118 T.C. No. 17
UNITED STATES TAX COURT
DAVID H. AND SUZANNE HILLMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket No. 19893-97. Filed April 9, 2002.
P’s S corporation (S) performed management
services for real estate partnerships in which P had
direct and indirect interests. P actively participated
in S by performing management services that S had
contracted to perform for the partnerships. P was not
an active participant in any of the partnerships. On
the Schedule K-1 issued to P from S, P’s portion of the
management income was reduced by the portion of the
corresponding management fee expense paid by the
partnerships to S in an amount proportionate to P’s
ownership percentage in each partnership. The
reduction from the management income was treated as a
loss from a trade or business. R disallowed the
management fee expense deductions on the grounds that
the expenses were passive within the meaning of sec.
469, I.R.C., and that P was not entitled to treat the
*
This Opinion supplements a previously released opinion:
Hillman v. Commissioner, 114 T.C. 103 (2000).
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income and expenses as “self-charged” items under sec.
469, I.R.C., and sec. 1.469-7, Proposed Income Tax
Regs., 56 Fed. Reg. 14036 (Apr. 5, 1991).
Held: The management fee expense is passive and
may not be deducted from petitioner’s passthrough
management fee income which is nonpassive within the
meaning of sec. 469, I.R.C.
Stefan F. Tucker, for petitioners.
Wilton A. Baker, for respondent.
SUPPLEMENTAL OPINION
GERBER, Judge: In an earlier Opinion filed by the Court in
this case we decided that petitioners were entitled to treat
management fees as offsetting self-charged items for purposes of
section 469.1 The Court of Appeals for the Fourth Circuit
disagreed and reversed our holding. Hillman v. Commissioner, 263
F.3d 338 (4th Cir. 2001), revg. 114 T.C. 103 (2000).2
1
All section references are to the Internal Revenue Code in
effect for the years in issue, unless otherwise indicated.
2
Petitioner had a self-charged item with the same
attributes, in terms of economic substance, as provided for in
sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14036 (Apr.
5, 1991), with the difference being that it involved self-charged
management fees instead of interest. This Court held that the
same treatment should be afforded petitioner. In the reversal of
our holding, the Court of Appeals for the Fourth Circuit decided
that sec. 469(a) prohibited petitioner from a deduction or offset
until and unless it is specifically permitted by law (e.g., by
the issuance of an enabling regulation). Hillman v.
Commissioner, 250 F.3d 228 (4th Cir. 2001), revg. 114 T.C. 103
(2000). The Court of Appeals, however, was sympathetic to
petitioner’s plight, finding the situation to be an inequity, but
(continued...)
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Due to the reversal, we must now consider petitioners’
alternative argument concerning whether they correctly reported
the management fee items. In general we consider whether
petitioners’ reporting position should be sustained. Petitioners
contend that the real estate activity of the passthrough entities
may be segregated into separate rental and trade or business
activities; i.e., passive and nonpassive.
Background3
During 1993 and 1994 David H. Hillman (petitioner) owned 100
percent and 94.34 percent, respectively, of the stock of Southern
Management Corporation (SMC). SMC, an S corporation, provided
real estate management services to approximately 90 passthrough
entities (including joint ventures, limited partnerships, and S
corporations) that were involved in real estate rental activities
(passthrough entities). Petitioner held direct and indirect
interests in the passthrough entities. The general partner of
each partnership is either petitioner or an upper tier
partnership or S corporation in which petitioner owns an
interest.
2
(...continued)
one that only “Congress or the Secretary (as the holder of the
delegated authority from Congress) has the authority to
ameliorate.” Id. at 234.
3
This case was submitted fully stipulated, and the factual
background discussed in Hillman v. Commissioner, 114 T.C. 103
(2000), is incorporated by this reference.
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During 1993 and 1994, petitioner did not participate in the
passthrough entities’ activities, but he did actively participate
in SMC by performing management services that SMC had contracted
to perform for the passthrough entities. Petitioner treated his
involvement with SMC’s real estate management activity as a
separate activity from any other activities carried on by SMC.
During 1993 and 1994 petitioner materially participated in SMC’s
real estate management activity in excess of 500 hours. During
those same years, SMC also conducted other operations in addition
to real estate management services, such as recreational
services, medical insurance plan underwriting, credit/collection
services, and a maintenance training academy. Petitioner did not
materially participate in any of these other operations of SMC.
Petitioner reported his SMC salary as income, and SMC
deducted those amounts as an expense for compensation paid to
petitioner for services related to the conduct of the real estate
management activity for the 1993 and 1994 taxable years. SMC
separately reported management fee income (after deduction of
expenses, including petitioner’s salary from SMC) on petitioners’
1993 and 1994 Schedules K-1. The portion of the management fee
paid by the passthrough entities to SMC (and allocable to
petitioner’s ownership percentage in each passthrough entity) was
deducted as a loss from a trade or business on either
petitioner’s Schedules K-1 for the 1993 and 1994 taxable years or
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on the Schedules K-1 of upper tier passthrough entities for the
1993 and 1994 taxable years.
In computing their 1993 and 1994 taxable income, petitioners
treated the proportionate ownership share of the passthrough
entities’ management fee deduction as a reduction from
petitioners’ gross income from activities characterized as
nonpassive under section 469.
In the notice of deficiency, respondent disallowed the
characterization of the management fee expense as nonpassive,
referencing section 1.469-7, Proposed Income Tax Regs., 56 Fed.
Reg. 14036 (Apr. 5, 1991), which provides that lending
transactions (i.e., any transaction involving loans between
persons or entities) may be treated as self-charged.
Discussion
Enacted by Congress as part of the Tax Reform Act of 1986,
Pub. L. 99-514, 100 Stat. 2085, the passive activity loss rules
were designed to limit a taxpayer’s ability to use deductions
from one activity to offset income from another activity. In
particular, under the section 469 passive activity loss rules,
income generated from nonpassive activities cannot be offset by
deductions generated from passive activities.4
4
Nonpassive losses may be carried to future years and
applied against future passive income. Congress mandated in
section 469(l) that the Secretary issue regulations to implement
section 469. Under that mandate, sec. 1.469-7, Proposed Income
(continued...)
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Accordingly, to be successful here, petitioner would have to
show that the management fee income received and some portion of
the management fee deductions claimed by the real estate
passthrough entities were both passive or nonpassive.
Petitioners reported that the deductions (proportionate in amount
to their ownership in the passthrough entities) were nonpassive
and deductible from the management fee income. In order to
sustain that reporting position, petitioners must show that part
of the real estate pass-through entities’ deductions (expenses)
were incurred in a separate trade or business rather than from
the real estate activity, which is defined as passive by statute.
With that backdrop, we consider petitioners’ alternative
position that the real estate entities reported two separate
activities in connection with the payment of the management fees.
Petitioners describe the circumstances, as follows:
In this case, the Real Estate Entities separately, and
consistently, reported two K-1 line items: (1)Hillman’s
share of the management fee expense as “ordinary loss
from trade or business”, to the extent that he received
a distributive share of management fee income from SMC,
and (2) a line item from rental real estate income or
loss (which included the management fee expense in
excess of Hillman’s distributive share).
4
(...continued)
Tax Regs., was issued in 1991 to provide, in certain situations,
for the offset of passive interest deductions against nonpassive
interest income. The offset avoided an inequity where a taxpayer
incurred nonpassive income and passive loss from the same
transaction (self-charged) in the same year.
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Petitioner distinguishes himself from other partners because he
was the only partner/interest holder who received substantial
management fee income.5
In the notice of deficiency, respondent determined that
petitioner was not entitled to “recharacterize * * * [his] share
of the passive management expense of the Passthrough Entities as
nonpassive so as to match it against * * * [his] share of
nonpassive management income of * * * [SMC].” Respondent argues
that the payment of management fees by the real estate entities
cannot constitute a trade or business separate from the
associated income for purposes of section 469. We agree with
respondent.
In effect, petitioner’s reporting approach treated his
management income and the corresponding management fee deductions
as a “self-charged” item in the same manner as provided for by
sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14036 (Apr.
5, 1991). The Court of Appeals for the Fourth Circuit, however,
did not approve the self-charged approach for petitioner’s
management fee income and expense. As an alternative to the
self-charged approach, petitioners argue that the real estate
entities’ management fee deductions, relative to SMC’s nonpassive
5
Petitioners do not dispute that the real estate entities
were engaged in rental (generally passive) activities or that
petitioner’s management income earned through SMC was nonpassive
in nature.
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management income, are a part of a separate trade or business of
the real estate entities. It should be noted that the management
fee deduction, as it related to taxpayers other than petitioner
(partners and interest holders in the same pass-through
entities), was treated as part of the passive income regime.
Accordingly, we must decide whether the deducted portion of
the passthrough entities’ management fee deductions constitutes a
separate “trade or business”; i.e., are nonpassive deductions.
Section 1.469-4(b),6 Income Tax Regs., contains the following
definition of “trade or business activities” for purposes of
section 469:
(1) Trade or business activities. Trade or
business activities are activities, other than rental
activities or activities that are treated under sec.
1.469-1T(e)(3)(vi)(B) as incidental to an activity of
holding property for investment, that–-
(i) Involve the conduct of a trade or business
(within the meaning of section 162);
(ii) Are conducted in anticipation of the
commencement of a trade or business; or
(iii) Involve research or experimental
expenditures that are deductible under section 174
* * * .
To be engaged in a trade or business within the meaning of
section 162, a “taxpayer must be involved in the activity with
continuity and regularity and * * * the taxpayer’s primary
6
These regulations were amended in 1995, but they were
intended to apply retroactively to the years before the Court.
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purpose for engaging in the activity must be for income or
profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).
In order to hold for petitioners on this argument we would have
to decide that the real estate entities’ payment of management
fees, by itself, constituted a trade or business and/or an
activity separate from the real estate rental activity in which
they were engaged.
On the facts presented, we hold that the payment of
management fees by the real estate entities did not constitute a
trade or business or separate activity from the rental activity
of those entities. The management fees were incurred by the
entities in connection with rental activity and, therefore, would
be a deduction attributable to the rental income/activity. See
sec. 1.469-2T(d)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg.
5716 (Feb. 25, 1988). We, accordingly, hold that respondent’s
determination that petitioners were not entitled to reduce
management income by the management fee deduction of the real
estate entities was not in error.
Petitioners, as additional support for their attempt to
treat the real estate entities’ management fee deductions as
nonpassive items, generally argue that respondent’s disallowance
of the deductions contravenes certain fundamental or established
principles of taxation. For example, petitioners argue that, in
effect, they had no accession to wealth because the corresponding
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income and deductions result in no economic significance. For
that proposition, petitioners reference section 61 and cases,
including Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955).
Petitioners also argue that respondent’s disallowance is
inconsistent with the fundamental and global principle of
matching income and expenses for purposes of taxation. In
addition, they question whether there is some form of ordering of
various Code provisions so that, for example, partnership
provisions should not be preempted by section 469. Finally,
petitioners argue that section 469 was not intended to negate
these fundamental principles.
The principles referenced by petitioners are not being
obviated or eclipsed by respondent’s application of section 469.
Such principles (i.e., the question of what is income, rules of
subchapter K, etc.) precede the congressionally imposed section
469 limitation on reductions of nonpassive income by passive
deductions. To the extent that the passive losses cannot be
used, Congress has provided that they may be carried into the
future to apply against a future year’s passive income. Section
469 expressly limits petitioners’ ability to offset the real
estate entities’ passive management fee deductions against SMC’s
(petitioner’s) nonpassive management fee income from the same
transaction. SMC and the real estate entities are, for purposes
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of section 469, unrelated. SMC provides services for the real
estate entities and receives income in exchange. The real estate
entities’ correlative expense or deductions are not costs
incurred by SMC in the performance of the management services.
Finally, petitioner’s ownership in the real estate entities is
not exclusive, and it was not exclusive in all years for SMC.
Unfortunately, petitioners have been snared by the reach of
section 469 in, what appears to be, most inequitable
circumstances. As we discussed in our prior opinion, section 469
was designed to limit the use of losses generated by passive
activities to offset unrelated income generated by nonpassive
activities. Although section 469 was designed to stop these
practices, Congress recognized that it would be inappropriate to
treat certain transactions between related taxpayers as giving
rise to passive expense and nonpassive income.
The Secretary was charged with issuing regulations to
implement section 469. Commentary contained in the legislative
history suggests that self-charged items should be provided for
in the regulations. In 1991, regulations were proposed that
provided for self-charged interest. Although more than 15 years
have passed since the enactment of section 469 and 10 years have
passed since the self-charged regulation for interest was
proposed, no action has been taken to relieve inequity that may
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be suffered with respect to self-charged items other than
interest.
Although we find petitioners’ plight lamentable, the Court
of Appeals for the Fourth Circuit has held that the courts are
incapable of providing relief in this situation.
To reflect the foregoing,
A decision will be entered
for respondent.