Originally published on Forbes.com.
The Fifth Circuit decision in the case of Larry and Dora Williams has not attracted much attention as it merely confirms a Tax Court decision , but I have a passion for the passive activity loss rules (Code Section 469).
Background On The Oxymoron Of Passive Activities
When I first started tax blogging way back in 2009, I named my blog Passive Activities and Other Oxymorons. It was a kind of joke about Code Section 469, which is one of the most challenging sections in the field of individual taxation. It was ushered in by the Tax Reform Act of 1986 as a way of eliminating traditional tax shelters. TRA 1986 more or less made my career as it, for a time, placed a premium on accountants who were actually able to look things up.
What Code Section 469 requres us to do is to put our trade or business activities into buckets. If the activities in the passive bucket net to a loss, that loss is suspended until the activity that generated it is totally disposed or there is income from that passive activity or any other. The regulations that interperet 469 are pretty challenging. They serve as an illustration of Reilly’s Third Law of Tax Planning – Any clever idea that pops into your head probably has a corresponding rule that makes it not work.
A Clever Idea
The clever idea that Larry and Dora Williams had was to generate some passive income to abosorb their passive losses. The passive income that they generated was rent paid by BEK Medical Inc, a C corporation the couple owned to BEK Real Estate Holdings LLC, an S corporation. By taking rent out of BEK Medical rather than salary, they transformed otherwise active income into passive income allowing them to currently use passive losses from other activities
That clever idea was probably first thought of about half an hour after TRA 1986 hit the streets. So is hardly shocking that there is a regulation about it – 1.469-2(f)(6) – the so called “self-rental rule”
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
It is not the only rule like this and like similar ones, land leases for examples, it is kind of a heads you lose, tails they win type of propostion. An activity subject to rules like this can remain a passive activity, with suspended losses. It is only treated as non-passive, when and to the extent that it is net positive. Back in the eighties at Joseph B Cohan and Associates we had a term for rules like that. Sorry I can’t share it. Contributor guidelines and all.
An Argument Even If Not A Winning One
The taxpayers had an argument. Code Section 469 does not refer at all to S Corporations, so the rules could not apply to BEK Real Estate] Holdings. The argument went nowhere in Tax Court and the Fifth Circuit agreed.
As the Tax Court acknowledged, § 469 does not refer to S corporations at all. The statute specifically applies to “taxpayers” who are individuals, estates, trusts, closely held C corporations, and personal service corporations.13 An associated regulation defining certain passive activities, including rental activities, specifies:
This section sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of section 469. A taxpayer’s activities include those conducted through C corporations that are subject to section 469, S corporations, and partnerships.
Citing substantial authority, the Tax Court concluded that § 469 did not need to specifically refer to S corporations because S corporations are merely pass-through entities , and its individual shareholders are the ultimate taxpayers.
They took another shot with the argument that BEK Real Estate Holdings did not materially participate in BEK Medical. That did not work either.
We agree with the Tax Court that there is no basis for the Petitioners’ reading of the regulation. As noted above, Treasury Regulation § 1.469—2(f)(6) classifies rental income as nonpassive if the property “s rented for use in a trade or business activity in which the taxpayer materially participates.” As explained above, the S corporation, BEK Real Estate, is not the taxpayer for purposes of§ 469 or the associated regulation. Rather, BEK Real Estate is only a pass-through entity; the Petitioners are the taxpayers. Thus, the proper focus is not on BEK Real Estate, a non-taxpayer S corporation, but on the actual taxpayers, the Petitioners.
Chevron
It is worth noting that even though the taxpayers did not have a really good commons sense argument, they did have an argument. There are some areas of the Code where partnerships and S Corporations are recognized as “taxpayers” – making elections, having distinct accounting methods and engaging in transactions with owners for example. Who knows maybe if they had gotten this up to the Supremes, the late Justice Scalia, God rest his soul, would have been on their side from a strict textual reading. Or maybe not.
By the way, speaking of Justice Scalia, Jack Townsend in Federal Tax Procedures has a really nice piece on the justice’s influence on “Chevron Deference”. The idea is that courts should, when possible defer to administrative interpertations of statutes. The Fifth Circuit quoted Chevron in the Williams decision.
This circuit has held that Treasury Regulation § 1.469-2(f)(6) is valid because it is not “arbitrary, capricious, or manifestly contrary to the statute.”
RIP Justice Scalia
Like many others, I will be watching with bated breath the drama of selecting Justice Scalia’ successor. One of my friends has suggested that we could really shake things up by letting a Protestant on. I was thinking that there needs to be some consideration of georgraphic diversity, so that preference should be given to somebody from Staten Island, since the other boroughs have had their turn. Having a fellow graduate of Xavier High School being the most colorful Supreme has been a running gag on my blog for quite a while now, so I’m hoping for another, but that’s a lot to ask for.