Connor v. Commissioner of Internal Revenue
| Decision Date | 05 July 2000 |
| Docket Number | No. 99-3324,99-3324 |
| Citation | 218 F.3d 733 |
| Parties | (7th Cir. 2000) Michael F. CONNOR and Jane H. Connor, Petitioners-Appellants, v. Commissioner of Internal Revenue, Respondent-Appellee |
| Court | U.S. Court of Appeals — Seventh Circuit |
Appeal from the United States Tax Court. No. 3552-98--John J. Pajak, Judge.
Before Flaum, Ripple and Kanne, Circuit Judges.
Michael and Jane Connor appeal a tax court decision finding a deficiency of $3,616 in their 1993 federal income tax and $6,089 in their 1994 federal income tax. This finding of deficiency arose from the determination that Michael Connor actively managed his personal services C corporation, which rents an office building owned by Jane Connor, and for this reason, the passive activity loss rules barred the offset of income from the rental against other passive losses. The Connors claim on appeal that in 1993 and 1994 the "material participation" requirement of the passive activity rules did not apply to shareholders in C corporations and that the lease was exempted from passive activity rules under a "written binding contract" exception. Because we find that in 1993 and 1994, the "material participation" test applied to shareholders in non-pass-through entities and that the lease between the C corporation and Jane Connor was not binding, we affirm the decision of the tax court.
Michael Connor is a dentist. He owns a majority of the shares in his personal services C corporation, Connor & McKeever, S.C. ("corporation"), which was known in 1993 as Michael F. Connor, D.D.S., S.C., and works full- time for the corporation. The corporation leases from Jane Connor, Michael Connor's wife, the office building in which Michael Connor practices. The Connors file a joint tax return.
The lease on Michael Connor's office commenced in October 1979. According to the original document, the lease was to run until October 1982, and thereafter to continue year to year under the same terms and conditions. However, in October 1982, the Connors signed an addendum to the lease, which provided that Both parties continue to abide by the terms of the lease up to the present, but the rent has increased from $900 per month in 1979 to $2,000 per month in 1994.
In 1993, the Connors reported $10,503 in net income from the lease of the office. The Connors characterized this income as passive and used it to set off certain passive losses from the rental of a second property. In 1994, the Connors reported $15,937 in net income from the lease of the office. They characterized this income as passive and again used it to set off passive losses from the rental of other property.
In 1997, the Commissioner of Internal Revenue ("Commissioner") issued a notice of deficiency to the Connors, informing them that the Commissioner had determined that the rental of the dental office to be a non-passive activity. For this reason, the Commissioner believed that the Connors should not have offset their gains from this activity against losses from their other passive activities. The Commissioner assessed a deficiency of $3,616 for 1993 and $6,089 for 1994 as a result of the Connors' mischaracterization and also sought a penalty of $723 for 1993 and $1,218 for 1994 for negligence, pursuant to Internal Revenue Code (I.R.C.) sec. 6662(a).
The Connors contested this notice of deficiency in tax court. They claimed that because the Corporation, rather than Michael Connor, leased the dental property, the rental was a passive activity for the Connors. In support of this position, they maintained that the 1993-1994 regulations applying the passive activity rules provided that shareholders in C corporations did not materially participate in the activities of these corporations. The tax court disagreed, holding that although Connor was only a shareholder in the Corporation, he materially participated in the lease, and for that reason, the lease income was non-passive income for the Connors. On this basis, the tax court affirmed the deficiency claimed by the Commissioner but declined to penalize the Connors for negligence.
On appeal, the Connors contest the determination of the tax court on two grounds. First, they argue that the tax court erred in concluding that the passive activity regulations then in effect deemed C corporation shareholders as materially participating in the activities of those corporations. We review de novo conclusions of law reached by the tax court. See L & C Springs Assocs. v. Commissioner, 188 F.3d 866, 869 (7th Cir. 1999). Second, the Connors argue that the "written binding contract" exception applies to their lease, exempting the income generated by the lease from the passive activity rules. For this reason, the Connors claim that the tax court erred as a matter of law in finding them in deficiency. We review de novo this question of law. See Pittman v. Commissioner, 100 F.3d 1308, 1312 (7th Cir. 1996).
The Connors contend that during 1993-94, the I.R.C. regulations in force allow them to use the income generated from the lease between Jane Connor and the corporation to offset certain investment losses generated by other passive investments in real estate held by Michael Connor. The I.R.C. regulations in force prior to 1993 allowed the Connors to perform this income offset, but the regulations issued in 1993 failed to reenact the exemption that allowed the Connors to do so, and in 1994, the regulations promulgated by the Secretary of the Treasury ended the Connors' ability to offset this income by characterizing the rental income from the lease as "non-passive" in contrast with the "passive" income generated by the Connors' other investment activities. Thus, the Connors ask us to interpret the I.R.C. regulations governing passive activity income attribution in effect in 1993-1994 to determine whether income generated by a lease like that made by the Connors should be considered passive or non-passive, a determination which depends on whether a taxpayer like Michael Connor can be said to "materially participate" in the activities of his corporation.
As part of the Tax Reform Act of 1986, enacted at 26 U.S.C. sec. 1 et seq., Congress limited the financial incentive for many taxpayers to structure traditional tax shelters. Pursuant to this legislative purpose, the passive activity rules, enacted as I.R.C. sec. 469, disallow the deductibility of certain losses generated by "passive activities," except insofar as to offset the gains from other passive activities. See I.R.C. sec. 469(a). Section 469(c) defines a passive activity as "any activity--(A) which involves the conduct of any trade or business, and (B) in which the taxpayer does not materially participate." I.R.C. sec. 469(c)(1)(A)-(B).
Code section 469(h) defines "material participation" in an activity as involvement that is regular, continuous and substantial. See I.R.C. sec. 469(h)(1)(A)-(C). To supplement this provision, however, Congress also authorized the Secretary of the Treasury to promulgate regulations "which specify what constitutes an activity, material participation, or active participation for the purposes of this section." I.R.C. sec. 469(l)(1).
Rental activities are expressly included as passive activities, but if a taxpayer participates materially in an entity involved in the rental of property, the proceeds from that rental may be deemed to arise from a non-passive activity. See I.R.C. sec. 469(c)(2); Treas. Reg. sec. 1.469-4. Passive activity rules apply to personal services corporations, see I.R.C. sec. 469(a)(2)(C), and for purposes of determining whether a taxpayer materially participates in an activity, participation of his spouse will be included as participation of the taxpayer. See I.R.C. sec. 469(h)(5); Treas. Reg. sec. 1.469-5T (f)(3); see also Fransen v. United States, 191 F.3d 599, 601 (5th Cir. 1999). On this basis, the parties agree that if the regulations setting out the passive activity rules deem Michael Connor to have participated materially in the activities of his personal services corporation, the income from the rental of his dental office would be characterized as non-passive.
The instant dispute centers on the regulations issued by the Secretary to explain when a taxpayer participates materially in an entity to which he leases property, a scenario in which "self-rental income" is generated. Prior to 1992, the temporary regulations promulgated by the Secretary to apply the passive activity rules ("temporary regulations") provided that shareholders in non-pass-through entities, such as the corporation, did not participate materially in the activities of such entity, making self-rental income from a lease to a C corporation passive in nature. See Temp. Treas. Reg. sec. 1-469-4T(b)(2)(ii)(B) (1989). For pass- through entities, the temporary regulations applied a seven-part test to determine whether the owners participated materially in the entity's activities. See Temp. Treas. Reg. sec. 1.469-5T(a) (1989). If a taxpayer was determined to have participated materially in an entity to which he rented, the resulting self-rental income was non-passive income and could not be offset against other passive losses. Because of the exemption for non-pass-through entities, Michael Connor did not participate materially in the rental activity of his personal services corporation before 1993, and during this period, the parties agree that the income from the rental was appropriately characterized as passive income.
Effective for all tax years beginning May 11, 1992, however, the Secretary replaced the temporary regulations with a new set of...
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