Sidell v. Commissioner

United States Court of Appeals
For the First Circuit

No. 00-1078

CHESTER F. SIDELL AND FAYE L. SIDELL,

Petitioners, Appellants,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent, Appellee.

APPEAL FROM THE UNITED STATES TAX COURT

[Hon. Julian I. Jacobs, Judge]

Before

Torruella, Chief Judge,

Selya, Circuit Judge,

and Casellas,* District Judge.

David R. Andelman, with whom Juliette Galicia Pico and
Lourie & Cutler, P.C. were on brief, for appellants.
Ellen Page Delsole, Attorney, Tax Division, U.S. Dep't of
Justice, with whom Paula M. Junghans, Acting Assistant Attorney
General, and Kenneth L. Green, Attorney, Tax Division, were on
brief, for appellee.

September 22, 2000
_______________
*Of the District of Puerto Rico, sitting by designation.
 SELYA, Circuit Judge. The Commissioner of the Internal

Revenue Service (IRS) issued a deficiency notice to Mr. and Mrs.

Chester F. Sidell (the taxpayers) for taxes, interest, and

penalties allegedly due in respect to the years 1993 and 1994.

The Commissioner premised this deficiency determination on an

assertion that the taxpayers had misclassified certain rental

income as passive rather than nonpassive. Unhappy with this

turn of events, the taxpayers sought a judicial anodyne. The

Tax Court sided with the Commissioner. See Sidell v.

Commissioner, T.C. Memo. 1999-301, 78 T.C.M. (CCH) 423 (1999).

The taxpayers appeal, averring that the Tax Court erred in

accepting the Commissioner's recharacterization of their rental

income, and that in all events they should be permitted to use

credits for rehabilitation of historic property to offset their

income in the years in question. Discerning no error in the Tax

Court's resolution of this dispute, we affirm.

I. BACKGROUND

The relevant facts are straightforward. At the

pertinent times, Chester F. Sidell owned all the stock of KGR

Industries, a Massachusetts corporation. KGR operated as a

regular business corporation — a so-called C corporation — and

itself paid taxes. See 26 U.S.C. §§ 301-385 (subtit. A, ch. 1,

subch. C). C corporations are different in kind from entities

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that are not themselves taxpayers but which function as conduits

for attributing gains and losses to their owners (e.g.,

partnerships, see 26 U.S.C. §§ 701-771 (subtit. A, ch. 1, subch.

K), and S corporations, see id. §§ 1361-1379 (subtit. A, ch. 1,

subch. S)).

In 1985, increased demand for KGR's private-label

clothing generated a need for expanded production facilities.

Sidell met this need by purchasing the Everett Mill, an historic

property that he refurbished and leased to KGR.1 He was able to

benefit personally from this effort by claiming rehabilitation

tax credits under 26 U.S.C. § 46(b)(4)(A) (the precursor to 26

U.S.C. § 47). Those credits are not at issue in this appeal.

When KGR continued to experience growing pains, Sidell

endeavored to replicate this serendipitous scenario. In 1992,

he purchased the Kunhardt Mill, an historic property located

across the street from the Everett Mill. He structured this

transaction in nearly identical fashion, beginning a qualified

rehabilitation immediately after acquisition, see Secretary of

1
Sidell's acquisition of the Everett Mill and his subsequent
acquisition of the Kunhardt Mill, discussed infra, were both
accomplished through nominee trusts of which he was the sole
beneficiary. Because no one asserts that the trusts have
independent significance for tax purposes, we treat the
properties as owned outright by Sidell.

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the Interior, Standards for Rehabilitation, 36 C.F.R. § 67, and

completing it in approximately one year's time.

The taxpayers claimed rehabilitation tax credits in

connection with the Kunhardt Mill restoration. They used those

credits (totaling $85,361 in 1993 and $24,284 in 1994) to offset

rental income paid by KGR. But the story did not have quite so

happy an ending the second time around. In the Commissioner's

view, the rehabilitation tax credits could only be used to

offset passive income; and under the law applicable to the years

in question (1993 and 1994), the rental income received from KGR

was nonpassive. Because the taxpayers had no other passive

income for those years, the Commissioner disallowed the claimed

offsets and asserted deficiencies amounting to $103,728 for 1993

and $41,621 for 1994.

Dismayed by the Commissioner's stance, the taxpayers

brought suit. See 26 U.S.C. §§ 6213(a), 6214(a), 7442. The Tax

Court sustained the Commissioner's determination of the

existence and extent of the deficiencies. See Sidell, T.C.

Memo. 1999-301. This appeal followed.

II. ANALYSIS

In this court, as below, the taxpayers advance three

principal lines of argument. First, they maintain that the

regulations, namely, Treas. Reg. § 1.469-2(f)(6) (1992) and

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Treas. Reg. § 1.469-4(a) (1994), are invalid insofar as they

purpose to recharacterize income received from closely-held C

corporations as nonpassive. Second, they note that they had

completed the Kunhardt Mill rehabilitation before October 4,

1994 (the effective date of the attribution rule, Treas. Reg. §

1.469-4(a)), and they claim that certain transition rules apply

(under which, in their view, the rent received from KGR should

be treated as passive income). Finally, the taxpayers contend

that depriving them of the benefit of the rehabilitation tax

credits for the years in which the work was performed not only

would flout the language of 26 U.S.C. § 47, but also would

undermine the legislative policy behind it. We deal with each

of these asseverations in turn. As the case was submitted on a

stipulated record and the taxpayers train their fire on the Tax

Court's legal determinations, our review is plenary. See

Strickland v. Commissioner, Me. Dep't of Human Servs., 48 F.3d

12, 16 (1st Cir. 1995).

A. Validity of the Final Regulations.

The regulations at issue — Treas. Reg. § 1.469-2(f)(6)

and Treas. Reg. § 1.469-4(a) — were issued by the Secretary of

the Treasury under a specific grant of authority from Congress.

See 26 U.S.C. § 469(l). We afford such legislative regulations

a high degree of respect: an inquiring court must give

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legislative regulations "controlling weight unless they are

arbitrary, capricious, or manifestly contrary to the statute."

Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc.,

467 U.S. 837, 844 (1984). The upshot is that a court should

enforce such regulations as long as they have a rational basis

and are reasonably related to the purposes of the enabling

legislation. See P. Gioioso & Sons, Inc. v. OSHRC, 115 F.3d

100, 107 (1st Cir. 1997). Against this backdrop, the taxpayers'

claim of invalidity gains little traction.

The starting point for a reasoned appraisal of that

claim is 26 U.S.C. § 469(l), which empowers the Secretary, in

relevant part, to

prescribe such regulations as may be
necessary or appropriate to carry out
provisions of [Sec. 469], including
regulations — . . . (3) requiring net income
or gain from a limited partnership or other
passive activity to be treated as not from a
passive activity . . . .

The taxpayers suggest that Congress, through this language, only

intended the Secretary to promulgate regulations that required

net passive income derived from certain pass-through entities,

such as partnerships or S corporations, to be treated as

nonpassive. The Secretary, however, went further; after

considerable backing and filling, discussed infra, he released

the final regulations here at issue.

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 The first of these regulations — embodying what is

sometimes called the "self-rental rule" — instructs taxpayers on

how rental income is to be characterized for tax purposes. It

states:

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 (within the meaning of
paragraph (e)(2) of this section) in which
the taxpayer materially participates (within
the meaning of § 1.469-5T) for the taxable
year; and (ii) Is not described in § 1.469-
2T(f)(5).

Treas. Reg. § 1.469-2(f)(6) (1992).

The second regulation — which embodies what is

sometimes called the "attribution rule" — reads:

A taxpayer's activities include those
conducted through C corporations that are
subject to section 469, S corporations, and
partnerships.

Treas. Reg. § 1.469-4(a) (1994). This regulation hardly could

be clearer: it makes the self-rental rule applicable to

transactions between closely-held C corporations and their

owners.

The taxpayers' argument on this point prescinds from

the uncontroversial premise that, apart from persons whose

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primary trade or business is real estate, a taxpayer's receipt

of rent typically comprises passive income. The Secretary's

newly-devised regulatory regime alters this treatment in a

certain class of cases, and the taxpayers argue that Congress

intended to limit the Secretary's power to effect such

alterations to activities conducted by pass-through entities

(like partnerships or S corporations). The ultimate question,

then, is whether the Secretary had the authority under section

469(l) to stretch the bounds of coverage to include income or

gain received from entities which, like C corporations, are not

pass-through entities. We conclude that the Secretary acted

appropriately in setting the parameters of the regulatory

scheme.

The authority given to the Secretary, as illustrated

by the statutory text, is quite broad. The statute empowers him

to promulgate any regulations that he deems "necessary or

appropriate" to further the goals of section 469. Importantly,

this includes the explicit power to treat what normally would be

passive income as nonpassive if he believes that such a shift is

warranted. Although the statute mentions limited partnerships

as one possible subject of regulation, the category is open-

ended, not closed, as witness Congress's use of the inclusive

phrase "or other." Accord Fransen v. United States, 191 F.3d

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599, 600-01 (5th Cir. 1999). Given the apparent breadth of

authority ceded to the Secretary, and the congruence between the

final regulations and the statute's evident goal (eliminating

tax shelters), it is exceedingly difficult to imagine how the

application of the self-rental rule to shareholders of closely-

held C corporations (which the Tax Court accurately called the

"epitome" of self-renting transactions, see Sidell, T.C. Memo.

1999-301, at 20) can be considered arbitrary, capricious, or

contrary to Congress's will.

The legislative history points unerringly in the same

direction. The House Conference Report affords valuable insight

into the purposes behind the broad delegation of authority:

The conferees intend that this authority be
exercised to protect the underlying purpose
of the passive loss provision, i.e.,
preventing the sheltering of positive income
sources through the use of tax losses
derived from passive business activities . .
. . Examples of where the exercise of such
authority may . . . be appropriate include
the following . . . (2) related property
leases or sub-leases, with respect to
property used in a business activity, that
have the effect of reducing active business
income and creating passive income . . . .

H. Conf. Rept. 99-841, at 147, reprinted in 1986 U.S.C.C.A.N.

4075, 4235. This clear statement of congressional intent fits

hand and glove with the expansive language of the statute

itself. One may question the wisdom of the policy choice

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embodied in the regulatory scheme, but one hardly can question

the Secretary's authority to choose that policy.

To be sure, the tax structure of a C corporation

differs from that of a pass-through entity. Despite this

difference, however, embracing the taxpayers' rationale would

run a grave risk of contradicting congressional intent. If the

recharacterization rules were invalidated, individuals in the

Sidells' position would be able to avoid application of the

self-rental rule by the simple expedient of structuring

businesses that they controlled as C corporations and siphoning

off the profits as rent (and, therefore, as passive income).

Insofar as the possibility of converting earned income into

rental payments is concerned, the dangers of manipulation are

essentially the same as those that attend pass-through entities.

We think it reasonable to assume that Congress wanted to enable

the Secretary to restrict the opportunity for such manipulative

behavior across the board.

Our conclusion comports with that of other courts. The

Fifth Circuit has determined that the attribution rule, as

framed, is a valid outgrowth of the Secretary's power under

section 469. See Fransen, 191 F.3d at 601. So too the Tax

Court. See Krukowski v. Commissioner, 114 T.C. No. 25 (2000)

(en banc) [2000 U.S. Tax Ct. LEXIS 31, at *19-*23]; Schwalbach

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v. Commissioner, 111 T.C. 215, 220 (1998). These decisions

reinforce our conclusion that the treasury regulations here at

issue reflect a proper exercise of the Secretary's duly

delegated authority. Hence, we reject the taxpayers' challenge

to their legitimacy.

B. Applicability of the Attribution Rule.

The taxpayers assert that even if the final regulations

are valid as applied to the activities of closely-held C

corporations, this case avoids their grasp. Since this claim

depends on timing, we limn the chronology of relevant events.

In the Tax Reform Act of 1986, Pub. L. No. 99-514, 100

Stat. 2087 (codified, as amended, in scattered sections of 26

U.S.C.), Congress sought to eliminate a host of tax shelters

that savvy taxpayers had concocted over time. As part of this

bill, Congress carefully distinguished between passive and

nonpassive activities, and provided that "any activity — (A)

which involves the conduct of any trade or business, and (B) in

which the taxpayer does not materially participate" would be

regarded as a passive activity. 26 U.S.C. § 469(c)(1). As

previously noted, Congress authorized the Secretary of the

Treasury to promulgate regulations "which specify what

constitutes . . . material participation, or active

participation" for this purpose. 26 U.S.C. § 469(l)(1). Acting

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pursuant to this authority, the Secretary released a series of

regulations designed to describe when a taxpayer was materially

participating in a venture, such that the rental income from

that venture would be treated as nonpassive income.

The Secretary's pronouncements initially took the form

of temporary regulations. The first set of temporary

regulations provided that shareholders in non-pass-through

entities, such as C corporations, were not to be regarded as

materially participating in the entity's activities. See Temp.

Treas. Reg. § 1.469-5T(f)(1) (1988). The next year, the

Secretary supplanted these regulations with another set of

temporary regulations containing the same safe harbor for C

corporation shareholders. See Temp. Treas. Reg. § 1.469-

4T(b)(2)(ii)(B) (1989). The 1989 temporary regulations expired

in 1992, and the Secretary replaced them with a set of proposed

regulations. See 57 Fed. Reg. 20,802 (1992).

These new regulations worked a sea change. They

eliminated most of the specific benchmarks that had

characterized the temporary regulations and substituted a broad

"totality of the circumstances" approach for the earlier,

essentially mechanical approach used to determine whether an

owner participated materially in an owned entity's activities.

While the Commissioner simultaneously vouchsafed that the self-

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rental rule was still velivolant, see Treas. Reg. § 1.469-

2(f)(6) (1992), 57 Fed. Reg. 20,747, he omitted any further

reference to taxpayers involved in non-pass-through entities.

He was similarly silent as to whether owners of such entities

would be regarded as material participants for purposes of the

self-rental rule.

The attribution rule, contained in the final

regulations issued by the Secretary in 1994, closed the circle.

As noted above, see supra Part II(A), those regulations

explicitly stated that the self-rental rule would be applied to

shareholders of closely-held C corporations, and that such

shareholders would be deemed to be material participants in the

owned entity's activities. See Treas. Reg. § 1.469-4(a) (1994).

The Secretary made the final regulations retroactive to taxable

years ending after May 10, 1992. See id. § 1.469-11(a)(1).

Apparently mindful, however, that he had erected something of a

moving target, he gave taxpayers the option of relying on either

the proposed regulations or the final regulations in figuring

their taxes for tax years that both ended after May 10, 1992,

and began before October 4, 1994. See id. § 1.469-11(b)(1).

Seizing on this option, the taxpayers claim that they

are entitled to the largesse of the proposed regulations, and

that under those regulations they may treat the rental income

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paid by KGR as passive. The Commissioner acknowledges that,

under the transition rules, the taxpayers are entitled to the

benefit of the proposed regulations, but he asserts that those

regulations treat rental income from closely-held C corporations

exactly the same as do the final regulations (i.e., as

nonpassive). Like the Seventh Circuit, see Connor v.

Commissioner, 218 F.3d 733, 739 (7th Cir. 2000), we think that

the Commissioner has the better of the argument.

As a general rule, an agency's interpretation of its

own regulations is entitled to great deference. See Bowles v.

Seminole Rock & Sand Co., 325 U.S. 410, 414 (1945); Johnson v.

Watts Regulator Co., 63 F.3d 1129, 1134-35 (1st Cir. 1995). A

court must uphold such an interpretation unless it is obviously

erroneous or inconsistent with the language of the regulation.

See Stinson v. United States, 508 U.S. 36, 45 (1993); Visiting

Nurse Ass'n v. Bullen, 93 F.3d 997, 1002, 1008 (1st Cir. 1996).

We descry no such error or inconsistency here.

It is true, as the taxpayers emphasize, that the

proposed regulations contained no specific mention of C

corporations or their shareholders. But context is critically

important in the interpretive process, and the absence of such

a reference, when coupled with the conspicuous disappearance of

the safe harbor that had been a hallmark of the temporary

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regulations, left the way open for the agency to lump closely-

held C corporations with pass-through entities. The agency

followed this course — and its determination does not constitute

a plainly erroneous reading of the proposed regulations. When

a regulation reasonably can be interpreted in different ways,

courts ordinarily should honor the agency's choice among those

iterations. See Johnson, 63 F.3d at 1134-35; Strickland, 48

F.3d at 17-18. So it is here.

We add, moreover, that such a reading would be

preferred even if the agency itself had not made an independent

interpretation of the proposed regulations. A close comparison

of the sequential sets of regulations indicates that the

Secretary allowed many of the specific provisions contained in

the temporary regulations to expire and chose not to revivify

them when crafting the proposed regulations. In our view, this

chain of events is analogous to a legislative body's failure to

reenact an expiring statute. In that situation, courts

"generally refuse to construe a failure to re-enact a portion of

a statute as indicative of a desire to retain the rule set forth

in that portion." Connor, 218 F. 3d at 738 (citing Keppel v.

Tiffin Savings Bank, 197 U.S. 356, 373 (1905)); see also 1A

Norman J. Singer, Sutherland Statutory Construction § 23.28, at

413 (5th ed. 1993) (explaining that under traditional rules of

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statutory construction, a failure to reenact a provision repeals

the provision by implication). As the Tax Court perspicaciously

stated when considering the precise question that confronts us:

"The fact that the Secretary did not represcribe that exception

[for C corporation shareholders] as part of the 1992 proposed

regulations is persuasive evidence that he revoked the exception

at that time." Krukowski, 2000 U.S. Tax Ct. LEXIS 31, at *19.

Ably represented, the taxpayers labor valiantly to

forestall the conclusion that we reach. Some of their arguments

are covered by what we already have said. Others are adequately

treated in the Tax Court's opinion or are obviously incorrect.

Only two points merit further discussion.

The taxpayers rely heavily on the dissenting opinion

in Krukowski, a 9-to-7 en banc decision of the Tax Court. But

that opinion is not persuasive. The dissenting judges hitched

their wagon to a stated belief that "taxpayers could not have

inferred from [the absence of an express reference in the

proposed regulations] that the Commissioner had changed the

prior rules to provide that shareholders participate in the

activities of their C corporations . . . ." Id. at *68.

(Beghe, J., dissenting). This misconstrues the facts.

The proposed regulations put all concerned parties on

clear notice that change was in the wind. As noted by the

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Seventh Circuit, the shift in analytical models from the

mechanistic format favored in the temporary regulations to the

more impressionistic format advocated in the proposed

regulations "implies a repeal of all mechanical tests [not

specifically reenacted] previously used to compute whether a

taxpayer participated materially." Connor, 218 F.3d at 739. It

follows inexorably that

the natural interpretation of the failure to
renew expressly this regulation is that
taxpayers should be placed on notice that
the Secretary expanded the existing standard
for material participation . . . [and] the
Secretary repealed by implication any per se
exclusion of shareholders in non-passthrough
entities . . . .

Id. The Tax Court reached a functionally identical conclusion.

See Schwalbach, 111 T.C. at 228 ("[W]e read nothing in [these]

regulations that would lead us to believe that the Commissioner

was proposing to retain the [exclusion for C corporation

shareholders]."). So do we: from the taxpayers' perspective,

the deletion of the specific safe harbor for C corporation

shareholders should have set off warning bells and constituted

an early signal that a reversal of position had occurred.

The taxpayers also rely on a number of internal IRS

memoranda purporting to show that when the proposed regulations

were promulgated, IRS staff had not yet decided to apply the

self-rental rule to the activities of closely-held C

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corporations. The taxpayers maintain that this decision did not

come about until at least one year thereafter and they try to

use this asserted fact in two related ways. First, they contend

that this paper trail verifies that the proposed regulations

were not meant to take away the protection previously enjoyed by

C corporation shareholders. Second, they contend that the

memoranda debunk the IRS's interpretation of the proposed

regulations because they show that the IRS had not even

considered this implication when the regulations were announced.2

We reject both aspects of this argument. The tax code

is an intricate web and demands clear rules so that it may be

administered with as little uncertainty as possible. To achieve

this goal, the IRS must speak with a single voice, that is,

through formal statements of policy such as regulations or

revenue rulings. See Connecticut Gen. Life Ins. Co. v.

Commissioner, 177 F.3d 136, 145 (3d Cir. 1999). Accordingly,

statements by individual IRS employees cannot bind the

Secretary. See Armco, Inc. v. Commissioner, 87 T.C. 865, 867

(1986); see generally Irving v. United States, 162 F.3d 154, 166

2
For his part, the Commissioner deems the internal IRS
memoranda consistent with the agency's interpretation of the
proposed regulations and, in all events, conceptualizes them as
forming part of the agency's deliberative process. Because the
documents are irrelevant, see text infra, we need not evaluate
the bona fides of these assertions.

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(1st Cir. 1998) (en banc) ("[C]ourts customarily defer to the

statements of the official policymaker, not others, even though

the others may occupy important agency positions."). Because

these internal memoranda represent the personal views of the

authors, not the official position of the agency, they do not

figure in our decisional calculus. See Honeywell Inc. v. United

States, 661 F.2d 182, 185-86 (Ct. Cl. 1981).

C. The Rehabilitation Tax Credits.

Last — but not least — the taxpayers claim that they

were entitled to use their rehabilitation tax credits on their

1993 and 1994 returns regardless of the reclassification of

their rental income. In order to address this claim, we first

supply some background.

At the pertinent time, the law provided for tax credits

as an incentive for undertaking a qualified rehabilitation of an

historic structure. See 26 U.S.C. §§ 38(b), 46 (1), 47. To

qualify for such credits, a taxpayer had to meet certain

standards propounded by the Secretary of the Interior. See 36

C.F.R. § 67. Congress placed the rehabilitation tax credit

provision in subpart D of part IV of subchapter A of chapter 1

of subtitle A of the Internal Revenue Code.3 As such, the

3 The need for this descriptive detail adequately evinces
why, in the view of many Americans, the Internal Revenue Code is
thought to have become an impenetrable maze.

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provision comes within the purview of the statute restricting

the use of "passive activity" credits in any tax year to

the amount (if any) by which — (A) the sum
of the credits from all passive activities
allowable for the taxable year under — (i)
subpart D of part IV of subchapter A . . .
exceeds (B) the regular tax liability of the
taxpayer for the taxable year allocable to
all passive activities.

26 U.S.C. § 469(d)(2).

With this background in mind, we return to the case at

bar. Here, the taxpayers earned rehabilitation tax credits

while refurbishing the Kunhardt Mill. Nevertheless, the

Commissioner scotched the use of these credits for the tax years

in question. The Tax Court upheld this determination. See

Sidell, 78 T.C. Memo. 1999-301, at 28. The taxpayers brand this

disallowance as contrary to both the plain language of the

enabling statute and the tenor of the congressional policy

underlying it. We disagree.

To be sure, the applicable statute, as the taxpayers

suggest, imposes only two pertinent preconditions to the use of

rehabilitation tax credits. The first is that the credits arise

out of the qualified rehabilitation of a certified historic

structure (and, thus, be allowable under subpart D of part IV of

subchapter A). See 26 U.S.C. § 469(d)(2)(A)(i). The taxpayers

plainly satisfy this requirement.

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 The battleground here is the second condition — a

condition which requires that the tax liability that the credit-

holder seeks to offset be "allocable to [his] passive

activities." Id. § 469(2)(B). The taxpayers posit that since

only the income from a property is classified as nonpassive

under the self-rental rule, their rental activities remain

passive and, therefore, the tax liability incurred anent those

activities is eligible to be offset by rehabilitation tax

credits. See, e.g., Appellant's Reply Brief at 30 (maintaining

that although the rental income received from KGR has been

"recharacterized as nonpassive under the self-rental rule, the

rental income will generate a tax liability, and therefore, the

taxpayers will have a tax liability allocable to their passive

activities").

This argument is no more than a clever exercise in

semantics — and one that reads the rehabilitation tax credit

provision with much too sanguine an outlook. In the Tax Reform

Act of 1986, Congress aspired to close precisely the kind of tax

loophole that the taxpayers here seek to exploit. See, e.g.,

House Conf. Rep. 99-841, at 147, reprinted in 1986 U.S.C.C.A.N.

4075, 4235 (explaining that "the underlying purpose of the

passive loss provision [is to prevent] the sheltering of

positive income sources through the use of tax losses derived

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from passive business activities"). When Congress refined the

rehabilitation tax credit four years latter, it aspired to grant

a carefully circumscribed incentive for the restoration of

historic structures — but there are no signs that it meant to

blunt the thrust of its earlier handiwork. If allowed to

prevail, the taxpayers' reading of the rehabilitation tax credit

provision would undermine the overarching intent of Congress.

To be specific, the Secretary's regulations classify

rent paid by closely-held C corporations to their proprietors as

nonpassive income for a reason: so that the latter cannot

manipulate the corporation's revenues to take advantage of the

benefits that attach to the classification of income as passive.

Free use of rehabilitation tax credits comprises one of those

benefits. Thus, as more fully explained by the Tax Court, the

Sidells' credits were not available for use in 1993 and 1994

because they exceeded their passive tax liability for those

years. See Sidell, 78 T.C. Memo. 1999-301, at 27-28.

The sockdolager rests in the regulations. While both

the 1988 and 1989 temporary regulations contained sunset

provisions, the Secretary went out of his way to preserve Temp.

Treas. Reg. § 1.469-3T in T.D. 8417, Limitation on Passive

Activity Losses and Credits — Technical Amendments to

Regulations, 57 Fed. Reg. 20,747 (May 15, 1992). That preserved

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regulation, which comprises a part of the transition rules,

makes it very clear that a taxpayer who earns rehabilitation tax

credits must have net passive income in order to employ those

credits in a given year. See Temp. Treas. Reg. § 1.469-3T(g)

(Examples (3) and (4)). Since the taxpayers in this case do not

have any net passive income for the years in question — what

they had reported as passive income has now been reclassified by

the Commissioner, see supra — they are not eligible to use their

rehabilitation tax credits for those years.

Contrary to the taxpayers' importunings, this result

does not defeat the purpose of the rehabilitation tax credit

law. The law still provides a meaningful incentive. Indeed,

the taxpayers, notwithstanding the reclassification of the

Kunhardt Mill rental income, have at least three remaining

avenues for taking advantage of the credits in later tax years.

First, they may carry over any unused credits indefinitely until

such time as they have passive income to offset against these

credits. See 26 U.S.C. § 469(b); see also St. Charles Inv. Co.

v. Commissioner, 110 T.C. 46, 56 (1998). Second, upon sale or

disposition of the rehabilitated property, the taxpayers can use

any suspended credits against passive income from the same

activity, then against net passive income from other activities,

and finally, as a nonpassive loss. See 26 U.S.C. § 469(g); St.

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Charles, 110 T.C. at 49. Third, the taxpayers at the time of

disposition might be able to employ unused credits to adjust

their basis in the property. See 26 U.S.C. § 469(j)(9). Viewed

from this perspective, the Commissioner's disallowance of the

rehabilitation tax credits for 1993 and 1994 does not contravene

Congress's discernible intent.

III. CONCLUSION

We need go no further. The Commissioner's

determination of the tax due and owing rests on a sturdy factual

and legal foundation. Accordingly, we sustain the decision of

the Tax Court.

Affirmed.

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