T.C. Summary Opinion 2001-174
UNITED STATES TAX COURT
ROBERT W. AND LILA L. BLEWETT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6277-00S. Filed November 8, 2001.
Glen G. Utzman, for petitioners.
Julie L. Payne, for respondent.
WOLFE, Special Trial Judge: This case was heard pursuant to
the provisions of section 7463 of the Internal Revenue Code in
effect at the time the petition was filed.1 The decision to be
entered is not reviewable by any other court, and this opinion
1
Unless otherwise indicated, subsequent section references
are to the Internal Revenue Code in effect for the year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
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should not be cited as authority.
Some of the facts have been stipulated and are so found.
The stipulation of facts and the accompanying exhibits are
incorporated herein by this reference. Petitioners resided in
Grangeville, Idaho, at the time the petition was filed.
Respondent determined a deficiency of $8,506 in petitioners’
1996 Federal income tax. After concessions,2 the issue for
decision is whether petitioners’ losses during 1996 constitute
nondeductible passive losses under section 469.
Background
In 1976, Robert Blewett (petitioner) and his brother, Don
Blewett, organized Highland Enterprises, Inc. (Highland), a C
corporation. Petitioner and his brother each owned 50 percent of
the outstanding stock of Highland during 1996. Throughout the
year in issue, Highland was engaged in two separate businesses:
a general heavy construction business and a real estate sales
business. Highland’s general heavy construction business
included building logging and fire roads for the U.S. Forest
Service and private logging companies, building roads for
governmental entities, constructing homes and commercial
buildings, and developing residential and commercial land
subdivisions (including the building of streets, curbs,
2
Petitioners concede that they improperly failed to report
interest income of $72 and income of $1,724 from a jewelry sales
business on their 1996 Federal income tax return.
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sidewalks, and the installation of utilities). The activities of
Highland’s real estate sales operation, which did business during
1996 as “Highland Realty”, included selling residential and
unimproved real estate.
During 1996, both petitioner and his brother worked full-
time for Highland. Petitioner provided services to both
Highland’s general heavy construction business and its real
property sales activity. For the former, he managed the
corporate office, secured construction projects, acquired land
for property development, ordered construction materials and
supplies and assured their timely arrival at construction sites,
and reviewed construction progress at construction sites. For
the latter, petitioner provided services as a real estate broker.
Petitioner is licensed as a real estate broker in the State of
Idaho.
Prior to 1996, Highland suffered a series of setbacks that
put it in a dire financial situation. The setbacks included a
cost overrun in excess of $1 million on a road job with the U.S.
Forest Service, a lengthy lawsuit involving the company’s
purchase of faulty equipment, and deliberate interference with
Highland’s work by an environmental group (Earth First) that
blocked its roads and destroyed hydraulic hoses and three major
pieces of equipment.
Because of Highland’s poor financial condition, the company
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was unable to lease or purchase equipment on credit. Financial
institutions simply would not make any loan of any type to
Highland. Highland’s continued existence depended on its
obtaining equipment. Faced with this predicament, petitioner and
his brother separately purchased the necessary equipment in their
individual names and separately leased it to Highland. There is
no dispute that petitioner and his brother were engaged in an
equipment leasing activity amounting to a trade or business
during the year in issue, and the record clearly supports that
characterization. Respondent has not raised any questions as to
whether the leasing activity was for profit, and we treat that
matter as conceded by respondent. Petitioner and his brother
each owned 100 percent of the equipment that he leased to
Highland; none of the equipment was jointly owned. They leased
the equipment exclusively to Highland. It was never used in
another trade or business. Petitioners had no written rental
agreement with Highland. During 1996, Highland did not pay
petitioners any rent.
During 1995, Highland paid rent of $69,600 and $40,091 to
petitioners and Don Blewett, respectively. During 1996, Highland
paid rent of $56,263 to Don Blewett and no rent to petitioners.
At trial, petitioner testified that because of Highland’s poor
financial condition, its rental payments to the Blewetts were
irregular. In his words, “you pluck all the feathers off of that
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bird, and it’s not going to lay any more eggs.” Accordingly,
payments were made only when either petitioner or Don Blewett
needed the money to make payments to creditors for leased
equipment.
Petitioners claimed a net loss of $50,033 from their
equipment leasing activity on Schedule C, Profit or Loss From
Business (Sole Proprietorship), of their 1996 Federal income tax
return.3 In the notice of deficiency, respondent disallowed the
entire loss on the ground that the leasing activity was subject
to the passive loss limitations of section 469.
Discussion
Section 469(a)(1) limits the deductibility of losses from
certain passive activities. Generally, a passive activity
includes the conduct of a trade or business in which the taxpayer
does not materially participate. Rental activity is generally
treated as a passive activity without regard to whether the
taxpayer materially participates.4 Sec. 469(c)(1), (2), (4).
Rental activity is defined as “any activity where payments are
principally for the use of tangible property.” Sec. 469(j)(8).
3
The loss was attributable primarily to deductions of
$30,062 and $17,141 for depreciation and sec. 179 expenses,
respectively.
4
A statutory exception that was added in 1993 provides that
certain real estate operators need not treat their interests in
rental real estate as passive activities. Sec. 469(c)(7). That
exception is inapplicable here, because the subject of this
controversy is personal property.
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Both parties agree that petitioners’ equipment leasing
activity falls within the definition of a rental activity in
section 469(j)(8), and that the income from that activity is
passive in nature, unless petitioner qualifies under one of the
six exceptions listed in the regulations. See Tarakci v.
Commissioner, T.C. Memo. 2000-358; sec. 1.469-1T(e)(3)(ii)(A)
through (F), Temporary Income Tax Regs., 53 Fed. Reg. 5702 (Feb.
25, 1988). Petitioner specifically relies upon the so-called
incidental exception, which we previously discussed in the recent
and analogous case of Tarakci v. Commissioner, supra, and also
the so-called grouping exception (section 1.469-4(d)(1), Income
Tax Regs.). We agree with petitioner that the incidental
exception and the reasoning of the Tarakci opinion are applicable
here, so we discuss the rules of the grouping exception only
insofar as they relate to the provisions of the incidental
exception.
Petitioners’ position is that their leasing activity is not
a rental activity because it qualifies as an exception to the
definition of a rental activity under section 1.469-1T(e)(3)
(ii)(D), Temporary Income Tax Regs., 53 Fed. Reg. 5702 (Feb. 25,
1988),5 which, together with paragraph (e)(3)(vi), provides that
5
Temporary regulations are entitled to the same weight as
final regulations with respect to the years to which they apply.
Nissho Iwai Am. Corp. v. Commissioner, 89 T.C. 765, 776 (1987).
Sec. 1.469-1T, Temporary Income Tax Regs., 53 Fed. Reg. 5700-5711
(continued...)
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an activity involving the use of tangible property is not a
rental activity if the rental of such property is treated as
incidental to a nonrental activity of the taxpayer. Section
1.469-1T(e)(3)(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg.
5703 (Feb. 25, 1988), provides:
(C) Property used in a trade or business. The
rental of property during a taxable year shall be
treated as incidental to a trade or business activity
(within the meaning of paragraph (e)(2) of this
section) if and only if–-
(1) The taxpayer owns an interest in
such trade or business activity during the
taxable year;
(2) The property was predominantly
used in such trade or business activity
during the taxable year or during at least
two of the five taxable years that
immediately precede the taxable year; and
(3) The gross rental income from such
property for the taxable year is less than
two percent of the lesser of-–
(i) The unadjusted basis of
such property; and
(ii) The fair market value
of such property.
With respect to the application of the three tests of
subdivision (C), we consider it significant that the parties have
stipulated that during 1996: (1) Petitioner owned 50 percent of
5
(...continued)
(Feb. 25, 1988), is effective for taxable years beginning after
Dec. 31, 1986. Sec. 1.469-11(a)(2), Income Tax Regs., 53 Fed.
Reg. 5686 (Feb. 25, 1988).
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the outstanding stock of Highland; (2) the equipment in question
was used exclusively in Highland’s trade or business activity
throughout the year; and (3) petitioners did not receive any
gross rental income from Highland for the equipment.
Respondent contends that section 1.469-1T(e)(3)(vi)(C),
Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988), is
inapplicable to the instant case because it requires that a
taxpayer at least temporarily stop using property in his trade or
business and start using the property in a rental activity.
Respondent argues that the exception is not available when the
property is used in the rental activity and the trade or business
activity simultaneously. Respondent makes three arguments in
support of this construction of the regulation. Respondent’s
arguments are set forth below, but we note that in our view here
“respondent advocates a strained interpretation of language
prepared by respondent’s own employees.” See Ferguson v.
Commissioner, T.C. Memo. 1992-451. In interpreting the language
in question, we bear in mind that respondent’s personnel drafted
that language, and the resolution of doubts against the draftsman
is appropriate in many circumstances. See id. (and authorities
cited therein).
First, respondent argues that section 1.469-1T(e)(3)(vi)(C),
Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988),
uses the past tense when referring to the use of the property in
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the trade or business. Respondent contends that use of the verb
“was” in paragraph (2) of the relevant regulation means that for
the purposes of the incidental exception, the property cannot be
used in the trade or business activity and the rental activity
simultaneously.
We are not convinced by this argument. Section 1.469-1T(e)
(3)(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb.
25, 1988), provides that the rental of property during a taxable
year shall be treated as incidental to a trade or business
activity if, inter alia, “The property was predominantly used in
such trade or business activity during the taxable year or during
at least two of the five taxable years that immediately precede
the taxable year”. (Emphasis added.) The word “was” in the
regulation refers not only to past years, but also to the current
taxable year. The terms of the regulation are consistent with
the conclusion that the property can be used in the trade or
business activity at any time and still satisfy the requirements
for the incidental exception to the definition of a rental
activity. We conclude that the language of the regulation does
not require that the taxpayer must cease using the property in a
trade or business activity before it can be used in the rental
activity.
Second, respondent cites the preamble to T.D. 8175, the
Treasury Decision promulgating section 1.469-1T(e)(3)(vi)(C),
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Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988).
The preamble states that the exception applies if “an
insubstantial amount of rental income is derived from property
that was recently used in a trade or business activity of the
taxpayer and is temporarily rented”. Id.
We apply a regulation according to its plain or ordinary
meaning unless such interpretation would lead to absurd results
or another construction is supported by unequivocal evidence of
administrative intent. Phillips Petroleum Co. v. Commissioner,
101 T.C. 78, 107 (1993), affd. without published opinion 70 F.3d
1282 (10th Cir. 1995). Respondent does not suggest that the
application of the plain meaning of section 1.469-1T(e)(3)
(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25,
1988), leads to absurd results. Thus, we must determine whether
the language from the preamble amounts to unequivocal evidence of
administrative intent to limit the exception to only those
situations where the property being rented is no longer being
used in the trade or business activity.
The preamble does refer to the use of the property in the
trade or business activity in the past tense, and it does refer
to the use of the property in the rental activity in the present
tense. However, in our view, rather than creating a separate
requirement in addition to the requirements set forth in the text
of the regulations, the preamble merely recites one example of a
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situation that would satisfy section 1.469-1T(e)(3)(vi)(C)(2),
Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988).
The preamble’s general one-sentence introductory comment
concerning the regulation in question does not amount to
“unequivocal evidence of administrative intent” that use of the
property in the trade or business activity must cease before the
property is used in the rental activity. A contrary conclusion
would import into the regulation a requirement that simply is not
in the terminology of the regulation.
Third, respondent cites section 1.469-1T(e)(3)(viii),
Example (6), Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb.
25, 1988) (hereinafter referred to as example (6)). In example
(6), a taxpayer owns an interest in a farming activity, which is
a trade or business activity, and owns farmland that is used in
the farming activity in 1985 and 1986. In 1987, 1988, and 1989,
the taxpayer does not use the land in the farming activity.
Instead, during those years he leases the land to other parties,
but continues his interest in the farming activity. The taxpayer
is permitted to treat the rental of his land as incidental to his
farming activity in 1987 and 1989 based on the gross rental
income received. Id.
Example (6) does illustrate respondent’s narrow
interpretation of section 1.469-1T(e)(3)(vi)(C), Temporary Income
Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988). Example (6) is the
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only example in the regulations that applies section 1.469-
1T(e)(3)(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988). In our view, the applicability of the
regulation is not limited to the precise circumstances of an
example set forth in the regulation. The example plainly is
illustrative rather than limiting or exclusive.
Moreover, as stated above, section 1.469-1T(e)(3)(vi)(C)(2),
Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988),
permits the property to be used in the trade or business during
either the current year or 2 of the 5 years that precede the
taxable year. Example (6) is an illustration of the property
being used in 2 of the 5 preceding years. Subdivision (ii) of
example (6) provides: “For 1987 and 1989, the taxpayer owns an
interest in a trade or business activity, and the farmland which
the taxpayer leases to the rancher was used in such activity for
two out of the five immediately preceding taxable years.” Here,
petitioners’ property was used in the trade or business during
the current year. The facts of example (6) and the facts of the
instant case relate to different clauses of section 1.469-
1T(e)(3)(vi)(C)(2), Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988).
Respondent also argues that section 1.469-1T(e)(3)(vi)(C),
Temporary Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988),
does not apply to the facts here because the rental activity and
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the trade or business activity must be conducted by the same
entity. In effect, respondent argues that the regulation does
not apply because the equipment leasing activity of petitioners’
sole proprietorship was not incidental to any other trade or
business activity of their sole proprietorship.
We previously ruled on this issue in Tarakci v.
Commissioner, T.C. Memo. 2000-358. There, the taxpayer formed a
sole proprietorship that purchased equipment and leased it to a
general partnership in which the taxpayer and another individual
were equal partners. In the notice of deficiency, the
Commissioner disallowed the taxpayer’s entire loss from his sole
proprietorship on the ground that the loss was subject to the
passive activity loss limitations of section 469. The taxpayer
argued that section 1.469-1T(e)(3)(vi)(C), Temporary Income Tax
Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988), applied, and that for
purposes of that section, the trade or business activities of the
partnership were trade or business activities of the sole
proprietorship. The Commissioner contended that section 1.469-1T
(e)(3)(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988), did not apply because the equipment leasing
activity of the sole proprietorship was not incidental to any
other activity of the sole proprietorship.
We held that the trade or business activities of the
taxpayer for the year in issue included the trade or business
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activities of the partnership for purposes of section 1.469-
1T(e)(3)(vi)(C), Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988). We noted that the “The regulations require the
taxpayer own ‘an interest in such trade or business activity’,
not that the taxpayer be the sole owner of the trade or
business.” Tarakci v. Commissioner, supra (quoting sec. 1.469-
1T(e)(3)(vi)(C)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5703
(Feb. 25, 1988)). There, the taxpayer was actively involved in
the affairs of the partnership, “substantially contribut[ing]
both time and effort to the success of * * * [it].” Id.
Here, petitioner’s ownership of 50 percent of Highland’s
stock, as well as his substantial time commitment to Highland,
satisfies the requirement that he have an interest in such trade
or business.
Respondent argues that the holding of Tarakci conflicts with
the language of section 1.469-1T(e)(3)(vi)(C), Temporary Income
Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988), and section 1.469-
1T(e)(3)(viii) Example (6), Temporary Income Tax Regs., 53 Fed.
Reg. 5703 (Feb. 25, 1988). We disagree with respondent’s
analysis.
In our view, the reasoning and the holding in the Tarakci
case are correct and properly applicable to the facts and
circumstances here. The trade or business activities of
petitioners for 1996 include the trade or business activities of
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Highland for purposes of section 1.469-1T(e)(3)(vi)(C), Temporary
Income Tax Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988).
We hold that petitioners are entitled to treat their leasing
activity as incidental to Highland’s trade or business activities
under section 1.469-1T(e)(3)(vi)(C), Temporary Income Tax Regs.,
53 Fed. Reg. 5703 (Feb. 25, 1988). Consequently, petitioners’
leasing activity is not classified as a rental activity. Sec.
1.469-1T(e)(3)(ii)(D), Temporary Income Tax Regs., 53 Fed. Reg.
5703 (Feb. 25, 1988).
The passive loss limitations of section 469 still apply to
petitioners unless they meet the material participation standard.
Sec. 469(c)(1). The regulations permit a taxpayer to group an
activity conducted through a C corporation subject to section 469
with another activity of the taxpayer for purposes of determining
whether the taxpayer materially or significantly participates in
the other activity. Sec. 1.469-4(d)(5)(ii), Income Tax Regs.
Since petitioners conducted an activity through a C corporation
subject to section 469,6 petitioners are entitled to group their
6
The passive loss limitations of sec. 469 apply only to
individuals, estates, trusts, closely held C corporations, and
personal service corporations. Sec. 469(a)(2). A closely held C
corporation, for purposes of sec. 469(a)(2), is defined as any
corporation in which more than 50 percent in value of its
outstanding stock is owned, directly or indirectly, by or for not
more than five individuals at any time during the last half of
the taxable year. Secs. 469(j)(1), 465(a)(1)(B), 542(a)(2).
Since all of the stock of Highland, a C corporation, was owned
directly by two individuals during the year in issue, Highland is
(continued...)
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activities for the purpose of determining material participation.
Since it is undisputed that petitioner materially participated in
the trade or business activities of Highland,7 petitioners
automatically meet the material participation standard with
respect to their leasing activity.
For the foregoing reasons, petitioners’ losses during 1996
do not constitute nondeductible passive losses under section 469.
Reviewed and adopted as the report of the Small Tax Case
Division.
Decision will be entered
under Rule 155.
6
(...continued)
subject to sec. 469.
7
An individual is treated as materially participating in an
activity for the taxable year if the individual participates in
the activity for more than 500 hours during such year. Sec.
1.469-5T(a)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5725
(Feb. 25, 1988). The parties stipulated that during the year in
issue, petitioner worked 40 or more hours per week for Highland.
Thus, petitioner unquestionably satisfies the 500-hour
requirement.