Sidell v. Comm'r of Internal Revenue

• Decision Date: 02 August 2000
• Docket Number: No. 00-1078,00-1078
• Citation: 225 F.3d 103
• Parties: (1st Cir. 2000) CHESTER F. SIDELL AND FAYE L. SIDELL, PETITIONERS, APPELLANTS, V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT, APPELLEE. Heard
• Court: U.S. Court of Appeals — First Circuit

Page 103

225 F.3d 103 (1st Cir. 2000)

CHESTER F. SIDELL AND FAYE L. SIDELL, PETITIONERS, APPELLANTS,

V.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT, APPELLEE.

No. 00-1078

United States Court of Appeals For the First Circuit

Heard August 2, 2000

Decided September 22, 2000

APPEAL FROM THE UNITED STATES TAX COURT. Hon. Julian I. Jacobs, Judge. [Copyrighted Material Omitted] David R. Andelman, with whom Juliette Galicia Pico and Lourie & Cutler, P.C. were on brief, for appellants.

Ellen Page Delsole, Attorney, Tax Division, U.S. Dep't of Justice, with whom Paula M. Junghans, Acting Assistant Attorney General, and Kenneth L. Green, Attorney, Tax Division, were on brief, for appellee.

Before Torruella, Chief Judge, Selya, Circuit Judge, and Casellas,^* District Judge.

Selya, Circuit Judge.

The Commissioner of the Internal Revenue Service (IRS) issued a deficiency notice to Mr. and Mrs. Chester F. Sidell (the taxpayers) for taxes, interest, and penalties allegedly due in respect to the years 1993 and 1994. The Commissioner premised this deficiency determination on an assertion that the taxpayers had misclassified certain rental income as passive rather than nonpassive. Unhappy with this turn of events, the taxpayers sought a judicial anodyne. The Tax Court sided with the Commissioner. See Sidell v. Commissioner, T.C. Memo. 1999-301, 78 T.C.M. (CCH) 423 (1999). The taxpayers appeal, averring that the Tax Court erred in accepting the Commissioner's recharacterization of their rental income, and that in all events they should be permitted to use credits for rehabilitation of historic property to offset their income in the years in question. Discerning no error in the Tax Court's resolution of this dispute, we affirm.

I. BACKGROUND

The relevant facts are straightforward. At the pertinent times, Chester F. Sidell owned all the stock of KGR Industries, a Massachusetts corporation. KGR operated as a regular business corporation -- a so-called C corporation -- and itself paid taxes. See 26 U.S.C. §§ 301-385 (subtit. A, ch. 1, subch. C). C corporations are different in kind from entities that are not themselves taxpayers but which function as conduits for attributing gains and losses to their owners (e.g., partnerships, see 26 U.S.C. §§ 701-771 (subtit. A, ch. 1, subch. K), and S corporations, see id. §§ 1361-1379 (subtit. A, ch. 1, subch. S)).

In 1985, increased demand for KGR's private-label clothing generated a need for expanded production facilities. Sidell met this need by purchasing the Everett Mill, an historic property that he refurbished and leased to KGR.¹ He was able to benefit personally from this effort by claiming rehabilitation tax credits under 26 U.S.C. § 46(b)(4)(A) (the precursor to 26 U.S.C. § 47). Those credits are not at issue in this appeal.

When KGR continued to experience growing pains, Sidell endeavored to replicate this serendipitous scenario. In 1992, he purchased the Kunhardt Mill, an historic property located across the street from the Everett Mill. He structured this transaction in nearly identical fashion, beginning a qualified rehabilitation immediately after acquisition, see Secretary of the Interior, Standards for Rehabilitation, 36 C.F.R. § 67, and completing it in approximately one year's time.

The taxpayers claimed rehabilitation tax credits in connection with the Kunhardt Mill restoration. They used those credits (totaling $85,361 in 1993 and $24,284 in 1994) to offset rental income paid by KGR. But the story did not have quite so happy an ending the second time around. In the Commissioner's view, the rehabilitation tax credits could only be used to offset passive income; and under the law applicable to the years in question (1993 and 1994), the rental income received from KGR was nonpassive. Because the taxpayers had no other passive income for those years, the Commissioner disallowed the claimed offsets and asserted deficiencies amounting to $103,728 for 1993 and $41,621 for 1994.

Dismayed by the Commissioner's stance, the taxpayers brought suit. See 26 U.S.C. §§ 6213(a), 6214(a), 7442. The Tax Court sustained the Commissioner's determination of the existence and extent of the deficiencies. See Sidell, T.C. Memo. 1999-301. This appeal followed.

II. ANALYSIS

In this court, as below, the taxpayers advance three principal lines of argument. First, they maintain that the regulations, namely, Treas. Reg. § 1.469-2(f)(6) (1992) and Treas. Reg. § 1.469-4(a) (1994), are invalid insofar as they purpose to recharacterize income received from closely-held C corporations as nonpassive. Second, they note that they had completed the Kunhardt Mill rehabilitation before October 4, 1994 (the effective date of the attribution rule, Treas. Reg. § 1.469-4(a)), and they claim that certain transition rules apply (under which, in their view, the rent received from KGR should be treated as passive income). Finally, the taxpayers contend that depriving them of the benefit of the rehabilitation tax credits for the years in which the work was performed not only would flout the language of 26 U.S.C. § 47, but also would undermine the legislative policy behind it. We deal with each of these asseverations in turn. As the case was submitted on a stipulated record and the taxpayers train their fire on the Tax Court's legal determinations, our review is plenary. See Strickland v. Commissioner, Me. Dep't of Human Servs., 48 F.3d 12, 16 (1st Cir. 1995).

A. Validity of the Final Regulations.

The regulations at issue -- Treas. Reg. § 1.469-2(f)(6) and Treas. Reg. § 1.469-4(a) -- were issued by the Secretary of the Treasury under a specific grant of authority from Congress. See 26 U.S.C. § 469(l). We afford such legislative regulations a high degree of respect: an inquiring court must give legislative regulations "controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute." Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984). The upshot is that a court should enforce such regulations as long as they have a rational basis and are reasonably related to the purposes of the enabling legislation. See P. Gioioso & Sons, Inc. v. OSHRC, 115 F.3d 100, 107 (1st Cir. 1997). Against this backdrop, the taxpayers' claim of invalidity gains little traction.

The starting point for a reasoned appraisal of that claim is 26 U.S.C. § 469(l), which empowers the Secretary, in relevant part, to

"prescribe such regulations as may be necessary or appropriate to carry out provisions of [Sec. 469], including regulations -- . . . (3) requiring net income or gain from a limited partnership or other passive activity to be treated as not from a passive activity . . . ."

The taxpayers suggest that Congress, through this language, only intended the Secretary to promulgate regulations that required net passive income derived from certain pass-through entities, such as partnerships or S corporations, to be treated as nonpassive. The Secretary, however, went further; after considerable backing and filling, discussed infra, he released the final regulations here at issue.

The first of these regulations -- embodying what is sometimes called the "self-rental rule" -- instructs taxpayers on how rental income is to be characterized for tax purposes. It states:

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 (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of § 1.469-5T) for the taxable year; and (ii) Is not described in § 1.469-2T(f)(5).

Treas. Reg. § 1.469-2(f)(6) (1992).

The second regulation -- which embodies what is sometimes called the "attribution rule" -- reads:

A taxpayer's activities include those conducted through C corporations that are subject to section 469, S corporations, and partnerships.

Treas. Reg. § 1.469-4(a) (1994). This regulation hardly could be clearer: it makes the self-rental rule applicable to transactions between closely-held C corporations and their owners.

The taxpayers' argument on this point prescinds from the uncontroversial premise that, apart from persons whose primary trade or business is real estate, a taxpayer's receipt of rent typically comprises passive income. The Secretary's newly-devised regulatory regime alters this treatment in a certain class of cases, and the taxpayers argue that Congress intended to limit the Secretary's power to effect such alterations to activities conducted by pass-through entities (like partnerships or S corporations). The ultimate question, then, is whether the Secretary had the authority under section 469(l) to stretch the bounds of coverage to include income or gain received from entities which, like C corporations, are not pass-through entities. We conclude that the Secretary acted appropriately in setting the parameters of the regulatory scheme.

The authority given to the Secretary, as illustrated by the statutory text, is quite broad. The statute empowers him to promulgate any regulations that he deems "necessary or appropriate" to further the goals of section 469. Importantly, this includes the explicit power to treat what normally would be passive income as nonpassive if he believes that such a shift is warranted. Although the statute mentions limited partnerships as one possible subject of regulation, the category is open-ended, not closed, as witness Congress's use of the inclusive phrase "or other." Accord Fransen v. United States, 191 F.3d 599, 600-01 (5th Cir. 1999). Given the apparent breadth of authority ceded to the Secretary, and the congruence between the final regulations and the statute's evident goal (eliminating tax shelters), it is exceedingly...