CRSO v. Commissioner

128 T.C. No. 12

UNITED STATES TAX COURT

CRSO, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11804-05X. Filed April 30, 2007.

P is a nonprofit corporation. Its sole activity
involves renting out its two parcels of debt-financed
commercial real estate and distributing the profits to
a sec. 501(c)(3), I.R.C., organization.

P applied for tax exemption under sec. 501(c)(3),
I.R.C. In 2003, R sent a final adverse determination
letter to P at an incorrect address; P did not receive
the letter until R sent it to P’s counsel in 2005. P
filed its petition within 90 days of receiving the
final adverse determination letter.

Held: Because R’s initial, misdirected adverse
determination letter was ineffective for purposes of
triggering the 90-day period under sec. 7428(b)(3),
I.R.C., P’s petition was timely. Held, further,
because P’s rental activity is not excluded from
classification as a “trade or business” under sec.
502(b)(1), I.R.C., P is a feeder organization under
sec. 502, I.R.C., and is not operated exclusively for
 - 2 -

charitable or other exempt purposes within the meaning
of sec. 501(c)(3), I.R.C.

James J. Workland and Gary C. Randall, for petitioner.

Mark A. Weiner, for respondent.

OPINION

THORNTON, Judge: Respondent denied petitioner’s request for

tax-exempt status under section 501(c)(3).1 Pursuant to section

7428, petitioner seeks declaratory relief.

The parties submitted this case to the Court without trial

to be decided on the basis of the pleadings and the parties’

stipulation as to the administrative record. See Rules 122,

217(b). The Court’s decision will be based upon the assumption

that the facts as represented in the administrative record, as

stipulated, are true. See Rule 217(b).

Background

Petitioner

On December 26, 2000, petitioner was incorporated in the

State of Washington as a nonprofit corporation. When it filed

its petition, petitioner’s principal place of business was in

Spokane, Washington.

1
Unless otherwise indicated, section references are to the
Internal Revenue Code, as amended; Rule references are to the Tax
Court Rules of Practice and Procedure.
 - 3 -

Petitioner characterizes its sole activity as receiving

rental income from commercial real estate that it owns and

distributing the net proceeds to Chi Rho Corp. (Chi Rho), a

publicly supported section 501(c)(3) organization.

Articles of Incorporation

Petitioner’s articles of incorporation state that it is

organized and shall be operated exclusively for charitable,

educational, and scientific purposes within the meaning of

section 501(c)(3), by making distributions to carry out the

charitable, educational, and scientific purposes of Chi Rho. The

articles of incorporation further state that petitioner “is

organized to act as a supporting organization for Chi Rho

pursuant to section 509(a)(3)”.

Board of Directors and Officers

Petitioner’s initial board of directors consisted of three

individuals: Hudson R. Staffield, Cynthia T. Staffield

(collectively, the Staffields), and Peter A. Witherspoon. These

three individuals also served as petitioner’s president,

secretary/treasurer, and vice president, respectively. They each

devoted, on average, about 3 hours of service per week to these

positions.

Petitioner’s Real Estate Acquisitions

In 1997, the Staffields purchased two commercial retail

buildings (the real estate) that are part of a retail center in
 - 4 -

Wenatchee, Washington. The Staffields paid $2,297,000 for the

real estate, borrowing a portion of the funds from the Washington

Trust Bank.

In December 2000, the Staffields gave the real estate to

petitioner. In a certificate of corporate resolution dated

December 28, 2000, petitioner agreed to accept the real estate

and to assume the outstanding mortgage obligation, which was then

about $1.4 million. Washington Trust Bank did not modify the

original loan; the Staffields remained personally liable on the

mortgage.

Leases

When the Staffields purchased the real estate and at all

relevant times thereafter, the real estate was subject to

preexisting long-term leases; the tenants were a sporting goods

business and a cellular telephone business. Petitioner

characterizes the leases as “triple net leases”, contending that

the leases require “little or no expenditure of time or funds by

the Lessor” and that petitioner is entitled to reimbursement from

the lessees for “virtually all” costs it is required to pay under

the terms of the lease agreements.

On April 18, 2001, petitioner entered into a management

agreement with Kiemle & Hagood Co., which agreed to lease,

manage, and operate the real estate for a $250 monthly fee and a

percentage of future rents on any new leases with new tenants.
 - 5 -

Petitioner’s Application for Exemption

On October 15, 2001, petitioner submitted to respondent Form

1023, Application for Recognition of Exemption Under Section

501(c)(3) of the Internal Revenue Code. Part II of Form 1023

requests a “detailed narrative description of all the activities

of the organization--past, present, and planned.” In response to

this inquiry, petitioner’s application stated:

CRSO owns real estate in Wenatchee, Washington, which
is used as a shopping center. Its revenue is derived
from triple net leases on that property to unrelated
third parties. CRSO is a “supporting organization” for
Chi Rho Corporation, a California corporation holding a
Section 501(c)(3) exemption.

Petitioner’s Income Tax Returns

For taxable years 2001, 2002, 2003, and 2004, petitioner

reported the following figures on its Forms 990-T, Exempt

Organization Business Income Tax Return:

Gross
unrelated Unrelated Unrelated
debt- Average business business
Gross financed acquisition taxable income
Year rents income debt ratio income tax

2001 $275,570 $144,233 52.34% $37,684 $5,653
2002 280,577 147,107 52.43 50,234 7,559
2003 254,317 130,643 51.37 30,064 4,510
2004 228,116 113,168 49.6 16,655 2,498

Denial of Petitioner’s Application for Exemption

By letter dated November 8, 2002, respondent’s Exempt

Organizations Division proposed to deny petitioner’s request for
 - 6 -

tax-exempt status. The letter concluded that petitioner is a

feeder organization described under section 502 and does not meet

the operational test for exemption under section 501(c)(3).

By letter dated November 25, 2002, petitioner requested a

hearing with respondent’s Appeals Office concerning this matter.

In a letter dated November 4, 2003, the Appeals Office made a

“final adverse determination”, concluding:

Your only activity is the rental of improved real
property and forwarding net funds to an organization
described in section 501(c)(3). Your primary purpose
is to operate a trade or business for profit. As such,
you are an organization described in section 502(a).
You are not entitled to the exception set forth in
section 502(b)(1) because not all of your rents would
be excluded under section 512(b)(3). Finally, you did
not establish that you were operated exclusively for
one or more purposes specified under section 501(c)(3)
of the Code.

Respondent initially sent the determination letter to an

incorrect address. Petitioner received the determination letter

only after respondent mailed it by certified mail to petitioner’s

counsel on June 14, 2005. On June 27, 2005, petitioner filed its

petition requesting section 7428 declaratory relief as to its

tax-exempt status under section 501(c)(3).

Discussion

A. Jurisdiction Our jurisdiction over this action for

declaratory relief depends upon the filing of a timely petition.2

2
The parties do not disagree that petitioner timely filed
its petition and that we have jurisdiction pursuant to sec.
(continued...)
 - 7 -

Sec. 7428(a) and (b)(3); see Rule 210(c)(3). Petitioner was

required to file its petition within 90 days of the Secretary’s

sending to the organization, by certified or registered mail,

notice of his determination. Sec. 7428(b)(3). Respondent

originally mailed the purported notice of adverse determination,

dated November 4, 2003, to an incorrect address; respondent does

not contend that it was mailed to petitioner’s last known

address. Petitioner did not receive this purported notice.

Accordingly, this purported notice was ineffective for purposes

of triggering the 90-day period under section 7428(b)(3). Cf.

Roszkos v. Commissioner, 850 F.2d 514 (9th Cir. 1988) (holding

that misaddressed purported notices of deficiency, which the

taxpayers did not receive, were a nullity and ineffective for

terminating a Form 872-A agreement to extend the period for

assessment), vacating and remanding 87 T.C. 1255 (1986); Coffey

v. Commissioner, 96 T.C. 161 (1991) (following Roszkos and

decisions of other similarly aligned Courts of Appeals).

In Coffey v. Commissioner, supra, after sending the

original deficiency notice to an incorrect address, the

Commissioner issued another one and sent it to the correct

address. Because the petition was filed within 90 days

2
(...continued)
7428(a). The parties’ agreement is insufficient, however, to
confer jurisdiction if it is otherwise lacking. The Court still
must assure itself that jurisdictional conditions are satisfied.
Evans Publg., Inc. v. Commissioner, 119 T.C. 242, 247 n.5 (2002).
 - 8 -

thereafter, the petition was deemed timely. Id. at 163, 167.

Similarly, petitioner received the notice of determination only

after respondent sent a second notice by certified mail to

petitioner’s counsel on June 14, 2005. The petition was filed

within 90 days thereafter and, accordingly, was timely.

B. Whether Petitioner Is Entitled to Exempt Status

1. Statutory Provisions

An organization that is organized and operated exclusively

for charitable purposes, as described in section 501(c)(3), is

exempt from Federal income tax unless exemption is denied under

section 502 or 503. Sec. 501(a). The central issue in this case

is whether petitioner’s exemption is denied under section 502,

which deals with so-called feeder organizations. Section 502(a)

provides:

SEC. 502(a). General Rule.--An organization
operated for the primary purpose of carrying on a trade
or business for profit shall not be exempt from
taxation under section 501 on the ground that all of
its profits are payable to one or more organizations
exempt from taxation under section 501.

Section 502(b) excludes various types of activities from the

term “trade or business”. Of particular relevance here is

section 502(b)(1), which provides in part:

SEC. 502(b). Special Rule.-- For purposes of this
section, the term “trade or business” shall not
include--

(1) the deriving of rents which would be
excluded under section 512(b)(3), if section
512 applied to the organization * * *
 - 9 -

Thus, an organization’s rental activity is not a “trade or

business” for purposes of section 502 if the rents would be

excluded from unrelated business taxable income (UBTI) under

section 512(b)(3).3 Section 512(b)(3) excludes from UBTI “all

rents from real property”, subject to various exceptions that are

not germane here.4 Section 512(b)(4) provides, however, that

“Notwithstanding” this exclusion, rents from “debt-financed

property” (as defined in section 514) are included in UBTI.5

2. The Parties’ Contentions

Respondent contends that petitioner’s only activities are:

(1) Renting and managing two parcels of improved commercial real

estate, and (2) distributing the profits to Chi Rho. Respondent

contends that from 2001 through 2004, over half of petitioner’s

3
Sec. 511 taxes a tax-exempt organization’s “unrelated
business taxable income” (UBTI). Under the general rule of sec.
512(a), UBTI is the gross income that an exempt organization
derives from an “unrelated trade or business” (as defined in sec.
513) that it regularly carries on, less applicable deductions and
subject to modifications contained in sec. 512(b).
4
In general, the exclusion for rents is denied if the rents
depend in whole or part on the income or profits by any person
from the property leased. Sec. 512(b)(3)(B)(ii). Also, the
exclusion is limited if the rents attributable to personalty
leased with real property are more than “incidental”, sec.
512(b)(3)(A)(ii); the exclusion is denied if more than 50 percent
of the rents are attributable to the personalty, sec.
512(b)(3)(B)(i).
5
Debt-financed property generally means, subject to various
exceptions, any property held to produce income and with respect
to which there is acquisition indebtedness during the taxable
year. Sec. 514(b)(1).
 - 10 -

rental income was unrelated debt-financed income, which was not

excluded by reason of section 512(b)(3). Consequently,

respondent concludes, petitioner is operated for the primary

purpose of carrying on a “trade or business” within the meaning

of section 502, so as to preclude tax-exempt status under section

501(c)(3).6

Petitioner does not dispute that its real property holdings

are debt-financed property within the meaning of section 514 or

that its rental income is unrelated debt-financed income, which

would give rise to UBTI pursuant to sections 512(b)(4) and

514(a)(1) if petitioner were an exempt organization. On brief,

petitioner concedes that if respondent is correct “that debt

financed real estate is, for purposes of Section 502(a), a

prohibited trade or business because of Section 512(b)(4) * * *

the organization is a feeder organization and not a Section

501(c)(3) entity”, unless the exception in section 502(b)(1)

applies.7 Petitioner asserts, however, that it “does not agree

6
Respondent also contends that the facts and circumstances
show that petitioner’s ownership and management activities
associated with its commercial leasing activity are properly
categorized as a “common law trade or business”, without regard
to the UBTI provisions. Because we base our decision on
respondent’s primary argument described in the text supra, we
need not and do not address this alternative argument.
7
According to petitioner’s Forms 990-T, Exempt Organization
Business Income Tax Return, for the years 2001 through 2004,
petitioner’s average acquisition debt ratios declined from a high
of 52.43 percent in 2002 to 49.6 percent in 2004. Petitioner has
(continued...)
 - 11 -

that simply having unrelated business income causes it to become

a Section 502(a) organization”.

3. Is Petitioner’s Rental Activity a “Trade or Business”
Under Section 502?

Petitioner contends that its “triple net leases” are

“investment vehicles, not businesses”. Petitioner contends that

under well-established criteria for determining a trade or

business, as applied in Commissioner v. Groetzinger, 480 U.S. 23

(1987), and its progeny, these leases do not represent a regular

and continuous activity so as to constitute a trade or business.

Petitioner contends that there is no indication that Congress

intended “trade or business” to mean anything different for

purposes of section 502(a). Therefore, petitioner concludes,

section 502(a) fails to ensnare petitioner’s rental activity in

the “trade or business” classification. Accordingly, petitioner

suggests, we need not concern ourselves with the effect, if any,

of the section 502(b)(1) escape hatch. As petitioner puts it:

“The recipe for rabbit soup is to ‘first catch a rabbit’.”

7
(...continued)
not raised, and accordingly we do not consider, any issue as to
whether or how these declining ratios should affect a
determination as to whether petitioner fits the description of an
organization that carries on a business as its “primary purpose”
within the meaning of sec. 502(a).
 - 12 -

Whether or not respondent has caught a rabbit, it would

appear that petitioner is in the soup. The question is whether

petitioner belongs there.

Section 502(b)(1) expressly provides that its special rule

as to the meaning of “trade or business” applies “For purposes of

this section”. Consequently, in construing section 502, we do

not read subsection (a) in isolation but in conjunction with the

special rule of subsection (b)(1), which addresses the meaning of

the term “trade or business”.

Section 502(b)(1) excludes from the term “trade or business”

the deriving of rents that would be excluded from UBTI under

section 512(b)(3) if section 512 applied to the organization.

Under traditional principles of statutory construction, the

statute’s explicit provision excluding rental activity that meets

this test should be understood as precluding the exclusion of

rental activity that does not meet this test. See Silvers v.

Sony Pictures Entmt., Inc., 402 F.2d 881, 885 (9th Cir. 2005);

Catterall v. Commissioner, 68 T.C. 413, 421 (1977), affd. sub

nom. Vorbleski v. Commissioner, 589 F.2d 123 (3d Cir. 1978); see

also Black’s Law Dictionary 620 (8th ed. 2004) (the statutory

canon of construction “expressio unius est exclusio alterius”

holds that “to express or include one thing implies the exclusion

of the other, or of the alternative”).
 - 13 -

Consistent with this analysis, section 1.502-1(d)(2), Income

Tax Regs., provides in relevant part:

For purposes of section 502, and this section, for
taxable years beginning after December 31, 1969, the
term “trade or business” does not include--

(i) the deriving of rents described in section
512(b)(3)(A),

* * * * * * *

For purposes of the exception described in subdivision
(i) of this subparagraph, if the rents derived by an
organization would not be excluded from unrelated
business income pursuant to section 512(b)(3) and the
regulations thereunder, the deriving of such rents
shall be considered a “trade or business”. [Emphasis
added.]

Petitioner contends that because the just-quoted sentence

containing the emphasized matter applies by its terms only “For

purposes of the exception described in subdivision (i) of this

subparagraph”, it has no applicability in construing the meaning

of “trade or business” in section 502(a). We disagree. The

exception described in subdivision (i) of this regulation

applies, according to the regulation’s initial words, “For

purposes of section 502, and this section”. Inasmuch as this

exception applies for purposes of section 502 comprehensively,

the emphasized language supra, which delimits the exception, also

applies for purposes of section 502 comprehensively.

Accordingly, under the regulation, if rents are not excluded from
 - 14 -

UBTI pursuant to section 512(b)(3), the deriving of such rents is

a “trade or business” for all purposes under section 502.

Petitioner does not expressly contend that the subject

regulation is invalid but contends that it is inconsistent with

legislative history. We disagree.

Before amendment in 1969, both sections 502 (in defining

“trade or business” for purposes of the feeder organization

rules) and 512(b)(3) (in defining UBTI) broadly excluded rents

from real property and personal property leased with the real

property.8 In 1969, Congress acted to curtail perceived abuses

involving exempt organizations’ engaging in commercial activity.

See Staff of Joint Comm. on Taxation, General Explanation of the

Tax Reform Act of 1969, at 62-63 (J. Comm. Print 1970). To that

end, Congress amended section 512(b)(3) to narrow the exclusion

8
Before sec. 502 was amended in 1969, it read in its
entirety:

An organization operated for the primary purpose
of carrying on a trade or business for profit shall not
be exempt under section 501 on the ground that all of
its profits are payable to one or more organizations
exempt under section 501 from taxation. For purposes
of this section, the term “trade or business” shall not
include the rental by an organization of its real
property (including personal property leased with the
real property).

Similarly, before amendment in 1969, sec. 512(b)(3) excluded
from the definition of “trade or business”, for purposes of
defining UBTI, “all rents from real property (including personal
property leased with the real property).”
 - 15 -

for real property and associated personal property rentals that

previously had applied for purposes of determining UBTI. Tax

Reform Act of 1969 (TRA), Pub. L. 91-172, sec. 121(b)(1), 83

Stat. 537. In place of the former exclusion, Congress provided

the more limited exclusion now found in section 512(b)(3). S.

Rept. 91-552, at 68-69 (1969), 1969-3 C.B. 423, 468. In

addition, pursuant to new section 512(b)(4), rents that would be

treated as unrelated debt-financed income pursuant to section

514(a)(1) were included as UBTI. TRA sec. 121(b)(2); see also

Kern County Elec. Pension Fund v. Commissioner, 96 T.C. 845

(1991), affd. without published opinion 988 F.2d 120 (9th Cir.

1993).

In the same section of this legislation, Congress amended

section 502 to eliminate the former exclusion for rental

activity, replacing it with the more limited exclusion of section

502(b)(1), cross-referencing new section 512(b)(3). TRA sec.

121(b)(7), 83 Stat. 542. Congress also added other special rules

in section 502(b)(2) and (3), similarly intended to conform the

treatment of exempt organizations’ business activities for

purposes of the UBTI rules and the feeder organization rules

under section 502. Id.; see S. Rept. 91-552, supra at 70, 1969-3

C.B. at 469. Describing this amendment to section 502, the

Senate Finance Committee stated: “this amendment merely makes

these rules [i.e., the UBTI rules and the feeder organization
 - 16 -

rules] consistent.” S. Rept. 91-552, supra at 70, 1969-3 C.B. at

469.

In sum, the legislative history shows clearly that Congress,

in replacing the former exclusion for real property (and

associated personal property) rental activities with the more

limited exclusion provided in section 502(b)(1), did so to

preserve consistency between the feeder organization rules and

the UBTI rules. Petitioner’s position, by contrast, assumes that

the 1969 legislation introduced inconsistency, where it did not

exist before, between the feeder organization rules and the UBTI

rules. In the light of the legislative history, as well as the

plain meaning of the statute and the regulations, petitioner’s

position is untenable.

4. Does the Section 502(b)(1) Exclusion Apply?

Alternatively, petitioner argues that even if its rental

activity is deemed to be a “trade or business” under section

502(a), it qualifies for the section 502(b)(1) exclusion. As

previously noted, section 502(b)(1) excludes from the definition

of “trade or business” the deriving of rents “which would be

excluded under section 512(b)(3), if section 512 applied to the

organization”. Petitioner contends, and respondent does not

dispute, that petitioner’s rents would be excluded under section

512(b)(3) if that provision were applied in isolation.

Petitioner does not dispute that its rentals, deriving from debt-
 - 17 -

financed property, would be subject to UBTI pursuant to section

512(b)(4). Petitioner suggests, however, that the operation of

section 512(b)(4) is irrelevant for purposes of establishing

eligibility for the section 502(b)(1) exclusion. We disagree.

Section 512(b)(4) provides that “Notwithstanding” the

various exclusions from UBTI contained in section 512(b)(1), (2),

(3), and (5), unrelated debt-financed income is included in UBTI.

Section 512(b)(4) thereby “nullifies these exclusions for income

derived from ‘debt-financed property’”. Bartels Trust v. United

States, 209 F.3d 147, 149 (2d Cir. 2000). Consequently, “if

section 512 applied to the organization”, as section 502(b)(1)

provides, then section 512(b)(4) would preclude petitioner’s

exclusion of its rents from UBTI under section 512(b)(3). Hence,

petitioner does not satisfy the requirements of the section

502(b)(1) exclusion.

Conclusion

Petitioner’s rental activity constitutes a “trade or

business” within the meaning of section 502(a); the exclusion

under section 502(b)(1) does not apply. Consequently, petitioner

is not operated exclusively for charitable or other exempt

purposes and so is not entitled to exemption under section

501(c)(3).
 - 18 -

To reflect the foregoing,

Decision will be entered

for respondent.