                         T.C. Memo. 2004-99



                       UNITED STATES TAX COURT



         CAL INTERIORS INCORPORATED, ET AL.,1 Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos.    8052-01, 8053-01,     Filed April 7, 2004.
                   10869-01, 10870-01.



     Edward B. Simpson and John Gigounas, for petitioners.

     Andrew R. Moore, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:    Petitioners petitioned the Court to

redetermine the following Federal income tax deficiencies and

accuracy-related penalties under section 6662(a):


     1
       Cases of the following petitioners are consolidated
herewith: S & C Dent Corporation, docket No. 8053-01; Gary and
Dolores Beecher, docket No. 10870-01.
                                - 2 -

     Cal Interiors Inc., docket No. 8052-01

         Fiscal Year Ended    Deficiency      Sec. 6662(a)

          April 30, 1997       $43,156        $8,631.20

     S & C Dent Corp., docket No. 8053-01

         Fiscal Year Ended    Deficiency      Sec. 6662(a)

          April 30, 1997        $5,298        $1,059.60

     Cal Interiors Inc., docket No. 10869-01

         Fiscal Year Ended    Deficiency      Sec. 6662(a)

          April 30, 1998       $21,496        $4,299.20
          April 30, 1999        17,837        $3,567.40

     Gary & Dolores Beecher, docket No. 10870-01

               Year           Deficiency      Sec. 6662(a)

               1997           $150,774       $30,154.80
               1998             72,822        14,564.40
               1999             63,961        12,792.20

The cases resulting from these petitions are now before us

consolidated for purposes of trial, briefing, and opinion.

     Following concessions by the parties, we are left to decide

whether the recharacterization rule of section 1.469-2(f)(6),

Income Tax Regs., is valid as applied to net income realized by

Gary and Dolores Beecher (collectively, the Beechers) on the

rental of space in their home to two wholly owned C corporations

(collectively, the corporations); the Beechers materially

participated in the business activities of the corporations.    We

hold that the recharacterization rule of the regulations is

valid.    Unless otherwise stated, section references are to the
                                - 3 -

applicable versions of the Internal Revenue Code.    Rule

references are to the Tax Court Rules of Practice and Procedure.

                          FINDINGS OF FACT

     Many facts were stipulated.    We incorporate herein by this

reference the parties’ stipulation of facts and the exhibits

submitted therewith.    We find the stipulated facts accordingly.

The Beechers are husband and wife, and they resided in Woodside,

California, when their petition was filed with the Court.    The

principal place of business of the other two petitioners (i.e.,

the corporations) also was in Woodside, California, when their

petitions were filed.

     Cal Interiors, Inc., is a C corporation wholly owned by

Gary Beecher.    Its business is the repair of automobile

interiors.    S & C Dent Corp. is a C corporation wholly owned by

Dolores Beecher.    Its business is the removal of dents from

automobiles.    Both of the Beechers work full time in the

businesses of the corporations, and each corporation’s business

office (office) is located in the Beechers’ home.    The

corporations pay rent to the Beechers for use of the space in

which the office is located.

     On their 1997, 1998, and 1999 Federal income tax returns,

the Beechers reported the income and expenses of six rental

properties.    For the respective years, the net income of one of

these properties; i.e., the office, was reported as $39,307,
                               - 4 -

$23,387, and $22,160.   Each of the other five rental properties

reported a net loss such that the combined losses of the five

properties in each year exceeded the net income from the office.

                              OPINION

     Respondent determined that the Beechers’ net income from

their rental of the office was nonpassive income under the

recharacterization rule of section 1.469-2(f)(6), Income Tax

Regs.,2 because the Beechers materially participated in the

business activity of the lessees; i.e., the corporations.     Thus,

respondent determined, the net income from the office could not

be offset by any of the losses from the other rental properties.

Petitioners do not dispute respondent’s determination that the

recharacterization rule on its face treats the net income from

the office as nonpassive.   Nor do they dispute respondent’s

determination that the recharacterization rule on its face, as

applied to them, precludes them from offsetting the net income of


     2
       The recharacterization rule of sec. 1.469-2(f)(6), Income
Tax Regs., provides:

          (f)(6) 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 if the property--

               (i) Is rented for use in a trade or business
          activity * * * in which the taxpayer materially
          participates (within the meaning of sec. 1.469-5T)
          for the taxable year; * * *
                                 - 5 -

the office by the net losses from the other rental properties.

Petitioners’ sole argument is that the recharacterization rule is

invalid for two reasons.   First, petitioners assert, the

recharacterization rule is arbitrary, capricious, and contrary to

the statute.   Second, petitioners assert, the recharacterization

rule improperly negates their “bona fide business purpose” for

renting the office to the corporations.

     We disagree with petitioners’ argument that the

recharacterization rule is invalid.      As to the first assertion,

petitioners note correctly that this Court has declared the

recharacterization rule valid.    See Krukowski v. Commissioner,

114 T.C. 366 (2000) (Court-reviewed),3 affd. 279 F.3d 547 (7th

Cir. 2002); Schwalbach v. Commissioner, 111 T.C. 215 (1998); Shaw

v. Commissioner, T.C. Memo. 2002-35; Sidell v. Commissioner, T.C.

Memo. 1999-301, affd. 225 F.3d 103 (1st Cir. 2000); Connor v.

Commissioner, T.C. Memo. 1999-185, affd. 218 F.3d 733 (7th Cir.

2000).   Petitioners also note correctly that so have three Courts

     3
       Although the Court in Krukowski v. Commissioner, 114 T.C.
366 (2000), affd. 279 F.3d 547 (7th Cir. 2002), was split as to
whether the taxpayers qualified under sec. 1.469-11(b)(1),
Income Tax Regs., for transitional relief from application of the
recharacterization rule, id. at 376 (Beghe, J., concurring in
part and dissenting in part), the Court held unanimously that the
recharacterization rule is a valid regulation, id. Here,
petitioners challenge only the validity of the recharacterization
rule. Because their years in issue are 1997, 1998, and 1999,
they make no claim to transitional relief under sec.
1.469-11(b)(1), Income Tax Regs. Only taxable years beginning
before Oct. 4, 1994, qualify for transitional relief under that
section. Id.
                                - 6 -

of Appeals, namely, the First, Fifth, and Seventh.      See Krukowski

v. Commissioner, 279 F.3d 547 (7th Cir. 2002), affg. 114 T.C. 366

(2000); Sidell v. Commissioner, 225 F.3d 103 (1st Cir. 2000),

affg. T.C. Memo. 1999-301; Connor v. Commissioner, 218 F.3d 733

(7th Cir. 2000), affg. T.C. Memo. 1999-185; Fransen v. United

States, 191 F.3d 599 (5th Cir. 1999).      According to petitioners,

all of these cases were wrongly decided for the reasons argued by

the taxpayers there.    We disagree.    Given the detailed and

exhaustive analysis set forth in those cases in rejection of the

arguments made by the taxpayers there, we see no need to repeat

that analysis herein.    Suffice it to say that the

recharacterization rule of section 1.469-2(f)(6), Income Tax

Regs., is a legislative regulation that was properly promulgated

by the Secretary pursuant in part to the specific grant of

authority stated in section 469(l) 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(l)(1), and (2) “requiring net income or gain from a * * *

passive activity to be treated as not from a passive activity”,

sec. 469(l)(3).

     We also disagree with petitioners’ second assertion.        First,

from a factual point of view, we are unable to agree with

petitioners that the instant case is distinguishable from the
                               - 7 -

cases cited above.   Whereas petitioners state on brief that here,

unlike there, “it is crystal clear that the rental activity was

not contrived as a tax shelter”, they have directed us to no

evidence in support of that statement.   Nor have they directed us

to any evidence to support their related statement on brief that

the rental of the office served a bona fide business purpose in

that “It was reasonable that Cal Interiors and [S&C] Dent should

pay a fair rental for the [office] space”, given that the

Beecher’s [sic] spent their personal funds to construct office

space”.   Contrary to petitioners’ belief, the taxpayers in those

other cases also presumably used their personal funds to purchase

the property that was the subject of the rentals there.

     Moreover, from a legal point of view, we read nothing in the

statute or in the legislative history thereunder that would

require the Secretary to condition the recharacterization rule on

the absence of a bona fide purpose for a “self-rental” such as we

have here.   In fact, we and the Courts of Appeals that have

considered the validity of the recharacterization rule have read

the statute and the underlying legislative history to support a

contrary conclusion that the Secretary was authorized by Congress

to apply the recharacterization rule to all self-rentals in which

there is material participation by the taxpayer.   As we stated in

Krukowski v. Commissioner, supra at 369-370:

     The [recharacterization] rule is tied directly to the
     following passage set forth by the conferees in their
                                 - 8 -

     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
     activity, that have the effect of reducing active
     business income and creating passive income * * *.
     [H. Conf. Rept. 99-841 (Vol. II), at II-147, 1986-3
     C.B. (Vol.4) 1, 147.]

As the Court of Appeals for the First Circuit stated in Sidell v.

Commissioner, 225 F.3d at 107:

          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.

As the Court of Appeals for the Fifth Circuit stated in Fransen

v. United States, supra at 600-601:

          Here, the parties dispute the scope of passive
     activity the IRS may treat as non-passive. The point
     of uncertainty lies with the word “other” in
     § 469(l)(3). The Fransens suggest that “other” refers
     to activity not elsewhere defined in § 469 as passive.
     Grammatically, however, the more persuasive reading of
     the provision is that a regulation may treat any kind
                              - 9 -

     of passive activity as non-passive. The phrase “or
     other” appears to refer back to “limited partnership”
     and thus to include any passive activity other than a
     limited partnership.

          The legislative history supports this view: it
     provides examples of situations in which the Secretary
     may treat activities defined as passive under § 469(c),
     including rental activity, as non-passive. The report
     includes these examples as illustrations rather than as
     an exclusive list. See H.R. Conf. Rep. No. 99-841, at
     147 (1986), reprinted in 1986 U.S.C.C.A.N. 4075, 4235.

          The Fransens suggest that the regulation defeats
     the statutory purpose of privileging rental income.
     The statute, however, does not seek to privilege rental
     income by generally classifying it as passive.
     Instead, the purpose animating the statute is to
     foreclose tax shelters. See STAFF OF THE JOINT COMM.
     ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT
     OF 1986, 99th CONG., at 209-210 (J. Comm. Print 1987).
     In most cases, a classification of income as passive
     achieves this result. Tellingly, professional real
     estate lessors sought and obtained an exception from
     the passive designation in the 1993 amendments because
     a non-passive classification would be more favorable to
     them. See I.R.C. § 469(c)(7); Scott P. Greiner, The
     Real Estate Professional’s Tax Relief Act of 1993, 23
     COLO. LAW. 1317, 1318 (1994).

          In some cases, however, the opposite is true: the
     treatment of income as passive may create a shelter
     opportunity. The inclusion of § 469(l) allows for such
     situations by granting the IRS the authority to treat
     income as non-passive. See H.R. Conf. Rep. No. 99-841,
     at 147 (1986), reprinted in 1986 U.S.C.C.A.N. 4075,
     4235. Here, the IRS identified self-rentals as such a
     case and promulgated the regulation at issue.

See also Connor v. Commissioner, 218 F.3d at 738 (“the purpose of

the passive activity loss regulations * * * is to assess

accurately whether a taxpayer is involved in the active

management of a trade or business in such a fashion that passive

activity treatment would be inaccurate”).   Although petitioners
                              - 10 -

observe correctly that both the legislature and the judiciary

have referred to the combating of “tax shelters” as one of the

reasons for the enactment of section 469, we, unlike petitioners,

do not read that term to require a finding of a specific intent

to reduce taxes.   Instead, we read that term plainly in the

context of the setting at hand to include any transaction that,

but for the recharacterization rule, would allow taxpayers to use

passive losses to offset rental income received from a wholly

owned business in which they actively participate.

     We hold once again that the recharacterization rule is

valid.   In so doing, we have considered all of petitioners’

arguments for a contrary holding and, to the extent not discussed

above, find those arguments to be without merit or irrelevant.

To reflect the foregoing,

                                         An appropriate order will

                                    be issued.
