach. However, under the
circumstances of this case, where the Commissioner had issued two
sets of temporary regulations taking a position favorable to
taxpayers (and petitioners), the standards of fairness developed
by this Court (discussed in more detail below) require that the
Commissioner publicly announce his change of position, before the
new position can take effect. See Georgia Fed. Bank v.
Commissioner, 98 T.C. 105, 110 (1992), where we stated that an
agency that changes its position must acknowledge that its
interpretation has shifted and must supply a persuasively
reasoned explanation for the change. See also Gottesman & Co. v.
Commissioner, 77 T.C. 1149 (1981), and Corn Belt Hatcheries of
Arkansas, Inc. v. Commissioner, 52 T.C. 636 (1969) (discussed
infra pp. 48-50), where we decided that taxpayers were entitled
to rely on withdrawn or unclarified guidance from the
Commissioner, until the Commissioner publicly announced his new
or clarified position.
Against this background, the proper interpretation of the
“silent” 1992 proposed regulations becomes vitally important.
Although the Commissioner allowed the relevant portions of the
1988 and 1989 temporary regulations to “sunset” in 1992 and
replaced them with the 1992 proposed regulations, neither these
- 28 -
actions, nor the silent proposed regulations themselves,
constituted the necessary public announcement of the
Commissioner’s change of position from the temporary regulations.
Prior to the issuance of the 1994 final regulations,
taxpayers could not know (or, as explained below, even infer)
that the Commissioner had changed his interpretation of section
469 and the recharacterization rule. Although this delay did not
render the 1994 final regulations invalid, the standards of
fairness developed by this Court require that we interpret the
silence of the 1992 proposed regulations as preserving the
interpretation of the statute previously promulgated in both sets
of temporary regulations. Once that silence is so interpreted,
the transitional rule of the 1994 final regulations can perform
its relief-providing function, and protect taxpayers from the
unannounced and unanticipated change those regulations made to
the Commissioner’s prior interpretations of the law.
In reaching this conclusion, I’m not suggesting that the
Commissioner lacked the power to prescribe a final regulation
that would have applied the new activity definition
retroactively.10 As we concluded in Schwalbach, the
10
See sec. 7805(b) (the Secretary may prescribe the extent,
if any, to which a regulation shall be applied without
retroactive effect); Automobile Club of Michigan v. Commissioner,
353 U.S. 180, 184 (1957) (Commissioner may correct any regulation
retroactively, but also has discretion to limit retroactivity to
avoid inequitable results); cf. sec. 7805(b) as in effect for
regulations relating to statutory provisions enacted after July
(continued...)
- 29 -
Commissioner’s actions had at least alerted taxpayers to the
possibility that the definition of activity was under
reconsideration. What we should decide in the case at hand,
however, is that by promulgating the transitional rule of the
1994 final regulations, the Commissioner wisely chose to apply
the new activity definition prospectively, unless the taxpayer
benefited otherwise.
In summary, the majority’s plain reading of section 469 and
the recharacterization rule is an inadequate analysis of, and a
woefully inadequate response to, the situation in which
petitioners (and other similarly situated taxpayers) found
themselves during the year in issue. To understand that
situation fully-–and to interpret the silent 1992 proposed
regulations properly--it’s unfortunately necessary to describe
the long and tortuous history of the section 469 regulations (and
the parties’ arguments based thereon) in more detail; to that
task I now turn.
10
(...continued)
29, 1996. Of course, the Commissioner’s unexplained reversal of
position from the regulations promulgated in T.D. 8175, 1988-1
C.B. 191, 53 Fed. Reg. 5686 (Feb. 25, 1988) (the 1988 temporary
regulations), and in T.D. 8253, 1989-1 C.B. 121, 54 Fed. Reg.
20527 (May 12, 1989) (the 1989 temporary regulations), would be
relevant in any judicial review of the 1994 final regulations, if
the Commissioner had decided to apply those regulations
retroactively. See Georgia Fed. Bank v. Commissioner, 98 T.C.
105 (1992).
- 30 -
IV. Development of the Regulations Over Time
The recharacterization rule recharacterizes rental income
from property “rented for use in a trade or business activity * *
* in which the taxpayer materially participates * * * for the
taxable year”. Sec. 1.469-2(f)(6)(i), Income Tax Regs. During
1994, Mr. Krukowski rented the office building to the law firm.
Therefore, the recharacterization rule applies to petitioners’
income from the office building for that year only if Mr.
Krukowski materially “participated” in a trade or business
“activity” of the law firm during that year.
Because the law firm is a C corporation, we’re required to
decide whether a shareholder could participate in a trade or
business activity of his C corporation under the law applicable
to 1994. In 1988, 1989, 1992, and 1994, the Commissioner issued
temporary, proposed, or final regulations defining “activity” or
“material participation” for purposes of section 469. We must
therefore trace these regulations’ successive answers to that
question.
A. The 1988 Temporary Regulations
In 1988, the Commissioner issued the first section 469
regulations. See T.D. 8175, 1988-1 C.B. 191, 53 Fed. Reg. 5686(Feb. 25, 1988) (the 1988 temporary regulations). The 1988
temporary regulations contained the first version of the
recharacterization rule (see sec. 1.469-2T(f)(6), Temporary
Income Tax Regs., 53 Fed. Reg. 5686, 5723 (Feb. 25, 1988)). That
- 31 -
rule, like the current rule, applied where property was rented to
an “activity” in which the taxpayer materially “participates”.
The 1988 temporary regulations didn’t define “activity”.
See sec. 1.469-4T, Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5725 (Feb. 25, 1988), which stated in full: “Definition of
activity (temporary). [Reserved]”. They did, however, contain a
regulation entitled “Material participation”, which defined both
“participation” and the kind of participation deemed to be
material. Sec. 1.469-5T, Temporary Income Tax Regs., 53 Fed.
Reg. 5686, 5725-5728 (Feb. 25, 1988). The participation
definition in section 1.469-5T of the 1988 temporary regulations
provided:
(f) Participation–-(1) In general. Except as
otherwise provided in this paragraph (f), any work done
by an individual (without regard to the capacity in
which the individual does such work) in connection with
an activity in which the individual owns (directly or
indirectly, other than through a C corporation) an
interest at the time the work is done shall be treated
for purposes of this section as participation of such
individual in the activity. [Sec. 1.469-5T(f)(1),
Temporary Income Tax Regs., 53 Fed. Reg. 5686, 5726
(Feb. 25, 1988); emphasis added.]
The second parenthetical of this 1988 definition clearly
provided that an individual shareholder did not participate (and
thus could not materially participate) in the activities of his C
corporations.11 As a result, under the 1988 temporary
11
Unless the shareholder also owned a passthrough interest
in the C corporation’s activity, through which he could be
considered to participate. See sec. 1.469-5T(k), Examples (1)
(continued...)
- 32 -
regulations the recharacterization rule could not apply to income
received by a C corporation’s shareholder/lessor, notwithstanding
the absence of an “activity” definition in those regulations.
B. The 1989 Temporary Regulations
In 1989, the Commissioner issued T.D. 8253, 1989-1 C.B. 121,
54 Fed. Reg. 20527 (May 12, 1989) (the 1989 temporary
regulations). The 1989 temporary regulations amended certain
provisions of the 1988 temporary regulations; they also contained
the first regulation defining “activity” for purposes of section
469, section 1.469-4T, Temporary Income Tax Regs., 54 Fed. Reg.
20527, 20542 (May 12, 1989). See T.D. 8253, 1989-1 C.B. 121,
supra at “Summary”.
The 1989 temporary regulations amended the participation
definition contained in the 1988 temporary regulations by
deleting the parenthetical phrase “(directly or indirectly, other
than through a C corporation)”. Sec. 1.469-5T, Temporary Income
Tax Regs., 54 Fed. Reg. 20527, 20565 (May 12, 1989).12 As a
result, the material participation definition in the 1989
11
(...continued)
and (2), 53 Fed. Reg. 5686, 5727 (Feb. 25, 1988).
12
The majority opinion refers to the participation
definition of the 1988 temporary regulations, as amended by the
1989 temporary regulations, as the “amended 1988 temporary
regulations”. I prefer to describe the Commissioner’s
simultaneous 1989 definitions of both “participation” and
“activity” as the 1989 temporary regulations; after all, it was
those definitions taken together that established the law
applicable to 1989.
- 33 -
temporary regulations no longer expressly stated that a
shareholder could not participate in the activities of his C
corporations.
At first blush, one might think that this elimination of
restrictive language–-and the resulting silence about whether
individuals could participate in their indirectly owned
activities-–might mean that individuals could participate in the
activities of all their entities, including C corporations.
However, this was not the case. The new definition of “activity”
contained in section 1.469-4T of the 1989 temporary regulations
expressly provided that a shareholder did not participate in the
activities of his C corporations.13 As a result of this new
13
New sec. 1.469-4T of the 1989 temporary regulations
defined activity for purposes of the passive loss rules. See
sec. 1.469-4T, Temporary Income Tax Regs., 54 Fed. Reg. 20527,
20542 (May 12, 1989). Sec. 1.469-4T(b)(2)(ii)(B) of those
regulations provided that for purposes of section 469 and the
regulations thereunder “a taxpayer’s activities do not include
operations that a taxpayer conducts through one or more entities
(other than passthrough entities).” Id. at 20543. Sec. 1.469-
4T(b)(2)(i) in turn defined “passthrough entity”; that definition
did not include C corporations. Id. at 20543.
A shareholder’s inability to participate in the activities
of his C corporations under the cited provisions was made clear
by the example accompanying section 1.469-4T(b)(2) of the 1989
temporary regulations. In the facts of that example, taxpayer A
owned stock of closely held corporation X. The example stated:
X is a C corporation and therefore is not a passthrough
entity. Thus, for purposes of section 469 and the
regulations thereunder, A’s activities do not include
the operations of X’s real estate development business.
Accordingly, A’s participation in X’s business is not
participation in an activity of A, and is not taken
(continued...)
- 34 -
activity definition, it was clear that a shareholder did not
participate in C corporation activities under the 1989 temporary
regulations–-notwithstanding the silence on this issue in the
material participation definition itself.
C. The 1992 Proposed Regulations
In 1992, the Commissioner adopted the participation
definition of the 1989 temporary regulations substantially
unchanged, as final regulation section 1.469-5(f)(1), Income Tax
Regs. See T.D. 8417, 1992-1 C.B. 173, 57 Fed. Reg. 20747 (May
15, 1992).14 At the same time, the Commissioner allowed the
activity definition of the 1989 temporary regulations to “sunset”
under section 7805(e). The Commissioner replaced that definition
with a new proposed activity regulation, section 1.469-4,
Proposed Income Tax Regs. See Notice of Proposed Rulemaking, PS-
1-89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992) (the
1992 proposed regulations). Unlike the 1989 temporary
regulations, the 1992 proposed regulations didn’t contain a
general purpose definition of a taxpayer’s activities. Instead,
the 1992 proposed regulations were silent on whether a
shareholder could participate in the activities of his C
13
(...continued)
into account in determining whether A materially
participates (within the meaning of 1.469-5T) * * *
in any activity. [Sec. 1.469-4T(b)(2), Temporary
Income Tax Regs., 54 Fed. Reg. 20543-20544 (May 12,
1989).]
14
The majority opinion refers to this definition as the
1992 final regulations.
- 35 -
corporations. The effect of this silence on the application of
the recharacterization rule is what’s in issue in this case.
D. The 1994 Final Regulations
In 1994, the Commissioner issued T.D. 8565, 1994-2 C.B. 81,
59 Fed. Reg. 50485 (Oct. 4, 1994) (the 1994 final regulations).
The 1994 final regulations didn’t change the participation
definition adopted at the time of the 1992 proposed regulations.
However, the 1994 final regulations substantially revised the
1992 proposed regulations’ activity definition, by adding the
following statement to the “scope and purpose” provision: “A
taxpayer’s activities include those conducted through C
corporations that are subject to section 469, S corporations, and
partnerships.” Sec. 1.469-4(a), Income Tax Regs. As a result of
this change, it was clear that a shareholder would materially
participate in the activities of his C corporations under the
1994 final regulations-–even though the participation definition
itself was not affected.
The following table summarizes the development over time of
the activity and material participation definitions in the
section 469 regulations, as described above. It also notes
whether, as a result of those definitions, a shareholder could
participate in the activities of his C corporations.
- 36 -
Provision re shareholder’s
participation in his C
corporation’s activities
“Material
“Activity” participation” Overall
Year/event regulation regulation effect
1988 temporary Silent Parenthetical Shareholder
regulations (no activity expressly does not
(T.D. 8175) regulation) provides participate in
shareholder C corporation
does not activities
participate in
C corporation
activities
1989 temporary Definition and Silent Shareholder
regulations example (parenthetical does not
(T.D. 8253) expressly removed) participate in
provide C corporation
shareholder activities
does not
participate in
C corporation
activities
1992 proposed Silent Silent ???
regulations (no definition (same as (at issue in
(PS-1-89) or example) above) the case at
hand)
1994 final Expressly Silent Shareholder
regulations provides that (same as participates
(T.D. 8565) taxpayer’s above) in activities
activities of C
include those corporations
conducted subject to
through C sec. 469
corporations
subject to
sec. 469
V. The 1992 Proposed Regulations Control This Case
As the above discussion makes clear, the 1988 and 1989
temporary regulations expressly provided that shareholders did
- 37 -
not participate in C corporation activities; the 1994 final
regulations expressly provide that shareholders do so
participate. The 1992 proposed regulations said nothing about
this issue.
The 1994 final regulations generally apply to 1994. See
sec. 1.469-11(a)(1), Income Tax Regs. (sec. 1.469-4, Income Tax
Regs., applies for taxable years ending after May 10, 1992).
However, taxpayers may choose to apply the 1992 proposed
regulations, rather than the 1994 final regulations, to determine
tax liability for years ending after May 10, 1992 and beginning
before October 4, 1994. See sec. 1.469-11(b)(1), Income Tax
Regs.
The parties agree that the 1992 proposed regulations apply
to this case.
VI. We Need Not Infer that Shareholders Participate in
C Corporation Activities Under the 1992 Proposed
Regulations
The majority conclude (as respondent argued) that the
silence of the 1992 proposed regulations must be interpreted as
allowing shareholder participation in C corporation activities.
According to the majority (and respondent), because the 1992
proposed regulations do not contain the express nonparticipation
rule of the temporary regulations, it must be inferred that the
Commissioner did not intend to continue that rule in the 1992
proposed regulations. The majority conclude that it must be
inferred further that shareholders participate in C corporation
- 38 -
activities where the 1992 proposed regulations apply. I
disagree.15
A. The Proposed Regulations’ Silence Is Ambiguous
The long and tortuous history of the section 469 regulations
proves that we need not infer a shareholder participation rule
from the silence of the 1992 proposed regulations. To the
contrary, the history shows that silence was ambiguous.
The recharacterization rule employs the terms “activity”
and “material participation”. As the table, supra p. 36, clearly
shows, under both the 1988 and 1989 temporary regulations, the
definition of one of these key terms didn’t discuss a
shareholder’s participation in C corporation activities.
Nevertheless, under both sets of temporary regulations, a
shareholder clearly did not participate in C corporation
activities, because one or the other of the two key terms was
interpreted as precluding attribution of or participation in such
activities.
15
Our memorandum opinion in Sidell v. Commissioner, T.C.
Memo. 1999-301, made a similar inference in support of its
conclusion that shareholders participate in corporate activities
under the 1992 proposed regulations. Although Sidell v.
Commissioner, 78 T.C.M. (CCH) 53,537 at 430, 1999 T.C.M. (RIA)
par. 99,301 at 99-1929, stated that “Simply put, the proposed
regulations’ silence means nothing, not something”, Sidell
nevertheless concluded that from this silence “it is inferable”
that the Commissioner didn’t intend, in the 1992 proposed
regulations, to adhere to the position of the temporary
regulations.
- 39 -
Under the 1994 final regulations, one of the key
definitions–-regarding material participation--still does not
address the question of C corporation shareholder participation.
Yet, as a result of the new activity definition contained in
those regulations, a shareholder clearly participates in C
corporation activities under the regulations as a whole.
The result of all this is that in 1988 and 1989, regulatory
silence with respect to one of the key terms employed by the
recharacterization rule meant that a shareholder did not
participate in C corporation activities. By contrast, in 1994,
such regulatory silence means that the shareholder does
participate in those activities. Under these circumstances, it
is difficult to infer either an intent to repeal a
nonparticipation rule, or an intent to prescribe a participation
rule, from the “silence” of the 1992 proposed regulations. More
tellingly, it would have been far more difficult for petitioners
to divine either of these results from that silence during 1994,
the year in issue; the 1994 final regulations were not
promulgated until October of that year. See supra p. 35.
B. The Canons of Construction Do Not Mandate A
Participation Interpretation
The majority attempt to support their interpretation of the
1992 proposed regulations by reference to a canon of statutory
construction. However, canons of construction simply do not
require us to reach the majority’s result.
- 40 -
The majority note that material contained in earlier-
enacted legislation, but omitted in subsequently enacted
legislation, is deemed to be repealed by the subsequent
enactment. The majority employ this canon (and apply it to
regulations) to support their conclusion that the 1992 proposed
regulations’ failure to restate one or the other of the express
nonparticipation rules contained in the 1988 and 1989 temporary
regulations means that the 1992 proposed regulations repealed
that rule.
Although the majority’s canon may be helpful at times, this
case should not (and need not) be decided by a canon of
construction. First, the canon cited by the majority is far from
an absolute rule. It may be disregarded where the lawmaker’s
intent is found to be otherwise. See Singer, Sutherland
Statutory Construction, sec. 23.32 at 283 and sec. 23.12 at 363
(5th ed. 1993).
Second, and more importantly, the canons of construction
usually cut both ways, see Llewellyn, The Common Law Tradition:
Deciding Appeals 521-535 (1960), even when they’re not just
wrong. See Posner, Statutory Interpretation--in the Courtroom
and in the Classroom, 50 U. of Chi. L. Rev. 800, 806 (1983).16
16
The temporary regulations contain an excellent example of
a situation in which the majority’s canon would produce the wrong
answer. The 1988 temporary regulations’ participation definition
contained language expressly preventing shareholder participation
in C corporation activities. The 1989 temporary regulations
(continued...)
- 41 -
For example, another canon of construction, applied in
Smietanka v. First Trust & Sav. Bank, 257 U.S. 602, 607 (1922),
on the effect of material added on reenactment, not material
omitted, cuts against the majority’s argument. In First Trust &
Sav. Bank, the Supreme Court treated the addition of an express
rule, by a later enactment, as proof the rule was not included in
the analogous provisions of an earlier statute.
The 1994 final regulations expressly state that a
shareholder’s activities include those conducted through C
corporations subject to section 469. The silent 1992 proposed
regulations contained no such participation/attribution rule.
Therefore, the First Trust & Sav. Bank canon of construction
suggests that shareholders did not participate in C corporation
activities under the 1992 proposed regulations. As the Supreme
Court concluded in First Trust & Sav. Bank, where a provision has
been added to a later act, a court cannot supply the omission in
the earlier act.17
16
(...continued)
deleted this language. Applying the majority’s canon, one would
conclude the Commissioner intended shareholders to participate in
C corporation activities under the later regulation. However,
this was not the case, as the activity definition of the 1989
temporary regulations clearly shows. See supra pp. 32-34.
17
One other point: the cases cited by the majority to
support their canons of construction argument concern situations
where an express rule was clearly required to sustain a party’s
position. For example, Independent Ins. Agents of Am., Inc. v.
Clarke, 955 F.2d 731 (D.C. Cir. 1992), revd. on other grounds sub
nom. United States Natl. Bank v. Independent Ins. Agents of Am.,
(continued...)
- 42 -
C. The Express Participation Rule of the 1994 Final
Regulations Did Not “Clarify” the 1992 Proposed
Regulations
To support the position that shareholders participate in C
corporation activities under the 1992 proposed regulations,
respondent additionally argued that the express participation
rule of the 1994 final regulations simply “clarified” the 1992
proposed regulations. This is also incorrect.
The 1994 final regulations included the following sentence
dealing with the “scope and purpose” of the activity definition:
“A taxpayer’s activities include those conducted through C
corporations that are subject to section 469, S corporations, and
partnerships.” Sec. 1.469-4(a), Income Tax Regs. (the express
participation (or attribution) rule). It is true that the
preamble to the 1994 final regulations stated that this language
17
(...continued)
Inc., 508 U.S. 439 (1993), concerned a national bank’s ability to
sell insurance. In the Court of Appeals’ view, section 24 of the
National Bank Act, 12 U.S.C. sec. 24 (1988), limited banks’
activities to those expressly authorized by law. Starting from
this premise, it of course followed, after Congress omitted the
section of the banking laws authorizing banks to sell insurance,
that banks no longer had the power to do so.
The majority assert that an express nonattribution rule is
necessary to prevent shareholder participation in C corporation
activities. As made clear in the text, this is incorrect. The
Commissioner’s interpretations of the statute in both sets of
temporary regulations, the Commissioner’s inclusion of an express
participation rule in the 1994 final regulations, and our
decision in Schwalbach v. Commissioner, 111 T.C. 215 (1998),
treating the 1994 final regulations as necessary, all suggest
that shareholders do not participate in C corporation activities,
under the plain meaning of section 469.
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was a clarification. See T.D. 8565, 1994-2 C.B. 81, 59 Fed. Reg.
50485 (Oct. 4, 1994), at “Supplementary Information: Explanation
of Provisions; II. Public Comments”. Under the circumstances of
this case, however, there is no reason to give the Commissioner’s
retrospective rationalization contained in the preamble to the
1994 final regulations any more interpretative weight than
respondent’s litigating position.
Of course, a preamble may be used as an aid in interpreting
the regulation it accompanies. See Armco, Inc. v. Commissioner,
87 T.C. 865, 868 (1986). But the case at hand concerns the
meaning of the 1992 proposed regulations, not the meaning of the
1994 final regulations. The 1994 preamble was not a
contemporaneous interpretation of the 1992 regulations in issue.
As a retrospective rationalization, it’s entitled to little or no
interpretative weight. See id. at 868, where we stated:
The proper interpretation of a regulation as a matter
of law is a responsibility that ultimately rests with
the courts. In exercising its judicial function, the
court may be aided by the views of the drafters on the
intended meaning of the language, but to be accorded
any weight, those views cannot be post hoc * * * .
More importantly, the preamble’s statement that the language
added to the 1992 proposed regulations’ activity definition by
the 1994 final regulations was only a clarification simply does
not withstand scrutiny. According to the preamble, the new
language clarified a “grouping” rule contained in the 1992
proposed regulations, by explaining that a taxpayer could group
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activities conducted through C corporations with other
activities. See 59 Fed. Reg. 50485, 50486 (Oct. 4, 1994). The
1992 proposed regulations’ grouping rule (contained in section
1.469-4(j) of the 1992 proposed regulations, 57 Fed. Reg. 20802,
20805 (May 15, 1992)) had provided as follows:
(j) Activities conducted through partnerships or
S corporations. A partnership or S corporation must
group its activities under the rules of this section.
Once a partnership or S corporation determines its
activities, a partner or shareholder groups those
activities with activities conducted directly by the
partner or shareholder or with activities conducted
through other partnerships or S corporations in
accordance with the rules of this section.
As the above-quoted passage makes clear, the grouping rule
of the 1992 proposed regulations provided that a taxpayer could
group activities conducted through passthrough entities with
activities conducted directly. Notwithstanding the
Commissioner’s claim in the preamble, I fail to understand how a
rule entitled “Activities conducted through partnerships or S
corporations”, and which refers explicitly several times only to
such passthrough entities, could be “clarified” to provide that a
taxpayer may group activities conducted through nonpassthrough
entities as well, such as “C corporations that are subject to
section 469".
Our decision in Schwalbach v. Commissioner, 111 T.C. 215(1998), also establishes that the express attribution rule of the
1994 final regulations was not simply a “clarification” of the
1992 proposed regulations. Although our memorandum opinion in
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Connor v. Commissioner, T.C. Memo. 1999-185, suggested Schwalbach
had concluded that the 1994 final regulations clarified the
proposed regulations, what we actually said in Schwalbach was
that the preamble to the final regulations itself asserted that
the inclusion of an attribution rule in the final regulations was
a clarification; we didn’t so conclude ourselves. To the
contrary, in Schwalbach v. Commissioner, supra at 221-226, we
described the language added to the 1994 final regulations as a
“change” from the 1992 proposed regulations, as a “new position”,
and as a “complete reversal” from the 1989 temporary regulations.
We also stated that “the change in language from the proposed
regulations was substantial; up until the final regulations, the
Commissioner had not publicly taken the position that an
individual’s activities could include activities conducted
through a C corporation.” Id. at 226.
VII. Fairness Demands We Interpret the Silence of the 1992
Proposed Regulations as Continuing the
Nonparticipation Rule of the Temporary Regulations
Respondent and the majority assert that the silence of the
1992 proposed regulations must be interpreted as repealing the
nonparticipation rule of the temporary regulations and as
prescribing an express participation rule instead. For the
reasons just set forth, I disagree. Placing the silence of the
1992 proposed regulations in its proper context, it’s difficult
to infer from such silence either an intent to repeal a
nonparticipation rule, or an intent to prescribe a participation
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rule. With respect to the issue in the case at hand, the
recharacterization rule and the 1992 proposed regulations are
ambiguous.
Nevertheless, setting aside for the moment any inferences
that may be drawn from the silence (or other ambiguity) of the
1992 proposed regulations, three aspects of those regulations are
crystal clear. First, the 1992 proposed regulations do not
expressly provide that a shareholder participates in C
corporation activities. Second, the 1992 proposed regulations do
not expressly disavow the rule of nonattribution that had been
set forth in the 1988 and 1989 temporary regulations. Third, the
1992 proposed regulations neither state that the Commissioner was
changing his position on shareholder participation in C
corporation activities, nor explain why such a change was being
made. For all these reasons, the standards of fairness developed
by this Court require us to interpret the ambiguity of the 1992
proposed regulations as maintaining the nonattribution
interpretation of the statute and the recharacterization rule
formerly contained in the temporary regulations.
As an example of these standards of fairness, we noted in
Georgia Fed. Bank v. Commissioner, 98 T.C. at 110, that sharp
changes of agency course constitute danger signals to which a
reviewing court must be alert; we also stated that an agency that
changes its position must acknowledge that its interpretation has
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shifted, and must supply a persuasively reasoned explanation for
the change.18
It is in this context that (contrary to the statement in
Sidell v. Commissioner, T.C. Memo. 1999-301) the silence of the
1992 proposed regulations means something, not nothing. The
silent proposed regulations could not (and did not) serve as the
required public announcement of the Commissioner’s change of
position from the temporary regulations, or as the required
explanation of the reasons for that change. It is uncontested
that the first public announcement by the Commissioner of his
complete reversal of position was contained in the 1994 final
regulations, which were not published in the Federal Register
until October 4, 1994. See Schwalbach v. Commissioner, supra at
226; 59 Fed. Reg. 50485 (Oct. 4, 1994) (promulgation of 1994
final regulations).
I agree with our conclusion in Schwalbach v. Commissioner,
supra, that the silence of the 1992 proposed regulations alerted
taxpayers to the possibility that the Commissioner was
considering changing the nonattribution rule contained in the
18
In Georgia Fed. Bank v. Commissioner, 98 T.C. 105, 109-
110 (1992), we also observed that if a regulation repudiates an
earlier interpretation, the manner in which it evolved merits
inquiry, and the more recent interpretation may be accorded less
deference than a consistently maintained position. We further
noted that an agency’s action must be upheld, if at all, on the
basis articulated by the agency at the time of the rule making;
post hoc rationalizations cannot be offered to buttress an
agency’s action.
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1988 and 1989 temporary regulations; the 1994 final regulations,
although different from the temporary and proposed regulations,
were therefore valid. However, taxpayers could not have
concluded, on the basis of the silence of the 1992 proposed
regulations, that the Commissioner had in fact changed that rule.
Our cases interpreting another large and detailed set of
legislative regulations-–the consolidated return regulations–-
provide another example of how the standards of fairness instruct
us to interpret the Commissioner’s silence in the case at hand.
We have held that the Commissioner is bound by the consequences
flowing from the silence (or the express terms) of the
consolidated return regulations, even when those consequences are
arguably at odds with larger tax principles or the statute as a
whole. See Woods Inv. Co. v. Commissioner, 85 T.C. 274 (1985)
(literal application of consolidated return regulations binding,
even though result was allegedly a double deduction for the
taxpayer); Gottesman & Co. v. Commissioner, 77 T.C. 1149 (1981)
(refusal to “fill in the gaps” regarding imposition of
accumulated earnings tax on corporations filing consolidated
returns).
Our opinion in Gottesman & Co. v. Commissioner, supra, is
particularly instructive. Gottesman & Co. also considered the
effect of the Commissioner’s silence, following the withdrawal of
regulations favorable to the taxpayer. In Gottesman & Co., we
considered whether the taxpayer (the common parent of an
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affiliated group) was required to compute “accumulated taxable
income” (for purposes of the accumulated earnings tax, section
531) on a consolidated basis as the Commissioner contended, or on
a separate-company basis as the taxpayer contended. Under one
set of proposed regulations, certain taxpayers (including the
taxpayer in Gottesman & Co.) would have computed accumulated
taxable income on a separate company basis. Those proposed
regulations were withdrawn prior to the years in issue in
Gottesman & Co.; proposed regulations reaching the opposite
result were promulgated after those years. In holding for the
taxpayer, we concluded, against this background, that the
Commissioner’s silence during the years in issue had failed to
provide sufficient guidance to the taxpayer:
Though the 1968 proposed regulations were withdrawn in
1971, before the years involved in this case, we can
readily understand petitioner’s confusion as to
respondent’s true position * * *. * * *
We cannot fault petitioner for not knowing what
the law was in this area when the Commissioner, charged
by Congress to announce the law (sec. 1502), never
decided what it was himself. * * *
Thus, we find that the Commissioner’s regulations
regarding the manner in which the accumulated earnings
tax was to be imposed on corporations making
consolidated returns were ambiguous during the years at
issue. This ambiguity was of the Commissioner’s
making, and, as such, must be held against him. * * *
We think that under these circumstances the failure of
petitioner to comply with respondent’s post hoc view of
the regulations is an insufficient ground on which to
impose the accumulated earnings tax, and we hold for
petitioner on the issues herein presented.4
- 50 -
4
See also Corn Belt Hatcheries of Arkansas, Inc. v.
Commissioner, 52 T.C. 636 (1969).
[Gottesman & Co. v. Commissioner, 77 T.C. at 1157-1158.]
Our opinion in Corn Belt Hatcheries of Arkansas, Inc. v.
Commissioner, 52 T.C. 636 (1969) (cited in Gottesman & Co. at
1158 n.4), further supports interpreting any ambiguity in the
1992 proposed regulations in petitioners’ favor; it also
addresses and downplays the role of the Commissioner’s
subsequently asserted “clarification” in that interpretation. In
Corn Belt Hatcheries of Arkansas, Inc., the taxpayer (a common
parent corporation) arguably would have been permitted to file a
separate return under the language of a revenue ruling. However,
the taxpayer clearly would not have been able to do so under a
subsequently published “clarification” of that language in
another revenue ruling. In holding for the taxpayer we wrote:
Petitioner interprets * * * [the first revenue
ruling] to permit what its words seem to say * * *. We
consider this interpretation a plausible one and we are
not disposed to reject it by importing into the ruling
the subsidiary qualification asserted by respondent.
Taxpayers are already burdened with an incredibly long
and complicated tax law. We see no reason to add to
this burden by requiring them anticipatorily to
interpret ambiguities in respondent’s rulings to
conform to his subsequent clarifications, particularly
in an area, such as consolidated returns, where
Congress has placed such reliance on respondent’s
expertise. * * * [Corn Belt Hatcheries of Arkansas,
Inc. v. Commissioner, supra at 639-640.]19
19
Sec. 1.469-1T(g)(3)(iii), Temporary Income Tax Regs., 53
Fed. Reg. 5686, 5707-5708 (Feb. 25, 1988), further supports the
interpretation that a shareholder did not participate in C
(continued...)
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Conclusion
Notwithstanding the majority’s belated resort to “plain
meaning”, section 469 is a technical and complicated statute.
The regulations promulgated under that section have been detailed
and voluminous; they have also changed significantly over time.
19
(...continued)
corporation activities under the 1992 proposed regulations.
Personal service corporations and closely held C corporations are
themselves subject to the passive loss rules. See sec.
469(a)(2)(B) and (C). Sec. 1.469-1T(g)(3), Temporary Income Tax
Regs., 53 Fed. Reg. 5707-5708 (Feb. 25, 1988) determines when
such corporations will be considered to participate in their own
activities. Sec. 1.469-1T(g)(3)(iii), Temporary Income Tax
Regs., supra, provides that for this purpose, the general
participation definition of sec. 1.469-5T, Temporary Income Tax
Regs., shall apply, except that individuals shall be treated as
holding an interest in all corporate activities.
This special participation definition was first promulgated
as part of the 1988 temporary regulations (see sec. 1.469-
1T(g)(3)(iii), Temporary Income Tax Regs., supra. It was an
exception to the general participation definition of those 1988
temporary regulations, which expressly provided that a
shareholder did not participate in C corporation activities. See
supra pp. 30-32.
The Commissioner did not amend or remove the special
participation definition of sec. 1.469-1T(g)(3)(iii), Temporary
Income Tax Regs., supra, when he promulgated the 1992 proposed
regulations. See T.D. 8417, 1992-1 C.B. 173, 57 Fed. Reg. 20747(May 15, 1992) (certain temporary passive loss regulations
amended or adopted as final regulations); Notice of Proposed
Rulemaking, PS-1-89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May
15, 1992) (the 1992 proposed regulations). Because the special
definition would not be necessary if shareholders generally
participated in C corporation activities, the Commissioner’s
failure to remove that definition when he promulgated the 1992
proposed regulations further suggests that shareholders did not
generally participate in C corporation activities under those
regulations.
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The Commissioner has long recognized the value of effective
date and transitional rule relief in the section 469 setting.
When the recharacterization rule was first promulgated as part of
the 1988 temporary regulations, the Commissioner ensured it would
not be applied retroactively, because “taxpayers could not
clearly foresee the particular recharacterization rules that
these regulations would adopt”. See T.D. 8175, 1988-1 C.B. 191,
53 Fed. Reg. 5686 (Feb. 25, 1988), at “Supplementary Information:
Significant Policy Issues; XVI. Recharacterization of Certain
Passive Activity Gross Income”. Also, when the Commissioner
allowed the activity definition in the 1989 temporary regulations
to “sunset” he published the 1992 proposed regulations to take
its place; the 1992 proposed regulations stated that they would
apply only to tax years ending after their date of publication.
See Notice of Proposed Rulemaking, PS-1-89, 57 Fed. Reg. 20802,
20803 (May 15, 1992).
The 1988 and 1989 temporary regulations expressly provided
that a shareholder could not participate in the activities of his
C corporations. By contrast, the 1992 proposed regulations were
silent on this issue. For the reasons set forth above, taxpayers
could not have inferred from this silence that the Commissioner
had changed the prior rules to provide that shareholders
participate in the activities of their C corporations under the
1992 proposed regulations.
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More importantly, notwithstanding any contrary inferences
that might have been drawn, it is clear that the activity
definition contained in the 1994 final regulations was the first
activity rule expressly providing that a shareholder participated
in his C corporation’s activities. I repeat the observation we
made in Schwalbach v. Commissioner, 111 T.C. at 226, about the
new 1994 activity definition:
the change in language from the proposed regulations
was substantial; up until the final regulations, the
Commissioner had not publicly taken the position that
an individual’s activities could include activities
conducted through a C corporation.
I also repeat that in Schwalbach we never questioned that this
1994 change was a prerequisite to the recharacterization of
rental income received by the shareholder of a C corporation.
In promulgating the 1994 final regulations containing this
substantial change, the Commissioner once again recognized the
importance of transitional relief. The 1994 final regulations
provided that taxpayers could determine their tax liability for
years ending after May 10, 1992, and beginning before October 4,
1994, under the 1992 proposed regulations if they so chose,
rather than under the final regulations. See 59 Fed. Reg. 50485,
50486-50487 (Oct. 4, 1994).
It would be inconsistent with this grant of transitional
relief to hold to their detriment that shareholders participated
in the activities of their C corporations under the 1992 proposed
regulations. Taxpayers could not learn or infer, from reading
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the 1992 proposed regulations, that shareholders participated in
the activities of their C corporations. Moreover, the addition
of an express attribution rule to the 1994 final regulations was
a significant change from those proposed regulations. The only
possible purpose of the transitional rule contained in the 1994
final regulations was to protect taxpayers from this type of
unanticipated change during the interim period.
The Commissioner has abused the regulatory process in
backing and filling on the transitional rule issue in this case
and in previous cases. Having with one hand granted transitional
relief in the 1994 final regulations by allowing C corporation
shareholders for 1993-94 to apply the 1992 proposed regulations,
the Commissioner should not be able to take it away with the
other, through statutory notices and litigation.
I would hold that shareholders who received net rental
income from their C corporations--during years to which the 1992
proposed regulations apply--are not subject to the
recharacterization rule. The majority’s holding to the contrary
is incorrect.
CHABOT, PARR, WHALEN, HALPERN, GALE, and MARVEL, JJ., agree
with this concurring in part and dissenting in part opinion.