An appropriate order will be issued, and decision will be entered for respondent.
P was the sole shareholder of two C corporations. One
corporation operated a health club; the other operated a law
firm for which P worked as an attorney. P realized a loss
renting a building to the health club, and he realized income
renting a building to the law firm. P's 1994 Federal income tax
return reported that the loss and income were both "passive"
under
income. R disallowed the offset because, R determined, the
recharacterization rule of
deemed the income nonpassive. HELD: The recharacterization rule
is valid. HELD, FURTHER, the written binding contract exception
of
to the facts herein. HELD, FURTHER, the transitional rule of
application of the recharacterization rule.
*366 OPINION
LARO, JUDGE: This case is before the Court on cross- motions for summary judgment. Respondent determined a $ 28,184 deficiency in petitioner's 1994 Federal income tax and a $ 5,637 accuracy-related penalty under section 6662(a). Petitioner, while residing in Greendale, Wisconsin, petitioned the Court to redetermine respondent's determination.
Following respondent's concession that petitioner is not liable for the accuracy-related penalty, we must decide whether petitioner may offset the income and loss that he realized on his separate rental activities. 1 We hold he may not. Unless otherwise stated, section references are to the Internal Revenue *367 Code applicable to 1994. Rule references are to the Tax Court Rules of Practice and Procedure. We refer to Thomas P. Krukowski as the sole petitioner.
BACKGROUND
Petitioner is the *33 president and sole shareholder of two subchapter C corporations. One corporation (the health club) operates a health club. The other corporation (the law firm) operates a law firm. Petitioner actively works for the law firm as an attorney.
Petitioner rents a building (the club) to the health club, and he rents a second building (the office building) to the law firm. Petitioner's 1994 Federal income tax return reported that: (1) He realized a $ 69,100 loss on the rental of the club, (2) he realized income of $ 175,149 on the rental of the office building, (3) the rental of the club and the rental of the office building were separate passive activities under
Petitioner leased the office building to the law firm on March 1, 1987, pursuant to a written, 5-year lease (the 1987 lease) that provided for monthly rent of $ 17,500. The 1987 lease contained the following renewal provision:
24. OPTION TO RENEW
Lessor grants to Lessee three (3) consecutive options to
renew this Lease, each for a term of three (3) years, at a
rental to be mutually agreed to by Lessor and Lessee prior to
the commencement of a renewal term *368 with respect *35 to that renewal
term, with all other terms and conditions of the renewal lease
to be the same as those herein. To exercise this option, Lessee
must:
(1) give Lessor written notice of the intention to do
so at least 60 days before initial term expires, and
(2) agree with Lessor on rental for renewal period at
least 30 days before initial term expires.
In Lessor's sole discretion, failure to comply with either (1)
or (2) above shall cause the option to renew to become null and
void.
On December 27, 1991, petitioner and the law firm executed a document entitled "Lease Renewal" (the 1991 lease), pursuant to the option provision in the 1987 lease. The 1991 lease provided in full:
Lease Renewal
Lease Renewal made this 27 day of December 1991 between
Thomas P. Krukowski, of Greendale, Wisconsin, herein referred to
as "Lessor" and Krukowski & Costello, S.C., of Milwaukee,
Wisconsin, herein referred to as "Lessee".
Pursuant to Paragraph 24 entitled "Option to Renew" in the
Lease dated March 1, 1987 between Lessor and Lessee (the
"Lease"), Lessee hereby gives written notice of its intention to
exercise the FIRST three year option *36 to renew the Lease.
The term of the Lease will be extended from March 1, 1992
until February 28, 1995 and all other terms and conditions of
the Lease shall remain the same including the monthly rent of
$ 17,500.00.
LESSEE:
KRUKOWSKI & COSTELLO, S.C.
BY: s/
Timothy G. Costello, Secretary
Agreed to and Accepted this 27 day of December 1991
s/
Thomas P. Krukowski, Lessor
DISCUSSION
The parties agree that we may decide this case by way of summary judgment because, they assert, the dispositive issues are purely legal. We agree that our decision herein turns entirely on legal determinations, and, hence, that we may decide this case summarily. Summary judgment is appropriate where, as here, "the pleadings, answers to interrogatories, depositions, admissions, and any other acceptable *369 materials, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law."
Petitioner *37 challenges the ability of the Commissioner to apply the recharacterization rule to the rental income from the office building. Petitioner argues primarily that the recharacterization rule is invalid because it conflicts with explicit statutory text as to the characterization of income derived from a rental activity. Petitioner observes that
We disagree with petitioner that the recharacterization rule is invalid. The recharacterization rule is a legislative regulation, see
The rechacterization rule is not arbitrary, capricious, or manifestly contrary to the statute. 3 It was prescribed by the Secretary pursuant in part to the specific grant of authority stated in
Regulatory authority of Treasury in defining non-passive
income. -- The conferees believe that clarification is desirable
regarding the regulatory authority provided to the Treasury with
regard to the definition of income that is treated as portfolio
income or as otherwise *39 not arising from a passive activity. 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 where the exercise of such authority may (if the
Secretary so determines) be appropriate include the following
* * * (2) related party 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, 1986-3 C.B. (Vol. 4) 1,
147.]
Petitioner also argues that the recharacterization rule is inapplicable to this case by virtue of
Applicable State (Wisconsin) law characterizes the 1991 lease as a renewal (as opposed to an extension) of the 1987 lease, which, in turn, means that the 1991 lease is a contract separate from the 1987 lease. See
First, the language used in both leases by the parties thereto leads to the conclusion that the 1991 lease is a renewal of the 1987 lease. See
*371 Second, the parties' conduct leads to the same conclusion. See id. The 1991 lease was signed by an officer of the law firm (other than petitioner) as "Lessee", and it was signed by petitioner as "Lessor", under the heading "Agreed *41 to and Accepted". If the parties to the leases had intended that the lessee could extend the 1987 lease at its option, petitioner's signature and agreement would have been unnecessary.
Third, the fact that petitioner, as the office building's lessor, had to perform a further act to lengthen the term of the 1987 lease also leads to the conclusion that the 1987 lease was renewed through the 1991 lease. Compare
We also bear in mind that the absence in the 1987 lease of an agreed-upon rent for the renewal period made the 1987 lease unenforceable for any period after the 5-year period expired. See
Petitioner also argues that he is not subject to the recharacterization rule by virtue of
We disagree with petitioner's assertion that
Nowhere in
As part of the regulatory project underlying the 1989 temporary regulations, the Secretary also amended the 1988 temporary regulations (the amended 1988 temporary regulations) to delete the parenthetical exception "(directly or indirectly, other than through a C corporation)" from
The 1988 temporary regulations (prior to the 1989 amendment) and the 1989 temporary regulations are not applicable to the year at bar. 5 The applicable rules are found in: (1) The 1992 proposed regulations, (2) the 1992 final regulations, and (3) the 1994 final regulations. The 1994 final regulations do *374 not help petitioner's cause because they provide specifically that "A taxpayer's activities include those conducted through C corporations that are subject to
Petitioner looks to the fact that the 1992 proposed regulations did not affirmatively and expressly disavow the exception set forth in the 1989 temporary regulations, and he discerns therefrom that the exception continued to exist in 1992. We disagree. The fact that the Secretary did not re-prescribe that exception as part of the 1992 proposed regulations is persuasive evidence that he revoked the exception at that time. See
The facts of
The taxpayers in Schwalbach also advanced an alternative argument that is the same argument that petitioner advances herein. The taxpayers in Schwalbach argued on brief:
in the event it is redetermined the provisions of Treas. Reg.
Sec. 1.469(d)(5) [sic] apply, the provisions of Treas. Reg. Sec.
1.469-4T(b)(2)(ii)(B) should be available to petitioners through
1994 due to the continued confusion with respect to provisions
of the May, 1992, proposed regulations and the absence of a
definitive statement as regards a non-passthrough entity not
conducting passive activities through itself. See, effective
date and transition rules under
We rejected this argument summarily, holding that nothing in
we decline petitioners' invitation to allow them to apply the
rules of
1.469-4(a), Income Tax Regs. Simply put, the effective date and
transition rules related to the regulatory rules under section
469 do not allow them to use it [i.e., the only rule stated in
Reg. 20543 (May 12, 1989), namely, that "a taxpayer's activities
do not include operations that the taxpayer conducts through one
or more entities (other than passthrough entities)."]. See sec.
1.469-11, Income Tax Regs. [Id.]
Although we recognize that
We conclude that petitioner may not offset part of the income that he realized on his rental of the office building to the law firm, by the loss that he realized on his rental of the club to the health club. We have considered all arguments in this case and, to the extent not discussed above, find those arguments to be without merit or irrelevant. To reflect the foregoing,
An appropriate order will be issued, and decision will be entered for respondent.
Reviewed by the Court.
COHEN, WELLS, RUWE, COLVIN, CHIECHI, FOLEY, VASQUEZ, and THORNTON, JJ., agree with this majority opinion.
* * * * * *
BEGHE, J., CONCURRING IN PART AND DISSENTING IN PART: I agree with the majority that
*377 The key question is whether shareholders did materially "participate" in the "activities" of their C corporations under the regulatory law applicable to 1994. The majority conclude that shareholders did so participate, under their "plain reading" of
I. THE MAJORITY'S "PLAIN READING" OF
RECHARACTERIZATION RULE IS UNPRECEDENTED AND INCORRECT
The majority's plain meaning approach to this case is unprecedented, in several disquieting respects. To begin with, neither party argued that the statutory text and the recharacterization rule suffice to answer the question in issue. *54 Instead, the parties' arguments were based on their respective analyses of the applicable provisions of the several successive sets of regulations the Commissioner has issued under
More particularly, the parties have agreed that the 1994 final regulations, and the 1992 proposed regulations, are the governing law. As discussed in more detail below, the 1994 final activity regulation clearly provides that shareholders participate in the activities of their C corporations; that regulation generally applies to 1994. See
For this reason, the parties believed that the crucial issue was whether *55 shareholders participate in C corporation activities UNDER THE 1992 PROPOSED REGULATIONS, and they made their arguments accordingly.
The majority's "plain reading" of
Our Schwalbach decision is a striking example of the importance we have attributed to the 1994 final activity regulation in this context. In Schwalbach, respondent applied the recharacterization rule to a C corporation shareholder. The taxpayers' primary argument was that this application was invalid, because: (1) The 1994 final regulation defining "activity" was a prerequisite to the application of the recharacterization rule to a C corporation shareholder; *56 and (2) the recharacterization rule and the 1994 final activity regulation were invalid for failure to comply with the notice and comment procedures of the Administrative Procedure Act,
In the course of Schwalbach's detailed analysis of the protracted regulatory process that ultimately gave rise to the 1994 final activity regulation, we never questioned that that regulation was a prerequisite to the application of the recharacterization rule. Indeed, if shareholders clearly participated in C corporation activities under the plain meaning of the statute and the recharacterization rule, as the majority now contend, Schwalbach's analysis and upholding of the 1994 final "activity" regulation would be dictum. 7*57
Most importantly, the majority's plain meaning approach is fundamentally inconsistent with the repeated efforts the Commissioner has found it necessary to exert, through *379 issuance of different regulations, simply to interpret and apply the assertedly "plain" language of
As the majority correctly observe,
If I were writing on a clean slate, before the Commissioner had issued any relevant regulations defining "material participation" or "activity", I might conclude that a shareholder could participate in the activities of his C corporations, under a plausible interpretation of the statute. 8 However, the slate was far from clean during the year in issue. As discussed in more detail below, on at least four separate occasions -- in 1988, 1989, 1992, and 1994 -- the Commissioner issued temporary, proposed, or final regulations interpreting "activity" or "participation" for purposes of
Of course, the mere existence of these detailed and often *59 contradictory versions of the regulations is compelling evidence that the meaning of
The majority conclude that shareholders participate in C corporation activities under the plain meaning of
In 1988 and 1989, the Commissioner was faced *60 with the same statutory language. And yet, during those years the *380 Commissioner interpreted that language -- in temporary regulations having the force of law -- to conclude that shareholders did not participate in C corporation activities. See the discussion of the 1988 and 1989 temporary regulations infra pp. 30-34.
The majority do not argue (or even dare to suggest) that the express nonparticipation (or nonattribution) rules set forth in the temporary regulations were invalid interpretations of the statute. Moreover, none of the parties litigating (or courts considering) the application of the recharacterization rule to C corporation shareholders has ever argued or concluded that the temporary regulations were invalid in this respect. The Commissioner's inclusion of express nonattribution rules in two sets of temporary regulations therefore completely refutes the majority's conclusion that shareholders participate in C corporation activities under the plain language of
II. THE SILENCE OF THE 1992 PROPOSED REGULATIONS IS NOT
DISPOSITIVE
The majority correctly note that the Commissioner allowed the relevant portions of the temporary *61 regulations to "sunset" in 1992. See infra p. 34. At the same time, the Commissioner promulgated the 1992 proposed regulations, which apply to the year in issue. See id.
Unlike the temporary regulations, the 1992 proposed regulations say nothing about shareholder participation in C corporation activities. The majority conclude, because the 1992 proposed regulations do not expressly preclude such participation, that shareholders participate in C corporation activities even when the proposed regulations apply. Once again, I disagree.
The majority's interpretation of the "silent" 1992 proposed regulations rests on their conclusion that shareholders participate in C corporation activities under the plain meaning of the statute and the recharacterization rule. As explained above, the majority's plain reading is incorrect; their interpretation of the 1992 proposed regulations is therefore also incorrect. The silence of the 1992 proposed regulations simply does not require (or as explained below, even permit) us to reach the majority's result.
*381 III. THE SILENCE OF THE 1992 PROPOSED REGULATIONS MUST BE
INTERPRETED IN LIGHT OF THE PRIOR AND SUBSEQUENT
REGULATIONS
In essence, the majority *62 view
My view is different. I see
Of course, the Commissioner later adopted a contrary interpretation. HOWEVER, THE COMMISSIONER DID NOT PUBLICLY ANNOUNCE THIS CONTRARY INTERPRETATION UNTIL 1994, WHEN HE ISSUED THE 1994 FINAL REGULATIONS. THIS ANNOUNCEMENT CAME MORE THAN 6 YEARS AFTER THE 1988 TEMPORARY REGULATIONS, AND ALMOST AT THE END OF 1994, THE TAXABLE YEAR IN ISSUE. See
I agree that the Commissioner is entitled to change his mind; we so decided in Schwalbach. However, under the circumstances of this case, where the Commissioner had issued two sets of temporary regulations taking a position favorable to taxpayers (and petitioners), the standards of fairness developed by this Court (discussed in more detail below) require that the Commissioner publicly announce his change of position, before the new position can take effect. See
Against this background, the proper interpretation of the "silent" 1992 proposed regulations *64 becomes vitally important. Although the Commissioner allowed the relevant portions of the 1988 and 1989 temporary regulations to "sunset" in 1992 and replaced them with the 1992 proposed regulations, neither these actions, nor the silent proposed regulations themselves, constituted the necessary public announcement of the Commissioner's change of position from the temporary regulations.
Prior to the issuance of the 1994 final regulations, taxpayers could not know (or, as explained below, even infer) that the Commissioner had changed his interpretation of
In reaching this *65 conclusion, I'm not suggesting that the Commissioner lacked the power to prescribe a final regulation that would have applied the new activity definition retroactively. 10*66 As we concluded in Schwalbach, the Commissioner's actions had at least alerted taxpayers to the possibility *383 that the definition of activity was under reconsideration. What we should decide in the case at hand, however, is that by promulgating the transitional rule of the 1994 final regulations, the Commissioner wisely chose to apply the new activity definition prospectively, unless the taxpayer benefited otherwise.
In summary, the majority's plain reading of
The recharacterization rule recharacterizes rental income from property "rented for use in a trade or business activity * * * in which the taxpayer materially participates * * * for the taxable year".
Because the law firm is a C corporation, we're required to decide whether a shareholder could participate in a trade or business activity of his C corporation under the law applicable to 1994. In 1988, 1989, 1992, and 1994, the Commissioner issued temporary, proposed, or final regulations defining "activity" or "material participation" for purposes of
In 1988, the Commissioner issued the first
The 1988 temporary regulations didn't define "activity". See
(f) PARTICIPATION -- (1) IN GENERAL. Except as otherwise
provided in this paragraph (f), any work done by an individual
(without regard to the capacity in which the individual does
such work) in connection with an activity in which the
individual owns (DIRECTLY OR INDIRECTLY, OTHER THAN THROUGH A C
CORPORATION) an interest at the time the work is done shall be
treated for purposes of this section as participation of such
individual in the activity.
emphasis *69 added.]
The second parenthetical of this 1988 definition clearly provided that an individual shareholder did not participate (and thus could not materially participate) in the activities of his C corporations. 11 As a result, under the 1988 temporary regulations the recharacterization rule could not apply to income received by a C corporation's shareholder/lessor, notwithstanding the absence of an "activity" definition in those regulations.
*385 B. THE 1989 TEMPORARY REGULATIONSIn 1989, the Commissioner issued
The 1989 temporary regulations amended the *70 participation definition contained in the 1988 temporary regulations by deleting the parenthetical phrase "(directly or indirectly, other than through a C corporation)".
At first blush, one might think that this elimination of restrictive language -- and the resulting silence about whether individuals could participate in their indirectly owned activities -- might mean that individuals could participate in the activities of all their entities, including C corporations. However, this was *71 not the case. The new definition of "activity" contained in
In 1992, the Commissioner adopted the participation definition of the 1989 temporary regulations substantially unchanged, as final regulation
In 1994, the Commissioner issued
The following table summarizes the development over time of the activity and material participation definitions in the
_____________________________________________________________________
Provision re shareholder's
participation in his C
corporation's activities
_________________________________
"Material
"Activity" participation" Overall
Year/event regulation regulation effect
_____________________________________________________________________
1988 temporary Silent Parenthetical Shareholder
regulations (no activity expressly does not
(
*75 shareholder C corporation
does not activities
participate in
C corporation
activities
1989 temporary Definition and Silent Shareholder
regulations example (parenthetical does not
(
provide C corporation
shareholder activities
does not
participate in
C corporation
activities
1992 proposed Silent Silent ???
regulations (no definition (same as (at issue in
(PS-1-89) or example) above) the case at
hand)
1994 final Expressly Silent Shareholder
regulations provides that (same as participates
(
activities of C
include those corporations
conducted subject to
through C
corporations
subject to
As the above discussion makes clear, the 1988 and 1989 *76 temporary regulations expressly provided that shareholders did not participate in C corporation activities; the 1994 final regulations expressly provide that shareholders do so participate. The 1992 proposed regulations said nothing about this issue.
The 1994 final regulations generally apply to 1994. See
The parties agree that the 1992 proposed regulations apply to this case.
VI. WE NEED NOT INFER THAT SHAREHOLDERS PARTICIPATE IN C
CORPORATION ACTIVITIES UNDER THE 1992 PROPOSED REGULATIONS
The majority conclude (as respondent argued) that the silence of the 1992 proposed regulations must be interpreted as allowing shareholder participation in C corporation activities. According to the majority (and respondent), because the 1992 proposed regulations do not contain the express nonparticipation rule of the temporary *77 regulations, it must be inferred that the Commissioner did not intend to continue that rule in the 1992 proposed regulations. The majority conclude that it must be inferred further that shareholders participate in C corporation activities where the 1992 proposed regulations apply. I disagree. 15
*389 A. THE PROPOSED REGULATIONS' SILENCE IS AMBIGUOUSThe long and tortuous history of the
The *78 recharacterization rule employs the terms "activity" and "material participation". As the table,
Under the 1994 final regulations, one of the key definitions -- regarding material participation -- still does not address the question of C corporation shareholder participation. Yet, as a result of the new activity definition contained in those regulations, a shareholder clearly participates in C corporation activities under the regulations as a whole.
The result of all this is that in 1988 and 1989, regulatory silence with respect to one of the key terms employed by the recharacterization rule meant that a shareholder did not participate in C corporation activities. By contrast, in 1994, such regulatory silence means that the shareholder does *79 participate in those activities. Under these circumstances, it is difficult to infer either an intent to repeal a nonparticipation rule, or an intent to prescribe a participation rule, from the "silence" of the 1992 proposed regulations. More tellingly, it would have been far more difficult for petitioners to divine either of these results from that silence during 1994, the year in issue; the 1994 final regulations were not promulgated until October of that year. See
B. THE CANONS OF CONSTRUCTION DO NOT MANDATE A
PARTICIPATION INTERPRETATION
The majority attempt to support their interpretation of the 1992 proposed regulations by reference to a canon of statutory *390 construction. However, canons of construction simply do not require us to reach the majority's result.
The majority note that material contained in earlier-enacted legislation, but omitted in subsequently enacted legislation, is deemed to be repealed by the subsequent enactment. The majority employ this canon (and apply it to regulations) to support their conclusion that the 1992 proposed regulations' failure to restate one or the other of the express nonparticipation rules contained in the 1988 and 1989 *80 temporary regulations means that the 1992 proposed regulations repealed that rule.
Although the majority's canon may be helpful at times, this case should not (and need not) be decided by a canon of construction. First, the canon cited by the majority is far from an absolute rule. It may be disregarded where the lawmaker's intent is found to be otherwise. See Singer, Sutherland Statutory Construction, sec. 23.32 at 283 and sec. 23.12 at 363 (5th ed. 1993).
Second, and more importantly, the canons of construction usually cut both ways, see Llewellyn, The Common Law Tradition: Deciding Appeals 521-535 (1960), even when they're not just wrong. See Posner, Statutory Interpretation -- in the Courtroom and in the Classroom,
For example, another canon of construction, applied in
The 1994 final regulations expressly state that a shareholder's activities include those conducted through C corporations subject to
C. THE EXPRESS PARTICIPATION RULE OF THE 1994 FINAL
REGULATIONS DID NOT "CLARIFY" THE 1992 PROPOSED
REGULATIONS
To support the position that shareholders participate in C corporation activities under the 1992 proposed regulations, respondent additionally argued that the express participation rule of the 1994 final regulations simply "clarified" the 1992 proposed regulations. This is also incorrect.
The 1994 final regulations included the following sentence dealing with the "scope and purpose" of the activity definition: "A taxpayer's activities include those conducted through C corporations that are subject to
*392 Of course, a preamble may be used as an aid in interpreting the regulation it accompanies. See
The proper interpretation of a regulation as a matter of law is
a responsibility that ultimately rests with the courts. In
exercising its judicial function, the court may be aided by the
views of the drafters on the intended meaning of the language,
but to be accorded any weight, those views cannot be post hoc
* * *.
More importantly, the preamble's statement that the language *85 added to the 1992 proposed regulations' activity definition by the 1994 final regulations was only a clarification simply does not withstand scrutiny. According to the preamble, the new language clarified a "grouping" rule contained in the 1992 proposed regulations, by explaining that a taxpayer could group activities conducted through C corporations with other activities. See
(j) ACTIVITIES CONDUCTED THROUGH PARTNERSHIPS OR S
CORPORATIONS. A partnership or S corporation must group its
activities under the rules of this section. Once a partnership
or S corporation determines its activities, a partner or
shareholder groups those activities with activities conducted
directly by the partner or shareholder or with activities
conducted through other partnerships or S corporations in
accordance with the rules of this section.
As the above-quoted passage makes clear, the grouping rule of the 1992 proposed regulations provided that a taxpayer could group activities *86 conducted through passthrough entities with activities conducted directly. Notwithstanding the Commissioner's claim in the preamble, I fail to understand how a rule entitled "Activities conducted through partnerships or S corporations", and which refers explicitly several times only to such passthrough entities, could be "clarified" *393 to provide that a taxpayer may group activities conducted through nonpassthrough entities as well, such as "C corporations that are subject to
Our decision in
VII. FAIRNESS DEMANDS WE INTERPRET THE SILENCE OF THE 1992
PROPOSED REGULATIONS AS CONTINUING THE NONPARTICIPATION
RULE OF THE TEMPORARY REGULATIONS
Respondent and the majority assert that the silence of the 1992 proposed regulations must be interpreted as repealing the nonparticipation rule of the temporary regulations and as prescribing an express participation rule instead. For the reasons just set forth, I disagree. Placing the silence of the 1992 proposed regulations in its proper context, it's difficult to infer from such silence either an intent to repeal a nonparticipation rule, or an intent to prescribe a participation rule. With respect to the issue in the case at hand, the recharacterization rule and the 1992 proposed *88 regulations are ambiguous.
Nevertheless, setting aside for the moment any inferences that may be drawn from the silence (or other ambiguity) of the 1992 proposed regulations, three aspects of those regulations *394 are crystal clear. First, the 1992 proposed regulations do not expressly provide that a shareholder participates in C corporation activities. Second, the 1992 proposed regulations do not expressly disavow the rule of nonattribution that had been set forth in the 1988 and 1989 temporary regulations. Third, the 1992 proposed regulations neither state that the Commissioner was changing his position on shareholder participation in C corporation activities, nor explain why such a change was being made. For all these reasons, the standards of fairness developed by this Court require us to interpret the ambiguity of the 1992 proposed regulations as maintaining the nonattribution interpretation of the statute and the recharacterization rule formerly contained in the temporary regulations.
As an example of these standards of fairness, we noted in
It is in this context that (contrary to the statement in
I agree with our conclusion in
Our cases interpreting another large and detailed set of legislative regulations -- the consolidated return regulations -- provide another example of how the standards of fairness instruct us to interpret the Commissioner's silence in the case at hand. We have held that the Commissioner is bound by the consequences flowing from the silence (or the express terms) of the consolidated *91 return regulations, even when those consequences are arguably at odds with larger tax principles or the statute as a whole. See
Our opinion in
*396 Though the 1968 proposed regulations were withdrawn in 1971,
before the years involved in this case, we can readily
understand petitioner's confusion as to respondent's true
position * * *. * * *
We cannot fault petitioner for not knowing what the law was
in this area when the Commissioner, charged by Congress to
announce the law (sec. 1502), never decided what it was himself.
* * *
Thus, we find that the Commissioner's regulations regarding
the manner in which the accumulated earnings tax was to be
imposed on corporations making consolidated returns were
ambiguous during the years at issue. This ambiguity was of the
Commissioner's making, and, as such, must be held against him.
* * * We think that under these circumstances the failure of
petitioner to comply with respondent's post *93 hoc view of the
regulations is an insufficient ground on which to impose the
accumulated earnings tax, and we hold for petitioner on the
issues herein presented. 4
___________
4*94 See also Corn Belt Hatcheries of Arkansas, Inc. v.
[
Our opinion in
Petitioner interprets * * * [the first revenue ruling] to
permit what its words seem to say * * *. We consider this
interpretation a plausible one and we are not disposed to reject
it by importing into the ruling the subsidiary qualification
asserted by respondent. Taxpayers are already burdened with an
incredibly long and complicated tax law. We see no reason to add
to this burdenby requiring them anticipatorily to interpret
ambiguities in respondent's rulings to conform to his subsequent
clarifications, particularly in an area, such as consolidated
returns, where Congress has placed such reliance on respondent's
expertise. * * * [Corn Belt Hatcheries of Arkansas, Inc. v.
*397 CONCLUSION
Notwithstanding the majority's belated resort to "plain meaning",
The Commissioner has long recognized the value of effective date and transitional rule relief in the
The 1988 and 1989 temporary regulations expressly provided that a shareholder could not participate in the activities of his C corporations. By contrast, the 1992 proposed regulations were silent on this issue. For the reasons set forth above, taxpayers could not have inferred from this *398 silence that the Commissioner had changed the prior rules to provide that shareholders participate in the activities of their C corporations *99 under the 1992 proposed regulations.
More importantly, notwithstanding any contrary inferences that might have been drawn, it is clear that the activity definition contained in the 1994 final regulations was the first activity rule expressly providing that a shareholder participated in his C corporation's activities. I repeat the observation we made in
the change in language from the proposed regulations was
substantial; up until the final regulations, the Commissioner
had not publicly taken the position that an individual's
activities could include activities conducted through a C
corporation.
I also repeat that in Schwalbach we never questioned that this 1994 change was a prerequisite to the recharacterization of rental income received by the shareholder of a C corporation.
In promulgating the 1994 final regulations containing this substantial change, the Commissioner once again recognized the importance of transitional relief. The 1994 final regulations provided that taxpayers could determine their tax liability for years ending after May 10, 1992, and beginning before October 4, 1994, under *100 the 1992 proposed regulations if they so chose, rather than under the final regulations. See
It would be inconsistent with this grant of transitional relief to hold to their detriment that shareholders participated in the activities of their C corporations under the 1992 proposed regulations. Taxpayers could not learn or infer, from reading the 1992 proposed regulations, that shareholders participated in the activities of their C corporations. Moreover, the addition of an express attribution rule to the 1994 final regulations was a significant change from those proposed regulations. The only possible purpose of the transitional rule contained in the 1994 final regulations was to protect taxpayers from this type of unanticipated change during the interim period.
The Commissioner has abused the regulatory process in backing and filling on the transitional rule issue in this case and in previous cases. Having with one hand granted transitional *399 relief in the 1994 final regulations by allowing C corporation shareholders for 1993-94 to apply the 1992 proposed regulations, the Commissioner should not be able to take it away with the other, through *101 statutory notices and litigation.
I would hold that shareholders who received net rental income from their C corporations -- during years to which the 1992 proposed regulations apply -- are not subject to the recharacterization rule. The majority's holding to the contrary is incorrect.
Footnotes
1. Petitioner asserts that he treated the separate rental activities as a single activity under
sec. 1.469-4(c)(1), Income Tax Regs.↩ The record does not support this assertion. To the contrary, the record reveals that petitioner treated his rental activities as separate activities.2. The recharacterization rule of
sec. 1.469-2(f)(6), Income Tax Regs. , provides:(f)(6) PROPERTY RENTED TO A NONPASSIVE ACTIVITY. 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 (within
the meaning of
sec. 1.469-5T ) for the taxable year * * *[Sec. 1.469-2(f)(6), Income Tax Regs.↩ ]3. The Court of Appeals for the Fifth Circuit has so concluded. See
Fransen v. United States, 191 F.3d 599">191 F.3d 599↩ (5th Cir. 1999).4. Although we understand the words "regular", "continuous", and "substantial" to support a finding that petitioner materially participated in the law firm's business activity, we note that petitioner also meets the definition of the term "material participation" as set forth in the applicable regulations.
Sec. 1.469-5T(a) and(d), Temporary Income Tax Regs. ,53 Fed. Reg. 5686 (Feb. 25, 1988) (an individual materially participates in an activity if, inter alia, he or she participates in an activity for more than 500 hours in the taxable year, he or she participates in the activity for more than 100 hours in the taxable year and no other individual spends more time in the activity, or the activity involves the performance of legal services and the individual had materially participated in the activity during any 3 years prior to the year in question).5. For completeness, we note that the Secretary allowed the 1989 temporary regulations to expire on May 11, 1992, under the sunset provision of sec. 7805(e)(2). See
57 Fed. Reg. 20803↩ (May 15, 1992).6. Neither party disputes that the corporation operating the law firm is a C corporation subject to
sec. 469 . See sec. 1.469- 1T(b)(4) and(5), Temporary Income Tax Regs. ,53 Fed. Reg. 5686, 5701 (Feb. 25, 1988) (a C corporation is subject tosec. 469↩ if it is a "Personal service" or "Closely held" corporation.7. Of course, in
Sidell v. Commissioner, T.C. Memo 1999-301">T.C. Memo 1999-301 , andConnor v. Commissioner, T.C. Memo 1999-185">T.C. Memo 1999-185 , we did conclude thatsec. 1.469-2(f)(6), Income Tax Regs. (the recharacterization rule), could be applied to C corporation shareholders where the regulations promulgated inT.D. 8565, 2 C.B. 81">1994-2 C.B. 81 , 59 Fed. Reg. 50485 (Oct. 4, 1994) (the 1994 final regulations), and the regulations promulgated in Notice of Proposed Rulemaking, PS-1-89,1 C.B. 1219">1992-1 C.B. 1219 , 57 Fed. Reg. 20802 (May 15, 1992) (the 1992 proposed regulations), applied. I believe those decisions should no longer be followed. As I explain in the text below, the 1992 proposed regulations, properly interpreted, prevent shareholder participation in C corporation activities.In any event, the majority rely little on Sidell and Connor for their conclusion; perhaps this is because the majority's view of the governing law is so fundamentally different from the views expressed in those opinions.↩
8. I'm not sure, however, that even in the absence of regulations I would agree with the majority that attributing C corporation activities to the shareholder is a foregone conclusion under either the statute or the recharacterization rule. Both the tax common-law rule of
Moline Properties, Inc. v. Commissioner, 319 U.S. 436">319 U.S. 436 , 87 L. Ed. 1499">87 L. Ed. 1499, 63 S. Ct. 1132">63 S. Ct. 1132↩ (1943), and the necessity of statutory stock ownership attribution rules in other areas, e.g., secs. 267, 318, and 544, would give me pause, even if they wouldn't bar this approach.9. One of the
section 469 regulations -- the temporary "activity" regulation promulgated in 1989 -- alone occupied over 20 pages of the Federal Register. Seesec. 1.469-4T, Temporary Income Tax Regs. ,54 Fed. Reg. 20527, 20542-20565 (May 12, 1989). As described in the text infra p. 34, the Commissioner allowed this regulation to "sunset" under sec. 7805(e), partly as a result of public criticism that it was overly long and complex, burdensome for small taxpayers, and mechanically inflexible. SeeSchwalbach v. Commissioner, 111 T.C. 215">111 T.C. 215 , 224↩ (1998).10. See sec. 7805(b) (the Secretary may prescribe the extent, if any, to which a regulation shall be applied without retroactive effect);
Automobile Club of Michigan v. Commissioner, 353 U.S. 180">353 U.S. 180 , 184, 1 L. Ed. 2d 746">1 L. Ed. 2d 746, 77 S. Ct. 707">77 S. Ct. 707 (1957) (Commissioner may correct any regulation retroactively, but also has discretion to limit retroactivity to avoid inequitable results); cf. sec. 7805(b) as in effect for regulations relating to statutory provisions enacted after July 29, 1996. Of course, the Commissioner's unexplained reversal of position from the regulations promulgated inT.D. 8175, 1 C.B. 191">1988-1 C.B. 191 , 53Fed. Reg. 5686 (Feb. 25, 1988) (the 1988 temporary regulations), and inT.D. 8253, 1 C.B. 121">1989-1 C.B. 121 , 54 Fed. Reg. 20527 (May 12, 1989) (the 1989 temporary regulations), would be relevant in any judicial review of the 1994 final regulations, if the Commissioner had decided to apply those regulations retroactively. SeeGeorgia Fed. Bank v. Commissioner, 98 T.C. 105">98 T.C. 105↩ (1992).11. Unless the shareholder also owned a passthrough interest in the C corporation's activity, through which he could be considered to participate. See
sec. 1.469-5T(k) , EXAMPLES (1) and (2),53 Fed. Reg. 5686, 5727↩ (Feb. 25, 1988).12. The majority opinion refers to the participation definition of the 1988 temporary regulations, as amended by the 1989 temporary regulations, as the "amended 1988 temporary regulations". I prefer to describe the Commissioner's simultaneous 1989 definitions of both "participation" and "activity" as the 1989 temporary regulations; after all, it was those definitions taken together that established the law applicable to 1989.↩
13. New
sec. 1.469-4T of the 1989 temporary regulations defined activity for purposes of the passive loss rules. Seesec. 1.469-4T, Temporary Income Tax Regs. ,54 Fed. Reg. 20527, 20542 (May 12, 1989).Sec. 1.469-4T(b)(2)(ii)(B) of those regulations provided that for purposes ofsection 469 and the regulations thereunder "a taxpayer's activities do not include operations that a taxpayer conducts through one or more entities (other than passthrough entities)."Id. at 20543 .Sec. 1.469-4T(b)(2)(i) in turn defined "passthrough entity"; that definition did not include C corporations.Id. at 20543 .A shareholder's inability to participate in the activities of his C corporations under the cited provisions was made clear by the example accompanying
section 1.469-4T(b)(2) of the 1989 temporary regulations. In the facts of that example, taxpayer A owned stock of closely held corporation X. The example stated:X is a C corporation and therefore is not a passthrough entity.
Thus, for purposes of
section 469 and the regulationsthereunder, A's activities do not include the operations of X's
real estate development business. Accordingly, A's participation
in X's business is not participation in an activity of A, and is
not taken into account in determining whether A materially
participates (within the meaning of 1.469-5T) * * * in any
activity.
[Sec. 1.469-4T(b)(2), Temporary Income Tax Regs. , 54Fed. Reg. 20543-20544 (May 12, 1989).]↩
14. The majority opinion refers to this definition as the 1992 final regulations.↩
15. Our memorandum opinion in
Sidell v. Commissioner, T.C. Memo 1999-301">T.C. Memo 1999-301 , made a similar inference in support of its conclusion that shareholders participate in corporate activities under the 1992 proposed regulations. AlthoughSidell v. Commissioner, 78 T.C.M. (CCH) 423">78 T.C.M. (CCH) 423 , T.C. Memo 1999-301">T.C. Memo 1999-301, 1999 Tax Ct. Memo LEXIS 347">1999 Tax Ct. Memo LEXIS 347↩ at *35, stated that "Simply put, the proposed regulations' silence means nothing, not something", Sidell nevertheless concluded that from this silence "it is inferable" that the Commissioner didn't intend, in the 1992 proposed regulations, to adhere to the position of the temporary regulations.16. The temporary regulations contain an excellent example of a situation in which the majority's canon would produce the wrong answer. The 1988 temporary regulations' participation definition contained language expressly preventing shareholder participation in C corporation activities. The 1989 temporary regulations deleted this language. Applying the majority's canon, one would conclude the Commissioner intended shareholders to participate in C corporation activities under the later regulation. However, this was not the case, as the activity definition of the 1989 temporary regulations clearly shows. See
supra pp. 32-34↩ .17. One other point: the cases cited by the majority to support their canons of construction argument concern situations where an express rule was clearly required to sustain a party's position. For example, Independent Ins. Agents of Am., Inc. v. Clarke, 955 F.2d 731 (D.C. Cir. 1992), revd. on other grounds sub nom.
United States Natl. Bank v. Independent Ins. Agents of Am., Inc., 508 U.S. 439">508 U.S. 439 , 124 L. Ed. 2d 402">124 L. Ed. 2d 402, 113 S. Ct. 2173">113 S. Ct. 2173 (1993), concerned a national bank's ability to sell insurance. In the Court of Appeals' view,section 24 of the National Bank Act,12 U.S.C. sec. 24 (1988) , limited banks' activities to those expressly authorized by law. Starting from this premise, it of course followed, after Congress omitted the section of the banking laws authorizing banks to sell insurance, that banks no longer had the power to do so.The majority assert that an express nonattribution rule is necessary to prevent shareholder participation in C corporation activities. As made clear in the text, this is incorrect. The Commissioner's interpretations of the statute in both sets of temporary regulations, the Commissioner's inclusion of an express participation rule in the 1994 final regulations, and our decision in
Schwalbach v. Commissioner, 111 T.C. 215">111 T.C. 215 (1998), treating the 1994 final regulations as necessary, all suggest that shareholders do not participate in C corporation activities, under the plain meaning ofsection 469↩ .18. In
Georgia Fed. Bank v. Commissioner, 98 T.C. 105">98 T.C. 105 , 109-110↩ (1992), we also observed that if a regulation repudiates an earlier interpretation, the manner in which it evolved merits inquiry, and the more recent interpretation may be accorded less deference than a consistently maintained position. We further noted that an agency's action must be upheld, if at all, on the basis articulated by the agency at the time of the rule making; post hoc rationalizations cannot be offered to buttress an agency's action.4. Although we understand the words "regular", "continuous", and "substantial" to support a finding that petitioner materially participated in the law firm's business activity, we note that petitioner also meets the definition of the term "material participation" as set forth in the applicable regulations.
Sec. 1.469-5T(a) and(d), Temporary Income Tax Regs. ,5686">53 Fed. Reg. 5686↩ (Feb. 25, 1988) (an individual materially participates in an activity if, inter alia, he or she participates in an activity for more than 500 hours in the taxable year, he or she participates in the activity for more than 100 hours in the taxable year and no other individual spends more time in the activity, or the activity involves the performance of legal services and the individual had materially participated in the activity during any 3 years prior to the year in question).4. Although we understand the words "regular", "continuous", and "substantial" to support a finding that petitioner materially participated in the law firm's business activity, we note that petitioner also meets the definition of the term "material participation" as set forth in the applicable regulations.
Sec. 1.469-5T(a) and(d), Temporary Income Tax Regs. ,53 Fed. Reg. 5686↩ (Feb. 25, 1988) (an individual materially participates in an activity if, inter alia, he or she participates in an activity for more than 500 hours in the taxable year, he or she participates in the activity for more than 100 hours in the taxable year and no other individual spends more time in the activity, or the activity involves the performance of legal services and the individual had materially participated in the activity during any 3 years prior to the year in question).19.
Sec. 1.469-1T(g)(3)(iii), Temporary Income Tax Regs. ,53 Fed. Reg. 5686, 5707-5708 (Feb. 25, 1988), further supports the interpretation that a shareholder did not participate in C corporation activities under the 1992 proposed regulations. Personal service corporations and closely held C corporations are themselves subject to the passive loss rules. Seesec. 469(a)(2)(B) and(C) .Sec. 1.469-1T(g)(3), Temporary Income Tax Regs. ,53 Fed. Reg. 5707- 5708 (Feb. 25, 1988) determines when such corporations will be considered to participate in their own activities. Sec. 1.469- 1T(g)(3)(iii),Temporary Income Tax Regs., supra , provides that for this purpose, the general participation definition ofsec. 1.469-5T, Temporary Income Tax Regs. , shall apply, EXCEPT THAT INDIVIDUALS SHALL BE TREATED AS HOLDING AN INTEREST IN ALL CORPORATE ACTIVITIES.This special participation definition was first promulgated as part of the 1988 temporary regulations (see
sec. 1.469-1T(g)(3)(iii), Temporary Income Tax Regs. , supra. It was an exception to the general participation definition of those 1988 temporary regulations, which expressly provided that a shareholder did not participate in C corporation activities. Seesupra pp. 30-32 .The Commissioner did not amend or remove the special participation definition of
sec. 1.469-1T(g)(3)(iii), Temporary Income Tax Regs. , supra, when he promulgated the 1992 proposed regulations. SeeT.D. 8417 ,1 C.B. 173">1992-1 C.B. 173 , 57 Fed. Reg. 20747 (May 15, 1992) (certain temporary passive loss regulations amended or adopted as final regulations); Notice of Proposed Rulemaking, PS-1- 89,1 C.B. 1219">1992-1 C.B. 1219↩ , 57 Fed. Reg. 20802 (May 15, 1992) (the 1992 proposed regulations). Because the special definition would not be necessary if shareholders generally participated in C corporation activities, the Commissioner's failure to remove that definition when he promulgated the 1992 proposed regulations further suggests that shareholders did not generally participate in C corporation activities under those regulations.