Krukowski v. Comm'r of Internal Revenue
| Decision Date | 22 May 2000 |
| Docket Number | No. 7765–98.,7765–98. |
| Citation | 114 T.C. No. 25,114 T.C. 366 |
| Parties | Thomas P. and Ermina A. KRUKOWSKI, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Taxpayers petitioned for redetermination of deficiencies arising from disallowed offset of passive loss. On cross-motions for summary judgment, the Tax Court, Laro, J., held that: (1) recharacterization rule was valid for self-rental real estate income; (2) written binding contract exception did not apply; and (3) transitional rule did not operate to avoid application of recharacterization rule.
Decision for IRS.
Beghe, J., concurred in part and dissented in part in written opinion, which was joined by Chabot, Parr, Whalen, Halpern, Gale, and Marvel, JJ.
Judgment affirmed, 279 F.3d 547. 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 sec. 469, I.R.C., and that the loss offset part of the income. R disallowed the offset because, R determined, the recharacterization rule of sec. 1.469–2(f)(6), Income Tax Regs., deemed the income nonpassive. Held: The recharacterization rule is valid. Held, further, the written binding contract exception of sec. 1.469–11(c)(1)(ii), Income Tax Regs., is inapplicable to the facts herein. Held, further, the transitional rule of sec. 1.469–11(b)(1), Income Tax Regs., does not operate to avoid application of the recharacterization rule.Victor A. Kornis, for petitioners.
Christa A. Gruber, for respondent.
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 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.
Petitioner is the 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 section 469, and (4) the loss from one activity offset an equal amount of the income from the other activity, resulting in the inclusion in petitioner's 1994 taxable income of $106,049 of rental income. Respondent determined that the rental income could not partially be offset by the rental loss; respondent determined that the income was recharacterized as nonpassive income under section 1.469–2(f)(6), Income Tax Regs.,2 because petitioner materially participated in the law firm's business activity. Respondent determined that petitioner's 1994 taxable income includes $175,149 (rather than the reported $106,049) of rental income.
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 with respect 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 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
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 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.” Rule 121(b); see P & X Mkts., Inc. v. Commissioner, 106 T.C. 441, 443, 1996 WL 323680 (1996), affd. without published opinion 139 F.3d 907 (9th Cir.1998); see also Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247–251, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986).
Petitioner 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 section 469(c)(2) and (4) provides that a rental activity is generally passive and that the recharacterization rule provides that certain rental income is nonpassive.
We disagree with petitioner that the recharacterization rule is invalid. The recharacterization rule is a legislative regulation, see Schwalbach v. Commissioner, 111 T.C. 215, 220, 1998 WL 567814 (1998) (); see also Fransen v. United States, 191 F.3d 599, 600 (5th Cir.1999); thus, it is invalid only if it is arbitrary, capricious, or manifestly contrary to the statute, see Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984); see also McKnight v. Commissioner, 99 T.C. 180, 183, 1992 WL 184971 (1992).
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 section 469(1) that allows him to prescribe all necessary or appropriate regulations to carry out the provisions of section 469, including regulations: (1) Defining the terms “activity” and “material participation”, sec. 469(1)(1), and (2) “requiring net income or gain from a limited partnership or other passive activity to be treated as not from a passive activity”, sec. 469(1)(3). The rule is tied directly to the following passage set forth by the conferees in their report as to the Secretary's regulatory authority under section 469:
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 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...
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