                      114 T.C. No. 25



                UNITED STATES TAX COURT



   THOMAS P. AND ERMINA A. KRUKOWSKI, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 7765-98.                       Filed May 22, 2000.




     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.
                                 - 2 -

     Victor A. Kornis, for petitioners.

     Christa A. Gruber, for respondent.


                                OPINION


     LARO, Judge:   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.

                             Background

     Petitioner is the president and sole shareholder of two

subchapter C corporations.     One corporation (the health club)


     1
       Petitioner asserts that he treated the separate rental
activities as a single activity under sec. 1.469-4(c)(1), Income
Tax Regs. The record does not support this assertion. To the
contrary, the record reveals that petitioner treated his rental
activities as separate activities.
                                - 3 -

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


     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
                                                     (continued...)
                              - 4 -

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




     2
      (...continued)
          participates (within the meaning of sec. 1.469-5T)
          for the taxable year * * * [Sec. 1.469-2(f)(6),
          Income Tax Regs.]
                               - 5 -

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

                            Discussion

     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,
                               - 6 -

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), affd. without published opinion 139 F.3d 907 (9th

Cir. 1998); see also Anderson v. Liberty Lobby, Inc., 477 U.S.

242, 247-251 (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) (the Secretary had to comply with the Administrative

Procedure Act (APA), 5 U.S.C. sec. 553(b) and (c) (1994), when he

prescribed sec. 1.469-2(f)(6), Income Tax Regs., because the

rules contained therein are legislative rather than

interpretative); see also Fransen v. United States, 191 F.3d 599,
                               - 7 -

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 (1984); see also McKnight v. Commissioner, 99 T.C. 180,

183 (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(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 limited partnership or other

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

sec. 469(l)(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


     3
       The Court of Appeals for the Fifth Circuit has so
concluded. See Fransen v. United States, 191 F.3d 599 (5th Cir.
1999).
                                - 8 -

     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, at 147, 1986-3 C.B. (Vol. 4) 1,
     147.]

     Petitioner also argues that the recharacterization rule is

inapplicable to this case by virtue of section 1.469-

11(c)(1)(ii), Income Tax Regs., which provides that the rule does

not apply to income “attributable to the rental of * * * property

pursuant to a written binding contract entered into before

February 19, 1988.”   Petitioner asserts that the office building

lease in effect during 1994 was the 1987 lease, or, in other

words, that he leased the office building to the law firm during

1994 pursuant to a pre-February 19, 1988, written binding

contract.   We disagree.   As discussed below, we conclude that the

office building lease in effect during 1994 was the 1991 lease

and, moreover, that the 1991 lease and the 1987 lease are

separate contracts.

     Applicable State (Wisconsin) law characterizes the 1991

lease as a renewal (as opposed to an extension) of the 1987

lease, which, in turn, means that the 1991 lease is a contract

separate from the 1987 lease.    See Seefeldt v. Keske, 111 N.W.2d

574, 575-576 (Wis. 1961).    We look at three critical factors to
                               - 9 -

determine whether a contract is renewed or extended under

Wisconsin law and conclude therefrom that the 1991 lease is a

renewal of the 1987 lease.

     First, the language used in both leases by the parties

thereto leads to the conclusion that the 1991 lease is a renewal

of the 1987 lease.   See id. at 576-577.   The leases refer several

times to a renewal; they refer only once to an extension.

     Second, the parties’ conduct leads to the same conclusion.

See id.   The 1991 lease was signed by an officer of the law firm

(other than petitioner) as “Lessee”, and it was signed by

petitioner as “Lessor”, under the heading “Agreed to and

Accepted”.   If the parties to the leases had intended that the

lessee could extend the 1987 lease at its option, petitioner’s

signature and agreement would have been unnecessary.

     Third, the fact that petitioner, as the office building’s

lessor, had to perform a further act to lengthen the term of the

1987 lease also leads to the conclusion that the 1987 lease was

renewed through the 1991 lease.   Compare Milwaukee Hotel Wis. Co.

v. Aldrich, 62 N.W.2d 14 (Wis. 1953) (lease providing for initial

term of 3 years could be extended at lessee’s option for 3 more

years at rent stated in lease; held, lease is a 6-year lease

because no further act required of lessor once lessee makes

election), with St. Regis Apt. Corp. v. Sweitzer, 145 N.W.2d 711

(Wis. 1966) (2-year lease automatically renews for 2 more years
                              - 10 -

if neither party gives contrary notice; held, lease is 2-year

lease because either party can prevent renewal by giving notice).

See also Sheppard v. Rosenkrans, 85 N.W. 199 (Wis. 1901).

Petitioner, as lessor, had to agree with the lessee/law firm as

to the rent that would be payable for any additional rental

period after the first 5 years.   Moreover, if they were unable to

reach such an agreement at least 30 days before the 5-year period

expired, petitioner possessed the sole discretion to declare the

option to renew null and void.

     We also bear in mind that the absence in the 1987 lease of

an agreed-upon rent for the renewal period made the 1987 lease

unenforceable for any period after the 5-year period expired.

See Wis. Stat. Ann. sec. 704.03(1) (West 1998) (Wisconsin statute

of frauds provides that a lease for more than a year, or a

contract to make such a lease, is unenforceable unless it sets

forth the amount of rent or other consideration).   In fact, an

enforceable contract for the additional period did not exist

until December 27, 1991, when the parties agreed on a rent for

the renewal period and created a writing memorializing that new

agreement.   See Borkin v. Alexander, 132 N.W.2d 587 (Wis. 1965);

Ratcliff v. Aspros, 35 N.W.2d 217 (Wis. 1948).

     Petitioner also argues that he is not subject to the

recharacterization rule by virtue of section 1.469-11(b)(1),

Income Tax Regs., which allows taxpayers, at their option, to use
                               - 11 -

certain proposed regulations to ascertain their tax liability for

years ending after May 10, 1992, and beginning before October 4,

1994.   See sec. 1.469-11(b)(1), Income Tax Regs.   These proposed

regulations (the 1992 proposed regulations) were prescribed by

the Secretary in 1992 to define the word “activity” for purposes

of the passive loss rules.   Notice of Proposed Rulemaking, PS-1-

89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992).

Petitioner argues that the 1992 proposed regulations preclude a

shareholder from participating in the activities of a C

corporation, which, petitioner concludes, means that the

recharacterization rule cannot be applied to his 1994 income from

the office building.

     We disagree with petitioner’s assertion that section 1.469-

11(b)(1), Income Tax Regs., precludes taxpayers from

participating in activities conducted by C corporations.   Our

conclusion is driven by a plain reading of the relevant text;

namely, section 469(a)(2)(A) and (h)(1) and section 1.469-

2(f)(6)(i), Income Tax Regs.   See Commissioner v. Soliman, 506

U.S. 168, 174 (1993); Crane v. Commissioner, 331 U.S. 1, 6

(1947); Venture Funding, Ltd. v. Commissioner, 110 T.C. 236, 241-

242 (1998), affd. without published opinion 198 F.3d 248 (6th

Cir. 1999).   Section 469(a)(2)(A) provides in relevant part that

the passive activity rules apply to “any individual”.   Section

469(h)(1) provides in relevant part that an individual is treated

as materially participating in an activity when he or she “is
                              - 12 -

involved in the operations of the activity on a basis which is *

* * regular, * * * continuous, and * * * substantial”.4    Section

1.469-2(f)(6)(i), Income Tax Regs., provides in relevant part

that rental income is recharacterized as nonpassive income if the

underlying property “Is rented for use in a trade or business

activity * * * in which the taxpayer materially participates”,

sec. 1.469-2(f)(6)(i), Income Tax Regs.

     Nowhere in section 469 or the regulations thereunder do we

read, as petitioner asks us to hold, that an individual’s

“regular”, “continuous”, and “substantial” involvement in the

operations of an activity is not treated as materially

participating in that activity when the activity is operated by a

C corporation.   Petitioner correctly observes that the Secretary

had set forth such an exception in two sets of temporary

regulations that he had prescribed before 1992.   In 1988, the

Secretary prescribed section 1.469-5T(f)(1), Temporary Income Tax

Regs., 53 Fed. Reg. 5686, 5726 (Feb. 25, 1988), (the 1988


     4
       Although we understand the words “regular”, “continuous”,
and “substantial” to support a finding that petitioner materially
participated in the law firm’s business activity, we note that
petitioner also meets the definition of the term “material
participation” as set forth in the applicable regulations. Sec.
1.469-5T(a) and (d), Temporary Income Tax Regs., 53 Fed. Reg.
5686 (Feb. 25, 1988) (an individual materially participates in an
activity if, inter alia, he or she participates in an activity
for more than 500 hours in the taxable year, he or she
participates in the activity for more than 100 hours in the
taxable year and no other individual spends more time in the
activity, or the activity involves the performance of legal
services and the individual had materially participated in the
activity during any 3 years prior to the year in question).
                               - 13 -

temporary regulations), providing that “any work done by an

individual * * * in connection with an activity in which the

individual owns (directly or indirectly, other than through a C

corporation) an interest at the time the work is done shall be

treated for purposes of this section as participation of such

individual in the activity.”   One year later, in 1989, the

Secretary prescribed section 1.469-4T(b)(2)(ii)(B), Temporary

Income Tax Regs., 54 Fed. Reg. 20527, 20543 (May 12, 1989) (the

1989 temporary regulations), providing that “For purposes of

applying section 469 and the regulations thereunder, a taxpayer’s

activities do not include operations that a taxpayer conducts

through one or more entities (other than passthrough entities).”

     As part of the regulatory project underlying the 1989

temporary regulations, the Secretary also amended the 1988

temporary regulations (the amended 1988 temporary regulations) to

delete the parenthetical exception “(directly or indirectly,

other than through a C corporation)” from section 1.469-5T(f)(1),

Temporary Income Tax Regs.   Sec. 1.469-5T(f)(1), Temporary Income

Tax Regs.   On May 15, 1992, the Secretary finalized the amended

1988 temporary regulations as section 1.469-5(f)(1), Income Tax

Regs. (the 1992 final regulations), leaving them virtually

unchanged in their final form.   Two years later, in 1994, the

Secretary finalized a substantially revised version of the 1992

proposed regulations as section 1.469-4, Income Tax Regs. (the

1994 final regulations).
                              - 14 -

     The 1988 temporary regulations (prior to the 1989 amendment)

and the 1989 temporary regulations are not applicable to the year

at bar.5   The applicable rules are found in:   (1) The 1992

proposed regulations, (2) the 1992 final regulations, and (3) the

1994 final regulations.   The 1994 final regulations do not help

petitioner’s cause because they provide specifically that “A

taxpayer’s activities include those conducted through C

corporations that are subject to section 469”.6    Sec. 1.469-4(a),

Income Tax Regs.   Nor are the 1992 final regulations of any help

to petitioner; as mentioned above, the parenthetical exception

“(directly or indirectly, other than through a C corporation)”

does not appear in those regulations.   The 1992 proposed

regulations also do not help petitioner’s cause; the 1992

proposed regulations do not contain the exception set forth in

the 1989 temporary regulations.

     Petitioner looks to the fact that the 1992 proposed

regulations did not affirmatively and expressly disavow the

exception set forth in the 1989 temporary regulations, and he

discerns therefrom that the exception continued to exist in 1992.


     5
       For completeness, we note that the Secretary allowed the
1989 temporary regulations to expire on May 11, 1992, under the
sunset provision of sec. 7805(e)(2). See 57 Fed. Reg. 20803 (May
15, 1992).
     6
       Neither party disputes that the corporation operating the
law firm is a C corporation subject to sec. 469. See sec. 1.469-
1T(b)(4) and (5), Temporary Income Tax Regs., 53 Fed. Reg. 5686,
5701 (Feb. 25, 1988) (a C corporation is subject to sec. 469 if
it is a “Personal service” or “Closely held” corporation.
                                - 15 -

We disagree.    The fact that the Secretary did not re-prescribe

that exception as part of the 1992 proposed regulations is

persuasive evidence that he revoked the exception at that time.

See Keppel v. Tiffin Sav. Bank, 197 U.S. 356, 373 (1905) ("it

cannot in reason be said that the omission * * * gives rise to

the implication that it was the intention of Congress to reenact

it."); Independent Ins. Agents of Am., Inc. v. Clarke, 955 F.2d

731, 735 (D.C. Cir. 1992) (“Under traditional rules of statutory

construction, * * * material omitted on reenactment is deemed

repealed.”), revd. on other grounds sub nom. United States Natl.

Bank v. Independent Ins. Agents of Am., Inc., 508 U.S. 439

(1993).   See generally Singer, Sutherland Statutory Construction,

sec. 23.28, at 413 (5th ed. 1993).       As we observed in Schwalbach

v. Commissioner, 111 T.C. 215, 228 (1998):       “Although the * * *

[1992 proposed regulations were] silent on this rule, including

whether the Commissioner was considering abandoning it, we read

nothing in * * * [those] regulations that would lead us to

believe that the Commissioner was proposing to retain the rule.”

     The facts of Schwalbach v. Commissioner, supra, are similar

to the facts at bar.     There, the taxpayers challenged the

Commissioner’s application of the recharacterization rule to

income they had realized in 1994 on their rental of property to a

corporation owned by 2 shareholders, one of whom was one of the

taxpayers.     The taxpayers argued primarily that the

recharacterization rule was invalid because the Secretary did not
                              - 16 -

comply with the APA when he prescribed section 1.469-4(a), Income

Tax Regs.; if the Secretary had not complied with the APA, the

taxpayers argued, then the recharacterization rule was invalid as

applied to them.   We concluded that the Secretary met the APA’s

requirements; in so doing, we analyzed the statutory text,

relevant legislative history, and various regulations prescribed

under section 469.

     The taxpayers in Schwalbach also advanced an alternative

argument that is the same argument that petitioner advances

herein.   The taxpayers in Schwalbach argued on brief:

     in the event it is redetermined the provisions of
     Treas. Reg. Sec. 1.469(d)(5) [sic] apply, the
     provisions of Treas. Reg. Sec. 1.469-4T(b)(2)(ii)(B)
     should be available to petitioners through 1994 due to
     the continued confusion with respect to provisions of
     the May, 1992, proposed regulations and the absence of
     a definitive statement as regards a non-passthrough
     entity not conducting passive activities through
     itself. See, effective date and transition rules under
     Treas. Reg. Sec. 1.469-11(b)(1).

     We rejected this argument summarily, holding that nothing in

section 1.469-11, Income Tax Regs., allowed us to apply the

exception appearing in the pre-1992 regulations under which a

taxpayer would not be considered to be a material participant of

an activity conducted through a C corporation.   See Schwalbach v.

Commissioner, supra at 230.   We stated:

     we decline petitioners' invitation to allow them to
     apply the rules of section 1.469-4T(b)(ii)(B),
     Temporary Income Tax Regs., 54 Fed. Reg. 20543, in lieu
     of the rules stated in section 1.469-4(a), Income Tax
     Regs. Simply put, the effective date and transition
     rules related to the regulatory rules under section 469
                              - 17 -

     do not allow them to use it [i.e., the only rule stated
     in sec. 1.469-4T(b)(ii)(B), Temporary Income Tax Regs.,
     45 Fed. Reg. 20543 (May 12, 1989), namely, that “a
     taxpayer's activities do not include operations that
     the taxpayer conducts through one or more entities
     (other than passthrough entities).”]. See sec.
     1.469-11, Income Tax Regs. [Id.]

Although we recognize that section 1.469-11(b)(1), Income Tax

Regs., does not explicitly reference section 1.469-4T(b)(ii)(B),

Temporary Income Tax Regs., but, instead, allows taxpayers to use

the rules set forth in the 1992 proposed regulations, we believe

that this distinction is meaningless under the facts herein.

Whereas section 1.469-4T(b)(ii)(B), Temporary Income Tax Regs.,

contains an explicit rule under which a taxpayer is not

considered to participate in a C corporation’s activities,

petitioner effectively asks the Court to imply the same rule in

the 1992 proposed regulations by virtue of the fact that those

regulations are silent as to the inapplicability of such a rule.

We decline to do so.   Accord Sidell v. Commissioner, T.C. Memo.

1999-301; Connor v. Commissioner, T.C. Memo. 1999-185.

     We conclude that petitioner may not offset part of the

income that he realized on his rental of the office building to

the law firm, by the loss that he realized on his rental of the

club to the health club.   We have considered all arguments in
                              - 18 -

this case 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, and decision will be

                              entered for respondent.



     Reviewed by the Court.

     COHEN, WELLS, RUWE, COLVIN, CHIECHI, FOLEY, VASQUEZ, and
THORNTON, JJ., agree with this majority opinion.
                                 - 19 -

     BEGHE, J., concurring in part and dissenting in part:     I

agree with the majority that section 1.469-2(f)(6), Income Tax

Regs. (popularly known as the self-rental rule, and referred to

by the majority and hereinafter as the recharacterization rule),

as in effect interpreted by the final 1994 activity regulation,

section 1.469-4(a), Income Tax Regs., is a valid regulation.       I

also agree that petitioners are not entitled to effective date

relief from the recharacterization rule under the pre-1988

written binding contract exception of section 1.469-11(c)(1)(ii),

Income Tax Regs.   However, I respectfully dissent from the

majority’s conclusion that petitioners are not entitled, under

section 1.469-11(b)(1), Income Tax Regs., to transitional relief

from application of the recharacterization rule for 1994 to the

net rental income from Mr. Krukowski’s C corporation law firm.

     The key question is whether shareholders did materially

“participate” in the “activities” of their C corporations under

the regulatory law applicable to 1994.    The majority conclude

that shareholders did so participate, under their “plain reading”

of section 469 and the recharacterization rule and their

interpretation of the “silent” 1992 proposed regulations that

flows therefrom.   I disagree.

     I.   The Majority’s “Plain Reading” of Section 469 and the
          Recharacterization Rule Is Unprecedented and Incorrect

     The majority’s plain meaning approach to this case is

unprecedented, in several disquieting respects.    To begin with,
                              - 20 -

neither party argued that the statutory text and the

recharacterization rule suffice to answer the question in issue.

Instead, the parties’ arguments were based on their respective

analyses of the applicable provisions of the several successive

sets of regulations the Commissioner has issued under section

469, interpreting the terms “participation” or “activity”.

     More particularly, the parties have agreed that the 1994

final regulations, and the 1992 proposed regulations, are the

governing law.   As discussed in more detail below, the 1994 final

activity regulation clearly provides that shareholders

participate in the activities of their C corporations; that

regulation generally applies to 1994.   See sec. 1.469-11(a)(1),

Income Tax Regs. (sec. 1.469-4, Income Tax Regs., applies for

taxable years ending after May 10, 1992).   However, the 1994

final regulations also contain a transitional rule applicable to

the year in issue.   Section 1.469-11(b)(1), Income Tax Regs.,

provides that taxpayers may apply the 1992 proposed regulations

to 1994 if they so choose, instead of the 1994 final activity

regulation otherwise applicable.   In other words, the 1994 final

regulations make the 1992 proposed regulations applicable to the

year in issue.

     For this reason, the parties believed that the crucial issue

was whether shareholders participate in C corporation activities

under the 1992 proposed regulations, and they made their

arguments accordingly.
                               - 21 -

     The majority’s “plain reading” of section 469 and the

recharacterization rule is also inconsistent with our precedent.

In Schwalbach v. Commissioner, 111 T.C. 215 (1998), Sidell v.

Commissioner, T.C. Memo. 1999-301, and Connor v. Commissioner,

T.C. Memo. 1999-185, we considered the application of the

recharacterization rule to C corporation shareholders.    None of

these opinions relied on the plain meaning of section 469 or of

the recharacterization rule.   To the contrary, all three opinions

treated the 1994 final regulations (and the 1992 proposed

regulations made applicable thereby) as the governing law.

     Our Schwalbach decision is a striking example of the

importance we have attributed to the 1994 final activity

regulation in this context.    In Schwalbach, respondent applied

the recharacterization rule to a C corporation shareholder.      The

taxpayers’ primary argument was that this application was

invalid, because:   (1) The 1994 final regulation defining

“activity” was a prerequisite to the application of the

recharacterization rule to a C corporation shareholder; and (2)

the recharacterization rule and the 1994 final activity

regulation were invalid for failure to comply with the notice and

comment procedures of the Administrative Procedure Act, 5 U.S.C.

sec. 553(b) and (c) (1994).    See Schwalbach v. Commissioner,

supra at 219.

     In the course of Schwalbach’s detailed analysis of the

protracted regulatory process that ultimately gave rise to the
                              - 22 -

1994 final activity regulation, we never questioned that that

regulation was a prerequisite to the application of the

recharacterization rule.   Indeed, if shareholders clearly

participated in C corporation activities under the plain meaning

of the statute and the recharacterization rule, as the majority

now contend, Schwalbach’s analysis and upholding of the 1994

final “activity” regulation would be dictum.7

     Most importantly, the majority’s plain meaning approach is

fundamentally inconsistent with the repeated efforts the

Commissioner has found it necessary to exert, through issuance of

different regulations, simply to interpret and apply the

assertedly “plain” language of section 469.

     As the majority correctly observe, section 469 defines

“material participation” generally.    Sec. 469(h).   That section,

however, neither defines a taxpayer’s “activities”, nor expressly



     7
       Of course, in Sidell v. Commissioner, T.C. Memo. 1999-301,
and Connor v. Commissioner, T.C. Memo. 1999-185, we did conclude
that sec. 1.469-2(f)(6), Income Tax Regs. (the recharacterization
rule), could be applied to C corporation shareholders where the
regulations promulgated in T.D. 8565, 1994-2 C.B. 81, 59 Fed.
Reg. 50485 (Oct. 4, 1994) (the 1994 final regulations), and the
regulations promulgated in Notice of Proposed Rulemaking, PS-1-
89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992) (the 1992
proposed regulations), applied. I believe those decisions should
no longer be followed. As I explain in the text below, the 1992
proposed regulations, properly interpreted, prevent shareholder
participation in C corporation activities.

     In any event, the majority rely little on Sidell and Connor
for their conclusion; perhaps this is because the majority’s view
of the governing law is so fundamentally different from the views
expressed in those opinions.
                              - 23 -

states whether a taxpayer can “participate” in the activities of

entities he owns.   Nor does the recharacterization rule, which

uses these terms, provide a definition of either of them.

     If I were writing on a clean slate, before the Commissioner

had issued any relevant regulations defining “material

participation” or “activity”, I might conclude that a shareholder

could participate in the activities of his C corporations, under

a plausible interpretation of the statute.8    However, the slate

was far from clean during the year in issue.    As discussed in

more detail below, on at least four separate occasions--in 1988,

1989, 1992, and 1994–-the Commissioner issued temporary,

proposed, or final regulations interpreting “activity” or

“participation” for purposes of section 469.

     Of course, the mere existence of these detailed and often

contradictory versions of the regulations is compelling evidence

that the meaning of section 469 is anything but plain.9    Above


     8
       I’m not sure, however, that even in the absence of
regulations I would agree with the majority that attributing C
corporation activities to the shareholder is a foregone
conclusion under either the statute or the recharacterization
rule. Both the tax common-law rule of Moline Properties, Inc. v.
Commissioner, 319 U.S. 436 (1943), and the necessity of statutory
stock ownership attribution rules in other areas, e.g., secs.
267, 318, and 544, would give me pause, even if they wouldn’t bar
this approach.
     9
       One of the section 469 regulations–-the temporary
“activity” regulation promulgated in 1989–-alone occupied over 20
pages of the Federal Register. See sec. 1.469-4T, Temporary
Income Tax Regs., 54 Fed. Reg. 20527, 20542-20565 (May 12, 1989).
As described in the text infra p. 34, the Commissioner allowed
                                                   (continued...)
                               - 24 -

all, however, the content of these successive regulations

demonstrates that the majority’s “plain meaning” interpretation

of the statute and the recharacterization rule is incorrect.

     The majority conclude that shareholders participate in C

corporation activities under the plain meaning of section 469 and

the recharacterization rule.   The fatal flaw of this conclusion

is that the Commissioner reached the opposite conclusion in the

section 469 regulations–-not once but twice.

     In 1988 and 1989, the Commissioner was faced with the same

statutory language.   And yet, during those years the Commissioner

interpreted that language--in temporary regulations having the

force of law--to conclude that shareholders did not participate

in C corporation activities.   See the discussion of the 1988 and

1989 temporary regulations infra pp. 30-34.

     The majority do not argue (or even dare to suggest) that the

express nonparticipation (or nonattribution) rules set forth in

the temporary regulations were invalid interpretations of the

statute.   Moreover, none of the parties litigating (or courts

considering) the application of the recharacterization rule to C

corporation shareholders has ever argued or concluded that the

temporary regulations were invalid in this respect.   The



     9
      (...continued)
this regulation to “sunset” under sec. 7805(e), partly as a
result of public criticism that it was overly long and complex,
burdensome for small taxpayers, and mechanically inflexible. See
Schwalbach v. Commissioner, 111 T.C. 215, 224 (1998).
                               - 25 -

Commissioner’s inclusion of express nonattribution rules in two

sets of temporary regulations therefore completely refutes the

majority’s conclusion that shareholders participate in C

corporation activities under the plain language of section 469

and the recharacterization rule.

     II.   The Silence of the 1992 Proposed Regulations Is Not
           Dispositive

     The majority correctly note that the Commissioner allowed

the relevant portions of the temporary regulations to “sunset” in

1992.   See infra p. 34.   At the same time, the Commissioner

promulgated the 1992 proposed regulations, which apply to the

year in issue.   See id.

     Unlike the temporary regulations, the 1992 proposed

regulations say nothing about shareholder participation in C

corporation activities.    The majority conclude, because the 1992

proposed regulations do not expressly preclude such

participation, that shareholders participate in C corporation

activities even when the proposed regulations apply.   Once again,

I disagree.

     The majority’s interpretation of the “silent” 1992 proposed

regulations rests on their conclusion that shareholders

participate in C corporation activities under the plain meaning

of the statute and the recharacterization rule.   As explained

above, the majority’s plain reading is incorrect; their

interpretation of the 1992 proposed regulations is therefore also
                               - 26 -

incorrect.    The silence of the 1992 proposed regulations simply

does not require (or as explained below, even permit) us to reach

the majority’s result.

     III.    The Silence of the 1992 Proposed Regulations Must Be
             Interpreted in Light of the Prior and Subsequent
             Regulations

     In essence, the majority view section 469 and the

recharacterization rule as self-executing and as mandating a rule

of shareholder participation in C corporation activities unless

another rule expressly bars such participation.     Consistent with

this view, the majority conclude that the silent 1992 proposed

regulations cannot constitute the necessary bar.

     My view is different.    I see section 469-–particularly as

implemented by the recharacterization rule--as an ambiguous

statute, which the Commissioner reasonably interpreted, in

temporary regulations having the force of law--not once but

twice-–as precluding shareholder participation in C corporation

activities.

     Of course, the Commissioner later adopted a contrary

interpretation.    However, the Commissioner did not publicly

announce this contrary interpretation until 1994, when he issued

the 1994 final regulations.    This announcement came more than 6

years after the 1988 temporary regulations, and almost at the end

of 1994, the taxable year in issue.     See Schwalbach v.

Commissioner, 111 T.C. at 226, where we stated that “up until the

[1994] final regulations, the Commissioner had not publicly taken
                                - 27 -

the position that an individual’s activities could include

activities conducted through a C corporation.”

     I agree that the Commissioner is entitled to change his

mind; we so decided in Schwalbach.       However, under the

circumstances of this case, where the Commissioner had issued two

sets of temporary regulations taking a position favorable to

taxpayers (and petitioners), the standards of fairness developed

by this Court (discussed in more detail below) require that the

Commissioner publicly announce his change of position, before the

new position can take effect.    See Georgia Fed. Bank v.

Commissioner, 98 T.C. 105, 110 (1992), where we stated that an

agency that changes its position must acknowledge that its

interpretation has shifted and must supply a persuasively

reasoned explanation for the change.      See also Gottesman & Co. v.

Commissioner, 77 T.C. 1149 (1981), and Corn Belt Hatcheries of

Arkansas, Inc. v. Commissioner, 52 T.C. 636 (1969) (discussed

infra pp. 48-50), where we decided that taxpayers were entitled

to rely on withdrawn or unclarified guidance from the

Commissioner, until the Commissioner publicly announced his new

or clarified position.

     Against this background, the proper interpretation of the

“silent” 1992 proposed regulations becomes vitally important.

Although the Commissioner allowed the relevant portions of the

1988 and 1989 temporary regulations to “sunset” in 1992 and

replaced them with the 1992 proposed regulations, neither these
                               - 28 -

actions, nor the silent proposed regulations themselves,

constituted the necessary public announcement of the

Commissioner’s change of position from the temporary regulations.

     Prior to the issuance of the 1994 final regulations,

taxpayers could not know (or, as explained below, even infer)

that the Commissioner had changed his interpretation of section

469 and the recharacterization rule.    Although this delay did not

render the 1994 final regulations invalid, the standards of

fairness developed by this Court require that we interpret the

silence of the 1992 proposed regulations as preserving the

interpretation of the statute previously promulgated in both sets

of temporary regulations.   Once that silence is so interpreted,

the transitional rule of the 1994 final regulations can perform

its relief-providing function, and protect taxpayers from the

unannounced and unanticipated change those regulations made to

the Commissioner’s prior interpretations of the law.

     In reaching this conclusion, I’m not suggesting that the

Commissioner lacked the power to prescribe a final regulation

that would have applied the new activity definition

retroactively.10   As we concluded in Schwalbach, the


     10
       See sec. 7805(b) (the Secretary may prescribe the extent,
if any, to which a regulation shall be applied without
retroactive effect); Automobile Club of Michigan v. Commissioner,
353 U.S. 180, 184 (1957) (Commissioner may correct any regulation
retroactively, but also has discretion to limit retroactivity to
avoid inequitable results); cf. sec. 7805(b) as in effect for
regulations relating to statutory provisions enacted after July
                                                   (continued...)
                              - 29 -

Commissioner’s actions had at least alerted taxpayers to the

possibility that the definition of activity was under

reconsideration.   What we should decide in the case at hand,

however, is that by promulgating the transitional rule of the

1994 final regulations, the Commissioner wisely chose to apply

the new activity definition prospectively, unless the taxpayer

benefited otherwise.

     In summary, the majority’s plain reading of section 469 and

the recharacterization rule is an inadequate analysis of, and a

woefully inadequate response to, the situation in which

petitioners (and other similarly situated taxpayers) found

themselves during the year in issue.   To understand that

situation fully-–and to interpret the silent 1992 proposed

regulations properly--it’s unfortunately necessary to describe

the long and tortuous history of the section 469 regulations (and

the parties’ arguments based thereon) in more detail; to that

task I now turn.




     10
      (...continued)
29, 1996. Of course, the Commissioner’s unexplained reversal of
position from the regulations promulgated in T.D. 8175, 1988-1
C.B. 191, 53 Fed. Reg. 5686 (Feb. 25, 1988) (the 1988 temporary
regulations), and in T.D. 8253, 1989-1 C.B. 121, 54 Fed. Reg.
20527 (May 12, 1989) (the 1989 temporary regulations), would be
relevant in any judicial review of the 1994 final regulations, if
the Commissioner had decided to apply those regulations
retroactively. See Georgia Fed. Bank v. Commissioner, 98 T.C.
105 (1992).
                                - 30 -

     IV.    Development of the Regulations Over Time

     The recharacterization rule recharacterizes rental income

from property “rented for use in a trade or business activity * *

* in which the taxpayer materially participates * * * for the

taxable year”.    Sec. 1.469-2(f)(6)(i), Income Tax Regs.    During

1994, Mr. Krukowski rented the office building to the law firm.

Therefore, the recharacterization rule applies to petitioners’

income from the office building for that year only if Mr.

Krukowski materially “participated” in a trade or business

“activity” of the law firm during that year.

     Because the law firm is a C corporation, we’re required to

decide whether a shareholder could participate in a trade or

business activity of his C corporation under the law applicable

to 1994.    In 1988, 1989, 1992, and 1994, the Commissioner issued

temporary, proposed, or final regulations defining “activity” or

“material participation” for purposes of section 469.      We must

therefore trace these regulations’ successive answers to that

question.

            A.   The 1988 Temporary Regulations

     In 1988, the Commissioner issued the first section 469

regulations.     See T.D. 8175, 1988-1 C.B. 191, 53 Fed. Reg. 5686

(Feb. 25, 1988) (the 1988 temporary regulations).      The 1988

temporary regulations contained the first version of the

recharacterization rule (see sec. 1.469-2T(f)(6), Temporary

Income Tax Regs., 53 Fed. Reg. 5686, 5723 (Feb. 25, 1988)).       That
                               - 31 -

rule, like the current rule, applied where property was rented to

an “activity” in which the taxpayer materially “participates”.

     The 1988 temporary regulations didn’t define “activity”.

See sec. 1.469-4T, Temporary Income Tax Regs., 53 Fed. Reg. 5686,

5725 (Feb. 25, 1988), which stated in full:     “Definition of

activity (temporary). [Reserved]”.      They did, however, contain a

regulation entitled “Material participation”, which defined both

“participation” and the kind of participation deemed to be

material.   Sec. 1.469-5T, Temporary Income Tax Regs., 53 Fed.

Reg. 5686, 5725-5728 (Feb. 25, 1988).     The participation

definition in section 1.469-5T of the 1988 temporary regulations

provided:

          (f) Participation–-(1) In general. Except as
     otherwise provided in this paragraph (f), any work done
     by an individual (without regard to the capacity in
     which the individual does such work) in connection with
     an activity in which the individual owns (directly or
     indirectly, other than through a C corporation) an
     interest at the time the work is done shall be treated
     for purposes of this section as participation of such
     individual in the activity. [Sec. 1.469-5T(f)(1),
     Temporary Income Tax Regs., 53 Fed. Reg. 5686, 5726
     (Feb. 25, 1988); emphasis added.]

     The second parenthetical of this 1988 definition clearly

provided that an individual shareholder did not participate (and

thus could not materially participate) in the activities of his C

corporations.11   As a result, under the 1988 temporary


     11
       Unless the shareholder also owned a passthrough interest
in the C corporation’s activity, through which he could be
considered to participate. See sec. 1.469-5T(k), Examples (1)
                                                   (continued...)
                               - 32 -

regulations the recharacterization rule could not apply to income

received by a C corporation’s shareholder/lessor, notwithstanding

the absence of an “activity” definition in those regulations.

          B.    The 1989 Temporary Regulations

     In 1989, the Commissioner issued T.D. 8253, 1989-1 C.B. 121,

54 Fed. Reg. 20527 (May 12, 1989) (the 1989 temporary

regulations).   The 1989 temporary regulations amended certain

provisions of the 1988 temporary regulations; they also contained

the first regulation defining “activity” for purposes of section

469, section 1.469-4T, Temporary Income Tax Regs., 54 Fed. Reg.

20527, 20542 (May 12, 1989).    See T.D. 8253, 1989-1 C.B. 121,

supra at “Summary”.

     The 1989 temporary regulations amended the participation

definition contained in the 1988 temporary regulations by

deleting the parenthetical phrase “(directly or indirectly, other

than through a C corporation)”.   Sec. 1.469-5T, Temporary Income

Tax Regs., 54 Fed. Reg. 20527, 20565 (May 12, 1989).12   As a

result, the material participation definition in the 1989



     11
      (...continued)
and (2), 53 Fed. Reg. 5686, 5727 (Feb. 25, 1988).
     12
       The majority opinion refers to the participation
definition of the 1988 temporary regulations, as amended by the
1989 temporary regulations, as the “amended 1988 temporary
regulations”. I prefer to describe the Commissioner’s
simultaneous 1989 definitions of both “participation” and
“activity” as the 1989 temporary regulations; after all, it was
those definitions taken together that established the law
applicable to 1989.
                              - 33 -

temporary regulations no longer expressly stated that a

shareholder could not participate in the activities of his C

corporations.

     At first blush, one might think that this elimination of

restrictive language–-and the resulting silence about whether

individuals could participate in their indirectly owned

activities-–might mean that individuals could participate in the

activities of all their entities, including C corporations.

However, this was not the case.   The new definition of “activity”

contained in section 1.469-4T of the 1989 temporary regulations

expressly provided that a shareholder did not participate in the

activities of his C corporations.13    As a result of this new


     13
       New sec. 1.469-4T of the 1989 temporary regulations
defined activity for purposes of the passive loss rules. See
sec. 1.469-4T, Temporary Income Tax Regs., 54 Fed. Reg. 20527,
20542 (May 12, 1989). Sec. 1.469-4T(b)(2)(ii)(B) of those
regulations provided that for purposes of section 469 and the
regulations thereunder “a taxpayer’s activities do not include
operations that a taxpayer conducts through one or more entities
(other than passthrough entities).” Id. at 20543. Sec. 1.469-
4T(b)(2)(i) in turn defined “passthrough entity”; that definition
did not include C corporations. Id. at 20543.

     A shareholder’s inability to participate in the activities
of his C corporations under the cited provisions was made clear
by the example accompanying section 1.469-4T(b)(2) of the 1989
temporary regulations. In the facts of that example, taxpayer A
owned stock of closely held corporation X. The example stated:

     X is a C corporation and therefore is not a passthrough
     entity. Thus, for purposes of section 469 and the
     regulations thereunder, A’s activities do not include
     the operations of X’s real estate development business.
     Accordingly, A’s participation in X’s business is not
     participation in an activity of A, and is not taken
                                                   (continued...)
                                  - 34 -

activity definition, it was clear that a shareholder did not

participate in C corporation activities under the 1989 temporary

regulations–-notwithstanding the silence on this issue in the

material participation definition itself.

             C.   The 1992 Proposed Regulations

     In 1992, the Commissioner adopted the participation

definition of the 1989 temporary regulations substantially

unchanged, as final regulation section 1.469-5(f)(1), Income Tax

Regs.     See T.D. 8417, 1992-1 C.B. 173, 57 Fed. Reg. 20747 (May

15, 1992).14      At the same time, the Commissioner allowed the

activity definition of the 1989 temporary regulations to “sunset”

under section 7805(e).      The Commissioner replaced that definition

with a new proposed activity regulation, section 1.469-4,

Proposed Income Tax Regs.      See Notice of Proposed Rulemaking, PS-

1-89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992) (the

1992 proposed regulations).      Unlike the 1989 temporary

regulations, the 1992 proposed regulations didn’t contain a

general purpose definition of a taxpayer’s activities.       Instead,

the 1992 proposed regulations were silent on whether a

shareholder could participate in the activities of his C


     13
      (...continued)
     into account in determining whether A materially
     participates (within the meaning of 1.469-5T) * * *
     in any activity. [Sec. 1.469-4T(b)(2), Temporary
     Income Tax Regs., 54 Fed. Reg. 20543-20544 (May 12,
     1989).]
     14
       The majority opinion refers to this definition as the
1992 final regulations.
                                - 35 -

corporations.    The effect of this silence on the application of

the recharacterization rule is what’s in issue in this case.

          D.     The 1994 Final Regulations

     In 1994, the Commissioner issued T.D. 8565, 1994-2 C.B. 81,

59 Fed. Reg. 50485 (Oct. 4, 1994) (the 1994 final regulations).

The 1994 final regulations didn’t change the participation

definition adopted at the time of the 1992 proposed regulations.

However, the 1994 final regulations substantially revised the

1992 proposed regulations’ activity definition, by adding the

following statement to the “scope and purpose” provision:    “A

taxpayer’s activities include those conducted through C

corporations that are subject to section 469, S corporations, and

partnerships.”    Sec. 1.469-4(a), Income Tax Regs.   As a result of

this change, it was clear that a shareholder would materially

participate in the activities of his C corporations under the

1994 final regulations-–even though the participation definition

itself was not affected.

     The following table summarizes the development over time of

the activity and material participation definitions in the

section 469 regulations, as described above.    It also notes

whether, as a result of those definitions, a shareholder could

participate in the activities of his C corporations.
                                 - 36 -

                  Provision re shareholder’s
                  participation in his C
                  corporation’s activities
                                    “Material
                  “Activity”        participation”   Overall
Year/event        regulation        regulation       effect
1988 temporary    Silent            Parenthetical    Shareholder
regulations       (no activity      expressly        does not
(T.D. 8175)       regulation)       provides         participate in
                                    shareholder      C corporation
                                    does not         activities
                                    participate in
                                    C corporation
                                    activities
1989 temporary    Definition and    Silent           Shareholder
regulations       example           (parenthetical   does not
(T.D. 8253)       expressly         removed)         participate in
                  provide                            C corporation
                  shareholder                        activities
                  does not
                  participate in
                  C corporation
                  activities
1992 proposed     Silent            Silent           ???
regulations       (no definition    (same as         (at issue in
(PS-1-89)         or example)       above)           the case at
                                                     hand)
1994 final        Expressly         Silent           Shareholder
regulations       provides that     (same as         participates
(T.D. 8565)       taxpayer’s        above)           in activities
                  activities                         of C
                  include those                      corporations
                  conducted                          subject to
                  through C                          sec. 469
                  corporations
                  subject to
                  sec. 469


     V.   The 1992 Proposed Regulations Control This Case

     As the above discussion makes clear, the 1988 and 1989

temporary regulations expressly provided that shareholders did
                                - 37 -

not participate in C corporation activities; the 1994 final

regulations expressly provide that shareholders do so

participate.     The 1992 proposed regulations said nothing about

this issue.

     The 1994 final regulations generally apply to 1994.     See

sec. 1.469-11(a)(1), Income Tax Regs. (sec. 1.469-4, Income Tax

Regs., applies for taxable years ending after May 10, 1992).

However, taxpayers may choose to apply the 1992 proposed

regulations, rather than the 1994 final regulations, to determine

tax liability for years ending after May 10, 1992 and beginning

before October 4, 1994.     See sec. 1.469-11(b)(1), Income Tax

Regs.

     The parties agree that the 1992 proposed regulations apply

to this case.

     VI.     We Need Not Infer that Shareholders Participate in
             C Corporation Activities Under the 1992 Proposed
             Regulations

        The majority conclude (as respondent argued) that the

silence of the 1992 proposed regulations must be interpreted as

allowing shareholder participation in C corporation activities.

According to the majority (and respondent), because the 1992

proposed regulations do not contain the express nonparticipation

rule of the temporary regulations, it must be inferred that the

Commissioner did not intend to continue that rule in the 1992

proposed regulations.     The majority conclude that it must be

inferred further that shareholders participate in C corporation
                                - 38 -

activities where the 1992 proposed regulations apply.   I

disagree.15

     A.   The Proposed Regulations’ Silence Is Ambiguous

     The long and tortuous history of the section 469 regulations

proves that we need not infer a shareholder participation rule

from the silence of the 1992 proposed regulations.   To the

contrary, the history shows that silence was ambiguous.

      The recharacterization rule employs the terms “activity”

and “material participation”.    As the table, supra p. 36, clearly

shows, under both the 1988 and 1989 temporary regulations, the

definition of one of these key terms didn’t discuss a

shareholder’s participation in C corporation activities.

Nevertheless, under both sets of temporary regulations, a

shareholder clearly did not participate in C corporation

activities, because one or the other of the two key terms was

interpreted as precluding attribution of or participation in such

activities.




     15
       Our memorandum opinion in Sidell v. Commissioner, T.C.
Memo. 1999-301, made a similar inference in support of its
conclusion that shareholders participate in corporate activities
under the 1992 proposed regulations. Although Sidell v.
Commissioner, 78 T.C.M. (CCH) 53,537 at 430, 1999 T.C.M. (RIA)
par. 99,301 at 99-1929, stated that “Simply put, the proposed
regulations’ silence means nothing, not something”, Sidell
nevertheless concluded that from this silence “it is inferable”
that the Commissioner didn’t intend, in the 1992 proposed
regulations, to adhere to the position of the temporary
regulations.
                              - 39 -

     Under the 1994 final regulations, one of the key

definitions–-regarding material participation--still does not

address the question of C corporation shareholder participation.

Yet, as a result of the new activity definition contained in

those regulations, a shareholder clearly participates in C

corporation activities under the regulations as a whole.

     The result of all this is that in 1988 and 1989, regulatory

silence with respect to one of the key terms employed by the

recharacterization rule meant that a shareholder did not

participate in C corporation activities.   By contrast, in 1994,

such regulatory silence means that the shareholder does

participate in those activities.   Under these circumstances, it

is difficult to infer either an intent to repeal a

nonparticipation rule, or an intent to prescribe a participation

rule, from the “silence” of the 1992 proposed regulations.    More

tellingly, it would have been far more difficult for petitioners

to divine either of these results from that silence during 1994,

the year in issue; the 1994 final regulations were not

promulgated until October of that year.    See supra p. 35.

     B.   The Canons of Construction Do Not Mandate A
          Participation Interpretation

     The majority attempt to support their interpretation of the

1992 proposed regulations by reference to a canon of statutory

construction.   However, canons of construction simply do not

require us to reach the majority’s result.
                               - 40 -

      The majority note that material contained in earlier-

enacted legislation, but omitted in subsequently enacted

legislation, is deemed to be repealed by the subsequent

enactment.    The majority employ this canon (and apply it to

regulations) to support their conclusion that the 1992 proposed

regulations’ failure to restate one or the other of the express

nonparticipation rules contained in the 1988 and 1989 temporary

regulations means that the 1992 proposed regulations repealed

that rule.

     Although the majority’s canon may be helpful at times, this

case should not (and need not) be decided by a canon of

construction.    First, the canon cited by the majority is far from

an absolute rule.    It may be disregarded where the lawmaker’s

intent is found to be otherwise.    See Singer, Sutherland

Statutory Construction, sec. 23.32 at 283 and sec. 23.12 at 363

(5th ed. 1993).

     Second, and more importantly, the canons of construction

usually cut both ways, see Llewellyn, The Common Law Tradition:

Deciding Appeals 521-535 (1960), even when they’re not just

wrong.    See Posner, Statutory Interpretation--in the Courtroom

and in the Classroom, 50 U. of Chi. L. Rev. 800, 806 (1983).16


     16
       The temporary regulations contain an excellent example of
a situation in which the majority’s canon would produce the wrong
answer. The 1988 temporary regulations’ participation definition
contained language expressly preventing shareholder participation
in C corporation activities. The 1989 temporary regulations
                                                   (continued...)
                             - 41 -

     For example, another canon of construction, applied in

Smietanka v. First Trust & Sav. Bank, 257 U.S. 602, 607 (1922),

on the effect of material added on reenactment, not material

omitted, cuts against the majority’s argument.    In First Trust &

Sav. Bank, the Supreme Court treated the addition of an express

rule, by a later enactment, as proof the rule was not included in

the analogous provisions of an earlier statute.

     The 1994 final regulations expressly state that a

shareholder’s activities include those conducted through C

corporations subject to section 469.   The silent 1992 proposed

regulations contained no such participation/attribution rule.

Therefore, the First Trust & Sav. Bank canon of construction

suggests that shareholders did not participate in C corporation

activities under the 1992 proposed regulations.   As the Supreme

Court concluded in First Trust & Sav. Bank, where a provision has

been added to a later act, a court cannot supply the omission in

the earlier act.17


     16
      (...continued)
deleted this language. Applying the majority’s canon, one would
conclude the Commissioner intended shareholders to participate in
C corporation activities under the later regulation. However,
this was not the case, as the activity definition of the 1989
temporary regulations clearly shows. See supra pp. 32-34.
     17
       One other point: the cases cited by the majority to
support their canons of construction argument concern situations
where an express rule was clearly required to sustain a party’s
position. For example, Independent Ins. Agents of Am., Inc. v.
Clarke, 955 F.2d 731 (D.C. Cir. 1992), revd. on other grounds sub
nom. United States Natl. Bank v. Independent Ins. Agents of Am.,
                                                   (continued...)
                              - 42 -

     C.   The Express Participation Rule of the 1994 Final
          Regulations Did Not “Clarify” the 1992 Proposed
          Regulations

     To support the position that shareholders participate in C

corporation activities under the 1992 proposed regulations,

respondent additionally argued that the express participation

rule of the 1994 final regulations simply “clarified” the 1992

proposed regulations.   This is also incorrect.

     The 1994 final regulations included the following sentence

dealing with the “scope and purpose” of the activity definition:

“A taxpayer’s activities include those conducted through C

corporations that are subject to section 469, S corporations, and

partnerships.”   Sec. 1.469-4(a), Income Tax Regs. (the express

participation (or attribution) rule).   It is true that the

preamble to the 1994 final regulations stated that this language



     17
      (...continued)
Inc., 508 U.S. 439 (1993), concerned a national bank’s ability to
sell insurance. In the Court of Appeals’ view, section 24 of the
National Bank Act, 12 U.S.C. sec. 24 (1988), limited banks’
activities to those expressly authorized by law. Starting from
this premise, it of course followed, after Congress omitted the
section of the banking laws authorizing banks to sell insurance,
that banks no longer had the power to do so.

     The majority assert that an express nonattribution rule is
necessary to prevent shareholder participation in C corporation
activities. As made clear in the text, this is incorrect. The
Commissioner’s interpretations of the statute in both sets of
temporary regulations, the Commissioner’s inclusion of an express
participation rule in the 1994 final regulations, and our
decision in Schwalbach v. Commissioner, 111 T.C. 215 (1998),
treating the 1994 final regulations as necessary, all suggest
that shareholders do not participate in C corporation activities,
under the plain meaning of section 469.
                               - 43 -

was a clarification.   See T.D. 8565, 1994-2 C.B. 81, 59 Fed. Reg.

50485 (Oct. 4, 1994), at “Supplementary Information:     Explanation

of Provisions; II. Public Comments”.    Under the circumstances of

this case, however, there is no reason to give the Commissioner’s

retrospective rationalization contained in the preamble to the

1994 final regulations any more interpretative weight than

respondent’s litigating position.

     Of course, a preamble may be used as an aid in interpreting

the regulation it accompanies.   See Armco, Inc. v. Commissioner,

87 T.C. 865, 868 (1986).    But the case at hand concerns the

meaning of the 1992 proposed regulations, not the meaning of the

1994 final regulations.    The 1994 preamble was not a

contemporaneous interpretation of the 1992 regulations in issue.

As a retrospective rationalization, it’s entitled to little or no

interpretative weight.    See id. at 868, where we stated:

     The proper interpretation of a regulation as a matter
     of law is a responsibility that ultimately rests with
     the courts. In exercising its judicial function, the
     court may be aided by the views of the drafters on the
     intended meaning of the language, but to be accorded
     any weight, those views cannot be post hoc * * * .

     More importantly, the preamble’s statement that the language

added to the 1992 proposed regulations’ activity definition by

the 1994 final regulations was only a clarification simply does

not withstand scrutiny.    According to the preamble, the new

language clarified a “grouping” rule contained in the 1992

proposed regulations, by explaining that a taxpayer could group
                              - 44 -

activities conducted through C corporations with other

activities.   See 59 Fed. Reg. 50485, 50486 (Oct. 4, 1994).   The

1992 proposed regulations’ grouping rule (contained in section

1.469-4(j) of the 1992 proposed regulations, 57 Fed. Reg. 20802,

20805 (May 15, 1992)) had provided as follows:

          (j) Activities conducted through partnerships or
     S corporations. A partnership or S corporation must
     group its activities under the rules of this section.
     Once a partnership or S corporation determines its
     activities, a partner or shareholder groups those
     activities with activities conducted directly by the
     partner or shareholder or with activities conducted
     through other partnerships or S corporations in
     accordance with the rules of this section.

     As the above-quoted passage makes clear, the grouping rule

of the 1992 proposed regulations provided that a taxpayer could

group activities conducted through passthrough entities with

activities conducted directly.   Notwithstanding the

Commissioner’s claim in the preamble, I fail to understand how a

rule entitled “Activities conducted through partnerships or S

corporations”, and which refers explicitly several times only to

such passthrough entities, could be “clarified” to provide that a

taxpayer may group activities conducted through nonpassthrough

entities as well, such as “C corporations that are subject to

section 469".

     Our decision in Schwalbach v. Commissioner, 111 T.C. 215

(1998), also establishes that the express attribution rule of the

1994 final regulations was not simply a “clarification” of the

1992 proposed regulations.   Although our memorandum opinion in
                              - 45 -

Connor v. Commissioner, T.C. Memo. 1999-185, suggested Schwalbach

had concluded that the 1994 final regulations clarified the

proposed regulations, what we actually said in Schwalbach was

that the preamble to the final regulations itself asserted that

the inclusion of an attribution rule in the final regulations was

a clarification; we didn’t so conclude ourselves.    To the

contrary, in Schwalbach v. Commissioner, supra at 221-226, we

described the language added to the 1994 final regulations as a

“change” from the 1992 proposed regulations, as a “new position”,

and as a “complete reversal” from the 1989 temporary regulations.

We also stated that “the change in language from the proposed

regulations was substantial; up until the final regulations, the

Commissioner had not publicly taken the position that an

individual’s activities could include activities conducted

through a C corporation.”   Id. at 226.

     VII.   Fairness Demands We Interpret the Silence of the 1992
            Proposed Regulations as Continuing the
            Nonparticipation Rule of the Temporary Regulations

     Respondent and the majority assert that the silence of the

1992 proposed regulations must be interpreted as repealing the

nonparticipation rule of the temporary regulations and as

prescribing an express participation rule instead.    For the

reasons just set forth, I disagree.    Placing the silence of the

1992 proposed regulations in its proper context, it’s difficult

to infer from such silence either an intent to repeal a

nonparticipation rule, or an intent to prescribe a participation
                              - 46 -

rule.   With respect to the issue in the case at hand, the

recharacterization rule and the 1992 proposed regulations are

ambiguous.

     Nevertheless, setting aside for the moment any inferences

that may be drawn from the silence (or other ambiguity) of the

1992 proposed regulations, three aspects of those regulations are

crystal clear.   First, the 1992 proposed regulations do not

expressly provide that a shareholder participates in C

corporation activities.   Second, the 1992 proposed regulations do

not expressly disavow the rule of nonattribution that had been

set forth in the 1988 and 1989 temporary regulations.    Third, the

1992 proposed regulations neither state that the Commissioner was

changing his position on shareholder participation in C

corporation activities, nor explain why such a change was being

made.   For all these reasons, the standards of fairness developed

by this Court require us to interpret the ambiguity of the 1992

proposed regulations as maintaining the nonattribution

interpretation of the statute and the recharacterization rule

formerly contained in the temporary regulations.

     As an example of these standards of fairness, we noted in

Georgia Fed. Bank v. Commissioner, 98 T.C. at 110, that sharp

changes of agency course constitute danger signals to which a

reviewing court must be alert; we also stated that an agency that

changes its position must acknowledge that its interpretation has
                              - 47 -

shifted, and must supply a persuasively reasoned explanation for

the change.18

     It is in this context that (contrary to the statement in

Sidell v. Commissioner, T.C. Memo. 1999-301) the silence of the

1992 proposed regulations means something, not nothing.   The

silent proposed regulations could not (and did not) serve as the

required public announcement of the Commissioner’s change of

position from the temporary regulations, or as the required

explanation of the reasons for that change.   It is uncontested

that the first public announcement by the Commissioner of his

complete reversal of position was contained in the 1994 final

regulations, which were not published in the Federal Register

until October 4, 1994.   See Schwalbach v. Commissioner, supra at

226; 59 Fed. Reg. 50485 (Oct. 4, 1994) (promulgation of 1994

final regulations).

     I agree with our conclusion in Schwalbach v. Commissioner,

supra, that the silence of the 1992 proposed regulations alerted

taxpayers to the possibility that the Commissioner was

considering changing the nonattribution rule contained in the



     18
       In Georgia Fed. Bank v. Commissioner, 98 T.C. 105, 109-
110 (1992), we also observed that if a regulation repudiates an
earlier interpretation, the manner in which it evolved merits
inquiry, and the more recent interpretation may be accorded less
deference than a consistently maintained position. We further
noted that an agency’s action must be upheld, if at all, on the
basis articulated by the agency at the time of the rule making;
post hoc rationalizations cannot be offered to buttress an
agency’s action.
                              - 48 -

1988 and 1989 temporary regulations; the 1994 final regulations,

although different from the temporary and proposed regulations,

were therefore valid.   However, taxpayers could not have

concluded, on the basis of the silence of the 1992 proposed

regulations, that the Commissioner had in fact changed that rule.

     Our cases interpreting another large and detailed set of

legislative regulations-–the consolidated return regulations–-

provide another example of how the standards of fairness instruct

us to interpret the Commissioner’s silence in the case at hand.

We have held that the Commissioner is bound by the consequences

flowing from the silence (or the express terms) of the

consolidated return regulations, even when those consequences are

arguably at odds with larger tax principles or the statute as a

whole.   See Woods Inv. Co. v. Commissioner, 85 T.C. 274 (1985)

(literal application of consolidated return regulations binding,

even though result was allegedly a double deduction for the

taxpayer); Gottesman & Co. v. Commissioner, 77 T.C. 1149 (1981)

(refusal to “fill in the gaps” regarding imposition of

accumulated earnings tax on corporations filing consolidated

returns).

     Our opinion in Gottesman & Co. v. Commissioner, supra, is

particularly instructive.   Gottesman & Co. also considered the

effect of the Commissioner’s silence, following the withdrawal of

regulations favorable to the taxpayer.   In Gottesman & Co., we

considered whether the taxpayer (the common parent of an
                             - 49 -

affiliated group) was required to compute “accumulated taxable

income” (for purposes of the accumulated earnings tax, section

531) on a consolidated basis as the Commissioner contended, or on

a separate-company basis as the taxpayer contended.    Under one

set of proposed regulations, certain taxpayers (including the

taxpayer in Gottesman & Co.) would have computed accumulated

taxable income on a separate company basis.    Those proposed

regulations were withdrawn prior to the years in issue in

Gottesman & Co.; proposed regulations reaching the opposite

result were promulgated after those years.    In holding for the

taxpayer, we concluded, against this background, that the

Commissioner’s silence during the years in issue had failed to

provide sufficient guidance to the taxpayer:

     Though the 1968 proposed regulations were withdrawn in
     1971, before the years involved in this case, we can
     readily understand petitioner’s confusion as to
     respondent’s true position * * *. * * *

          We cannot fault petitioner for not knowing what
     the law was in this area when the Commissioner, charged
     by Congress to announce the law (sec. 1502), never
     decided what it was himself. * * *

          Thus, we find that the Commissioner’s regulations
     regarding the manner in which the accumulated earnings
     tax was to be imposed on corporations making
     consolidated returns were ambiguous during the years at
     issue. This ambiguity was of the Commissioner’s
     making, and, as such, must be held against him. * * *
     We think that under these circumstances the failure of
     petitioner to comply with respondent’s post hoc view of
     the regulations is an insufficient ground on which to
     impose the accumulated earnings tax, and we hold for
     petitioner on the issues herein presented.4
                              - 50 -
     4
       See also Corn Belt Hatcheries of Arkansas, Inc. v.
     Commissioner, 52 T.C. 636 (1969).

[Gottesman & Co. v. Commissioner, 77 T.C. at 1157-1158.]

     Our opinion in Corn Belt Hatcheries of Arkansas, Inc. v.

Commissioner, 52 T.C. 636 (1969) (cited in Gottesman & Co. at

1158 n.4), further supports interpreting any ambiguity in the

1992 proposed regulations in petitioners’ favor; it also

addresses and downplays the role of the Commissioner’s

subsequently asserted “clarification” in that interpretation.     In

Corn Belt Hatcheries of Arkansas, Inc., the taxpayer (a common

parent corporation) arguably would have been permitted to file a

separate return under the language of a revenue ruling.     However,

the taxpayer clearly would not have been able to do so under a

subsequently published “clarification” of that language in

another revenue ruling.   In holding for the taxpayer we wrote:

          Petitioner interprets * * * [the first revenue
     ruling] to permit what its words seem to say * * *. We
     consider this interpretation a plausible one and we are
     not disposed to reject it by importing into the ruling
     the subsidiary qualification asserted by respondent.
     Taxpayers are already burdened with an incredibly long
     and complicated tax law. We see no reason to add to
     this burden by requiring them anticipatorily to
     interpret ambiguities in respondent’s rulings to
     conform to his subsequent clarifications, particularly
     in an area, such as consolidated returns, where
     Congress has placed such reliance on respondent’s
     expertise. * * * [Corn Belt Hatcheries of Arkansas,
     Inc. v. Commissioner, supra at 639-640.]19


     19
       Sec. 1.469-1T(g)(3)(iii), Temporary Income Tax Regs., 53
Fed. Reg. 5686, 5707-5708 (Feb. 25, 1988), further supports the
interpretation that a shareholder did not participate in C
                                                   (continued...)
                             - 51 -

                           Conclusion

     Notwithstanding the majority’s belated resort to “plain

meaning”, section 469 is a technical and complicated statute.

The regulations promulgated under that section have been detailed

and voluminous; they have also changed significantly over time.




     19
      (...continued)
corporation activities under the 1992 proposed regulations.
Personal service corporations and closely held C corporations are
themselves subject to the passive loss rules. See sec.
469(a)(2)(B) and (C). Sec. 1.469-1T(g)(3), Temporary Income Tax
Regs., 53 Fed. Reg. 5707-5708 (Feb. 25, 1988) determines when
such corporations will be considered to participate in their own
activities. Sec. 1.469-1T(g)(3)(iii), Temporary Income Tax
Regs., supra, provides that for this purpose, the general
participation definition of sec. 1.469-5T, Temporary Income Tax
Regs., shall apply, except that individuals shall be treated as
holding an interest in all corporate activities.

     This special participation definition was first promulgated
as part of the 1988 temporary regulations (see sec. 1.469-
1T(g)(3)(iii), Temporary Income Tax Regs., supra. It was an
exception to the general participation definition of those 1988
temporary regulations, which expressly provided that a
shareholder did not participate in C corporation activities. See
supra pp. 30-32.

     The Commissioner did not amend or remove the special
participation definition of sec. 1.469-1T(g)(3)(iii), Temporary
Income Tax Regs., supra, when he promulgated the 1992 proposed
regulations. See T.D. 8417, 1992-1 C.B. 173, 57 Fed. Reg. 20747
(May 15, 1992) (certain temporary passive loss regulations
amended or adopted as final regulations); Notice of Proposed
Rulemaking, PS-1-89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May
15, 1992) (the 1992 proposed regulations). Because the special
definition would not be necessary if shareholders generally
participated in C corporation activities, the Commissioner’s
failure to remove that definition when he promulgated the 1992
proposed regulations further suggests that shareholders did not
generally participate in C corporation activities under those
regulations.
                              - 52 -

     The Commissioner has long recognized the value of effective

date and transitional rule relief in the section 469 setting.

When the recharacterization rule was first promulgated as part of

the 1988 temporary regulations, the Commissioner ensured it would

not be applied retroactively, because “taxpayers could not

clearly foresee the particular recharacterization rules that

these regulations would adopt”.   See T.D. 8175, 1988-1 C.B. 191,

53 Fed. Reg. 5686 (Feb. 25, 1988), at “Supplementary Information:

Significant Policy Issues; XVI. Recharacterization of Certain

Passive Activity Gross Income”.   Also, when the Commissioner

allowed the activity definition in the 1989 temporary regulations

to “sunset” he published the 1992 proposed regulations to take

its place; the 1992 proposed regulations stated that they would

apply only to tax years ending after their date of publication.

See Notice of Proposed Rulemaking, PS-1-89, 57 Fed. Reg. 20802,

20803 (May 15, 1992).

     The 1988 and 1989 temporary regulations expressly provided

that a shareholder could not participate in the activities of his

C corporations.   By contrast, the 1992 proposed regulations were

silent on this issue.   For the reasons set forth above, taxpayers

could not have inferred from this silence that the Commissioner

had changed the prior rules to provide that shareholders

participate in the activities of their C corporations under the

1992 proposed regulations.
                                - 53 -

     More importantly, notwithstanding any contrary inferences

that might have been drawn, it is clear that the activity

definition contained in the 1994 final regulations was the first

activity rule expressly providing that a shareholder participated

in his C corporation’s activities.       I repeat the observation we

made in Schwalbach v. Commissioner, 111 T.C. at 226, about the

new 1994 activity definition:

     the change in language from the proposed regulations
     was substantial; up until the final regulations, the
     Commissioner had not publicly taken the position that
     an individual’s activities could include activities
     conducted through a C corporation.

I also repeat that in Schwalbach we never questioned that this

1994 change was a prerequisite to the recharacterization of

rental income received by the shareholder of a C corporation.

     In promulgating the 1994 final regulations containing this

substantial change, the Commissioner once again recognized the

importance of transitional relief.       The 1994 final regulations

provided that taxpayers could determine their tax liability for

years ending after May 10, 1992, and beginning before October 4,

1994, under the 1992 proposed regulations if they so chose,

rather than under the final regulations.       See 59 Fed. Reg. 50485,

50486-50487 (Oct. 4, 1994).

     It would be inconsistent with this grant of transitional

relief to hold to their detriment that shareholders participated

in the activities of their C corporations under the 1992 proposed

regulations.   Taxpayers could not learn or infer, from reading
                              - 54 -

the 1992 proposed regulations, that shareholders participated in

the activities of their C corporations.   Moreover, the addition

of an express attribution rule to the 1994 final regulations was

a significant change from those proposed regulations.   The only

possible purpose of the transitional rule contained in the 1994

final regulations was to protect taxpayers from this type of

unanticipated change during the interim period.

     The Commissioner has abused the regulatory process in

backing and filling on the transitional rule issue in this case

and in previous cases.   Having with one hand granted transitional

relief in the 1994 final regulations by allowing C corporation

shareholders for 1993-94 to apply the 1992 proposed regulations,

the Commissioner should not be able to take it away with the

other, through statutory notices and litigation.

     I would hold that shareholders who received net rental

income from their C corporations--during years to which the 1992

proposed regulations apply--are not subject to the

recharacterization rule.   The majority’s holding to the contrary

is incorrect.

     CHABOT, PARR, WHALEN, HALPERN, GALE, and MARVEL, JJ., agree
with this concurring in part and dissenting in part opinion.
