Schwalbach v. Comm'r of Internal Revenue
| Decision Date | 08 September 1998 |
| Docket Number | No. 17502–97.,17502–97. |
| Citation | 111 T.C. No. 9,111 T.C. 215 |
| Parties | Stephen and Ann SCHWALBACH, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Jay B. Kelly, for petitioners.
Blame C. Holiday, for respondent.
Ps rented a building to a personal service corporation for use in a business activity in which P materially participated. On Ps' 1994 Federal income tax return, Ps offset the rental income with unrelated passive losses. Relying on secs. 1.469–2(f)(6) and 1.469–4(a), Income Tax Regs., R determined that Ps could not offset the rental income with the passive losses because the rental income was recharacterized as nonpassive income. Ps argue that sec. 1.469–2(f)(6), Income Tax Regs., is invalid as applied to them because the meaning of the word “activity” as used therein does not include attributing a C corporation's activity to a material participant in that activity without reference to sec. 1.469–4(a), Income Tax Regs., which, Ps argue, is invalid because R prescribed the rules of that section without complying with the notice and comment requirements of the Administrative Procedure Act (APA), 5 U.S.C. sec. 553(b) and (c) (1994).
Held: R complied with the notice and comment requirements of the APA, id., when R prescribed sec. 1.469–4(a), Income Tax Regs., and neither that section nor sec. 1.469–2(f)(6), Income Tax Regs., is invalid due to a lack of compliance with those requirements.
Petitioners petitioned the Court to redetermine respondent's determination of an $11,869 deficiency in their 1994 Federal income tax and a $2,374 accuracy-related penalty under section 6662(a). Following concessions by petitioners, the primary issue left to be decided is whether sections 1.469–2(f)(6) and 1.469–4(a), Income Tax Regs., are valid as applied to recharacterize the rental income of an individual who rents property to a personal service corporation for use in a business in which the individual materially participates. We hold they are. We also decide whether petitioners are liable for the accuracy-related penalty determined by respondent. We hold they are not. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the subject year. Rule references are to the Tax Court Rules of Practice and Procedure. Dollar amounts are rounded to the nearest dollar.
Some facts have been stipulated. The stipulations of fact and the exhibits submitted therewith are incorporated herein by this reference. Petitioners resided in River Falls, Wisconsin, when they petitioned the Court. They filed a joint 1994 Federal income tax return which was prepared by a certified public accountant (the C.P.A.). Petitioners presented the C.P.A. with all relevant information to prepare the return, and he prepared the return based on his understanding of the tax law. As of the time that the C.P.A. prepared the return, he had been practicing accountancy as a C.P.A. for approximately 20 years, and he had performed work for petitioners, including preparing their individual and business tax returns, for at least 16 years. Petitioners rely on the C.P.A. for business and tax advice.
Stephen Schwalbach (Dr. Schwalbach) practices dentistry in River Falls. He is employed full time by Associated Dentists of River Falls, f.k.a. River Falls Dental Association (Associated Dentists), a personal service corporation that he owns equally with another dentist named Timothy Knotek. Associated Dentists' business is based in a building (the River Falls building) owned by petitioners and let to Associated Dentists under a lease dated January 1, 1992.
Petitioners' 1994 Schedule E, Supplemental Income and Loss, reported net income of $50,556 on the rental of the River Falls building to Associated Dentists. This schedule also reported that petitioners had realized a $1,670 loss renting a commercial building sited in Hudson, Wisconsin, and that they had realized $877 of net income renting a residential house sited in River Falls. Petitioners also reported on this schedule that they had realized a $10,148 passive loss on an investment in an S corporation named Golfview Heights, Inc., and that they had realized a $6,297 passive loss on an investment in a partnership named South Main Dental Partners. Petitioners took into account all these items of income and loss, the effect of which was that they reported net passthrough and rental income of $33,318 ($50,556 + ($10,148) + ($6,297) + ($1,670) + $877).
Respondent determined that the three losses aggregating $18,115 (($10,148) + ($6,297) + ($1,670)) could offset only the $877 gain, resulting in an adjustment (increase) in income of $17,238. According to the notice of deficiency:
On Schedule E, Part I of your 1994 return, in regards to property B [i.e., the River Falls building], you reported a net profit of $50,556. This property is related to your corporation for which you are a material participant. You further offset passive losses of $16,445 from other companies shown on Schedule E, Part II against the non-passive income from related property B. Internal Revenue Code section 469 changes the net income from the related rental property B from non-passive to passive income. [ 1]
Further, on Schedule E, Part V of your 1994 return, your total net profit that you reported on your return was $33,318. However, it has been determined that your total net profit on Schedule E is $50,556. Your increase in net profit of $17,238 is based on the unallowable loss of $17,238 * * * as summarized below. Therefore, your taxable income for 1994 is increased by $17,238.
+---------------------------------------------------+
¦¦Passive losses as corrected: ¦ ¦
++------------------------------------------+-------¦
¦¦Loss from Schedule E, Property A, Part I ¦$ 1,670¦
++------------------------------------------+-------¦
¦¦Loss from Schedule E, Part II ¦16,445 ¦
++------------------------------------------+-------¦
¦¦Total corrected passive losses ¦18,115 ¦
++------------------------------------------+-------¦
¦¦Allowable passive income: ¦ ¦
++------------------------------------------+-------¦
¦¦Profit from Schedule E, Property C, Part I¦877 ¦
++------------------------------------------+-------¦
¦¦Unallowable loss ¦17,238 ¦
+---------------------------------------------------+
On June 21, 1993, Dr. Schwalbach paid $16,050 for a 5/6 interest in 6,000 shares of stock in a corporation named Impression Delivery Corp. (Impression); the total purchase price was $19,266. Approximately 3 weeks later, the 6,000 shares were sold for $7,374, and 6 days after the sale, Dr. Schwalbach purchased an interest in another 4,100 shares of Impression. Petitioners did not recognize a loss in 1993 on the sale of the stock because the C.P.A. considered the purchase-sale-purchase as a “wash sale” under section 1091. In 1994, petitioners, upon the advice of the C.P.A., reported a short-term capital loss of $16,050 on their 1994 Schedule D, Capital Gains and Losses, with respect to Impression's stock. The C.P.A. rendered his advice after ascertaining that Impression had ceased operations and was facing litigation over allegedly fraudulent practices.
Respondent disallowed the $16,050 loss reported by petitioners. According to the notice of deficiency, Petitioners concede that they may not deduct this loss for 1994.
Respondent also determined that petitioners were liable for the accuracy-related penalty under section 6662(a), on account of negligence. Respondent determined that this penalty applied to the total underpayment shown in the notice of deficiency. The total underpayment was attributable to the disallowed capital loss, the increased income from the passive loss adjustment, and two de minimis computational adjustments.
OPINIONThe instant dispute involves the recharacterization rule of section 1.469–2(f)(6), Income Tax Regs., and the attribution rule of section 1.469–4(a), Income Tax Regs. Respondent used these rules to recharacterize petitioners' rental income from the River Falls building from passive income to nonpassive income. Petitioners do not argue that respondent misapplied these rules or that the Commissioner lacked the authority to prescribe them. Petitioners' sole argument is that section 1.469–2(f)(6), Income Tax Regs., is invalid as applied to them because, petitioners allege, the Commissioner prescribed section 1.469–4(a), Income Tax Regs., which is necessary to apply the recharacterization rule to a material participant of a C corporation's activity, without complying with the notice and comment requirements of the Administrative Procedure Act (APA), 5 U.S.C. sec. 553(b) and (c) (1994). The notice and comment requirements of the APA provide:
(b) General notice of proposed rule making shall be published in the Federal Register * * *. The notice shall include—
(1) a statement of the time, place, and nature of public rule making proceedings;
(2) reference to the legal authority under which the rule is proposed; and
(3) either the terms or substance of the proposed rule or a description of the subjects and issues involved.
Except when notice or hearing is required by statute, this subsection does not apply—
(A) to interpretative rules, general statements of policy, or rules of agency organization, procedure, or practice; or
(B) when the agency for good cause finds (and incorporates the finding and a brief statement of reasons therefor in the rules issued) that notice and public procedure thereon are impracticable, unnecessary, or contrary to the public interest.
(c) After notice required by this section, the...
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