T.C. Memo. 1999-185
UNITED STATES TAX COURT
MICHAEL F. & JANE H. CONNOR, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3552-98. Filed June 7, 1999.
David J. Bohl, for petitioners.
Christa A. Gruber, for respondent.
MEMORANDUM OPINION
PAJAK, Special Trial Judge: This case was heard pursuant to
section 7443A(b)(3) and Rules 180, 181, and 182. All section
references are to the Internal Revenue Code in effect for the
years in issue. All Rule references are to the Tax Court Rules
of Practice and Procedure.
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Respondent determined the following deficiencies and
accuracy-related penalties:
Accuracy-related Penalty
Year Deficiency Sec. 6662(a)
1993 $3,616 $723
1994 6,089 1,218
The issues we must decide are: (1) Whether respondent
properly recharacterized rental income petitioners received
during the taxable years at issue as nonpassive income pursuant
to section 469, and (2) whether petitioners are liable for
accuracy-related penalties for the taxable years at issue.
The parties submitted this case fully stipulated pursuant to
Rule 122, and the stipulated facts are so found. Petitioners
resided in Mukwonago, Wisconsin, at the time they filed their
petition.
On November 1, 1979, petitioner Jane H. Connor (Ms. Connor),
lessor, executed a 3-year standard office lease (Lease) with
Michael F. Connor, D.D.S., S.C., lessee, through petitioner
Michael F. Connor (Dr. Connor). Dr. Connor is the president and
a shareholder of a personal service corporation named Michael F.
Connor, D.D.S., S.C. The office was located at 603 Rochester
Street, Mukwonago, Wisconsin (Rochester Street building).
The terms of the Lease required the lessee to make monthly
rental payments in the amount of $900, for a total rent of
$32,400 for the 3-year period ending October 31, 1982. On
October 31, 1982, Ms. Connor executed an Addendum to Lease dated
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Nov. 1, 1979 (Addendum), with Michael F. Connor, D.D.S., S.C.
The Addendum provides that:
This lease will continue in force between Michael F.
Connor, D.D.S., S.C. "Lessee" and Jane H. Connor "Lessor"
until either party terminates such with written notice of 90
days.
Rental increase can be made only upon agreement of both
parties.
During 1993 and 1994, Ms. Connor owned the Rochester Street
building and rented it to Michael F. Connor, D.D.S., S.C.
On October 31, 1993, a portion of Michael F. Connor, D.D.S.,
S.C., was sold for $110,000 to Dr. McKeever.
Dr. Connor practiced dentistry at the Rochester Street
building. In 1993 and 1994, he was employed full-time by Drs.
Connor & McKeever, S.C. In 1993 and 1994, Dr. Connor received
wages in the amounts of $168,808.87 and $181,382.84,
respectively, from Drs. Connor & McKeever, S.C.
On their 1993 and 1994 Schedules E, Supplemental Income and
Loss, petitioners reported rents received from Michael F. Connor,
D.D.S., S.C., in the amounts of $22,000 and $24,000 for 1993 and
1994, respectively, from the rental of the Rochester Street
building. After deducting expenses, petitioners reported income
in the amounts of $10,503 and $15,937 for 1993 and 1994,
respectively, from the rental of the Rochester Street building.
Petitioners also reported rental real estate losses in the
amounts of $33,214 and $5,679 for 1993 and 1994, respectively,
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from the rental of another property listed as Jefferson Manor
Apartments. They reported carryover passive losses of $23,106
and $45,830 for 1993 and 1994, respectively.
Petitioners used $10,490 and $15,906 of the passive losses
to offset the Rochester Street building rent and reduced the
amounts of rent to the amounts of $13 and $31 for 1993 and 1994,
respectively. Petitioners further reduced the amounts of rent to
$0 for both years after deduction of passive losses from a
partnership listed as Dodge Corners Inv. Cl. in the amounts of
$13 and $31 for 1993 and 1994, respectively. Thus, petitioners
used total passive losses of $10,503 ($10,490 + $13) and $15,937
($15,906 + $31) to offset the rental incomes from the Rochester
Street building for 1993 and 1994, respectively.
Respondent determined that the rental profits from the
Rochester Street building are nonpassive income and therefore
were not allowable to offset petitioners' passive losses. As
respondent stated in the notice of deficiency:
On Schedule E of your 1993 AND [sic] 1994 returns, you
reported net profits from your rental properties in the
amounts of $10,503 in 1993 and $15,937 in 1994. You treated
these profits as passive income which you than [sic] used to
offset passive losses. It has been determined that these
rental net profits are nonpassive income and therefore
unallowable to offset your passive losses. Therefore, your
taxable incomes for 1993 and 1994 are increased by $10,503
and $15,937, respectively.
Respondent also adjusted petitioners' itemized deductions for
both years, child care credit for 1993, and the exemptions
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deduction for 1994. Respondent also determined that petitioners
were liable for the accuracy-related penalties for both years.
Respondent used the recharacterization rule of section
1.469-2(f)(6), Income Tax Regs., to characterize petitioners'
income from the Lease as nonpassive. Under this rule:
An amount of the taxpayer's gross rental
activity income for the taxable year from an
item of property equal to the net rental
activity income for the year from that item
of property is treated as not from a passive
activity if the property--
(i) Is rented for use in a trade or
business activity * * * in which the
taxpayer materially participates * * * for
the taxable year; * * *
The recharacterization rule was issued on May 15, 1992, and it
reads nearly verbatim as it appeared when it was proposed on
February 25, 1988. See Schwalbach v. Commissioner, 111 T.C. 215,
220-221 (1998).
Petitioners argue that the recharacterization rule does not
apply for the subject years to recharacterize their income from
the Lease because, petitioners state, the effective date and
transition rules in section 1.469-11(b)(1), Income Tax Regs.,
operate to prevent characterizing Dr. Connor as a material
participant of the dental activity of his personal service
corporation. Section 1.469-11, Income Tax Regs., provides in
relevant part:
§ 1.469-11. Effective date and transition
rules.--(a) Generally applicable effective dates.
Except as otherwise provided in this section--
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(1) The rules contained in
§ § 1.469-1, 1.469-1T, 1.469-2,
1.469-2T, 1.469-3, 1.469-3T,
1.469-4, 1.469-5, and 1.469-5T
apply for taxable years ending
after May 10, 1992.
* * * * * * *
(b) Additional effective dates--(1)
Application of 1992 amendments for taxable
years beginning before October 4, 1994. * *
* for taxable years that end after May 10,
1992, and begin before October 4, 1994, a
taxpayer may determine tax liability in
accordance with Project PS-1-89 published at
1992-1 C.B. 1219 * * *.
Project PS-1-89, supra, generally contains: (1) The second set
of regulations that the Commissioner issued to define the word
"activity", see Schwalbach v. Commissioner, supra at 220-225, for
a detailed discussion of the three sets of regulations which the
Commissioner issued on that subject, and (2) the effective date
rule in section 1.469-11(a)(1), Income Tax Regs.
Petitioners rely on the fact that the second set of
regulations made no mention of attributing the activity of a
corporation to a shareholder, see 57 Fed. Reg. 20802 (May 15,
1992), and that the first set of regulations provided that "a
taxpayer's activities do not include operations that a taxpayer
conducts through one or more entities (other than passthrough
entities)", see sec. 1.469-4T(b)(2)(ii)(B), Temporary Income Tax
Regs., 54 Fed. Reg. 20543 (May 12, 1989). According to
petitioners, the fact that the second set of regulations did not
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specifically disavow the rule of nonattribution as stated in the
first set of regulations means that the nonattribution rule
continued to apply up until the time that the Commissioner issued
the third set of regulations which provided explicitly that "A
taxpayer's activities include those conducted through C
corporations that are subject to section 469". Sec. 1.469-4(a),
Income Tax Regs.
We disagree with petitioners' assertion that Dr. Connor
cannot be a material participant of the dental activity of his
personal service corporation in a taxable year for which the
effective date and transition rules apply. In Schwalbach v.
Commissioner, supra, a setting strikingly similar to the setting
at hand, the taxpayers argued similarly that the effective date
and transition rules of section 1.469-11(b)(1), Income Tax Regs.,
coupled with no mention of attribution in the second set of
regulations, allowed them to apply a nonattribution rule similar
to that appearing in the first set of regulations. We disagreed.
See id. at 230. Petitioners' attempt to dismiss as dicta our
quick disposition of that issue is unavailing. That the
taxpayers in Schwalbach could not escape the moorings of the
attribution rule flowed naturally from our discussion of the
primary issue. As we had observed, an attribution rule appears
in the third set of regulations, the preamble to those
regulations clarifies that the silence as to attribution in the
second set of regulations indicates that attribution was meant to
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apply, and an attribution rule in section 469 is consistent with
that section and its legislative history. Id. at 223-229.
The same result follows here. Because Dr. Connor could, and
did, materially participate in the dental activity of his
personal service corporation, the recharacterization rule of
section 1.469-2(f)(6), Income Tax Regs., operates during the
subject years to characterize petitioners' income from the Lease
as nonpassive. We sustain respondent's determination on this
issue.
Finally, we must decide whether petitioners are liable for
accuracy-related penalties for the years in issue. Section
6662(a) imposes an accuracy-related penalty in the amount of 20
percent of the portion of an underpayment of tax attributable to
negligence or disregard of rules or regulations. Sec. 6662(a)
and (b)(1). Negligence is any failure to make a reasonable
attempt to comply with the provisions of the Internal Revenue
laws. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.
Moreover, negligence is the failure to exercise due care or the
failure to do what a reasonable and prudent person would do under
the circumstances. Neely v. Commissioner, 85 T.C. 934, 947
(1985). Disregard includes any careless, reckless, or
intentional disregard of rules or regulations. Sec. 6662(c);
sec. 1.6662-3(b)(2), Income Tax Regs.
Under section 6664(c), no penalty will be imposed with
respect to any portion of any underpayment if it is shown that
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there was a reasonable cause for such portion and that the
taxpayer acted in good faith with respect to such portion. This
determination is based on all of the facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs.
On the record before us, we find that there was reasonable
cause for petitioners to take the position they did and that they
acted in good faith with respect to that position. Accordingly,
we find that the penalties under section 6662(a) should not be
imposed with respect to the years in issue.
We have considered all arguments made by the parties and to
the extent not discussed above, we find these arguments to be
without merit or irrelevant.
Decision will be entered
for respondent as to the
deficiencies and for
petitioners as to the
accuracy-related penalties.