                  T.C. Memo. 1999-301



                UNITED STATES TAX COURT



     CHESTER F. AND FAYE L. SIDELL, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 10489-98.              Filed September 4, 1999.



          Respondent recharacterized the income
     petitioner husband received from the rental of
     property to his wholly owned C corporation
     from passive to nonpassive, pursuant to the
     attribution rule of sec. 1.469-4(a), Income
     Tax Regs., and the so-called self-rented
     property rule contained in sec. 1.469-2(f)(6),
     Income Tax Regs. As a consequence of this
     recharacterization, petitioners were able
     neither to reduce such rental income by losses
     from other rental properties nor to use
     certain rehabilitation credits.

          1.   Held: Pursuant to sec. 469(l),
     I.R.C., the Secretary properly promulgated the
     attribution and self-rented property rules.
     The self-rented property rule (by virtue of
     the attribution rule) is valid insofar as it
     recharacterizes rental income received by a
                                     - 2 -


            controlling shareholder from a C corporation
            from passive to nonpassive. See Schwalbach v.
            Commissioner, 111 T.C. 215 (1998).

                 2.   Held   further:   The   transitional
            relief provided in sec. 1.469-11(b), Income
            Tax Regs., is of no benefit to petitioners in
            determining their 1993 and 1994 tax liability
            because sec. 1.469-4, Proposed Income Tax
            Regs., 57 Fed. Reg. 20804 (May 15, 1992), PS-
            1-89, 1992-1 C.B. 1219, is silent as to
            whether the activities of a C corporation are
            or are not attributable to the corporation's
            shareholder.

                 3.   Held further:   Respondent properly
            disallowed rehabilitation credits claimed by
            petitioners for 1993 and 1994 because once
            their net rental income for those years is
            recharacterized as nonpassive, the limitation
            on passive activity credits mechanically
            disallows the claimed credits.



     David R. Andelman and Juliette Galicia Pico, for petitioners.

     Mary P. Hamilton, David N. Brodsky, and Maura A. Sullivan, for

respondent.


               MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS,   Judge:    Respondent    determined    deficiencies   and   an

accuracy-related penalty under section 6662(a) with respect to

petitioners' Federal income taxes, as follows:

                                                Penalty
     Year               Deficiency            Sec. 6662(a)

     1993                $103,728                     ---
     1994                  41,621                   $8,324
                                 - 3 -


     The deficiencies stem from respondent's recharacterizing the

income Chester F. Sidell (Mr. Sidell) received from the rental of

properties to his wholly owned C corporation from passive to

nonpassive.     Respondent now concedes the accuracy-related penalty

under section 6662(a) for 1994.

     The   issues   for   decision   are:      (1)   Whether   respondent's

recharacterization of the rental income Mr. Sidell received from

his wholly owned C corporation was proper; and if so, (2) whether

respondent    properly    disallowed     the     rehabilitation    credits

petitioners claimed for those years.

     All section references are to the Internal Revenue Code as in

effect for the years in issue.

                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.           The

stipulation of facts and the exhibits submitted therewith are

incorporated herein by this reference.

     Petitioners,    husband   and     wife,    resided   in    Framingham,

Massachusetts, at the time they filed their petition contesting

respondent's determinations.    For both years in issue, petitioners

filed joint Federal income tax returns.

Acquisition of Rental Properties

     Mr. Sidell was the sole beneficiary of five trusts:               The

Manche Realty Trust, CFS Realty Trust, FLS Realty Trust, GES Realty

Trust, and RMS Realty Trust. All five trusts are nominee trusts
                               - 4 -


under Massachusetts law and constitute grantor trusts for Federal

income tax purposes.   All income, deductions, and credits of these

trusts were reported as pass-through items on petitioners' 1993 and

1994 Federal income tax returns.

     On November 8, 1985, Manche Realty Trust acquired title to the

land and building known as the Everett Mill Cotton Weaving House

(the Everett Mill property), located at 181-183 Canal Street,

Lawrence, Massachusetts.   The Everett Mill property is located in

a National Register historical district.      Immediately after its

purchase in 1985, the Everett Mill property was leased to KGR, Inc.

(KGR), Mr. Sidell's wholly owned corporation.    At the time of its

acquisition, the Everett Mill property was in poor condition.

    On July 6, 1992, Mr. Sidell executed an agreement for the

acquisition of the land and building known as Kunhardt Mill,

located at 60 Island Street, Lawrence, Massachusetts. The Kunhardt

Mill property is a historic mill dating back to the late 1800's and

is located across the street from the Everett Mill property in the

same National Register historical district.    On October 14, 1992,

CFS Realty Trust (rather than Mr. Sidell) took title to the

Kunhardt Mill property.     At the time of its acquisition, the

Kunhardt Mill property needed substantial repair.        After its

acquisition, the Kunhardt Mill property was leased to KGR.      The

property was subsequently renovated and thereafter used as KGR's

corporate headquarters.
                                  - 5 -


      On February 23, 1993, FLS Realty Trust acquired the land and

building located at Canal, Mill, and Methuen Streets, Lawrence,

Massachusetts (the FLS Realty Trust property).          This property was

subsequently leased to KGR to alleviate a parking shortage around

KGR's offices.

      On July 14, 1993, and May 16, 1994, respectively, GES Realty

Trust and RMS Realty Trust acquired properties located near the

Everett Mill, Kunhardt Mill, and FLS Realty Trust properties.

These properties were acquired in anticipation of future expansion

of KGR's business; they were not rented to KGR during the years in

issue.

KGR

      KGR, incorporated in Massachusetts, has its principal place of

business    in   Lawrence,   Massachusetts.    For    Federal   income   tax

purposes it is a subchapter C corporation.           KGR is engaged in the

business of manufacturing women's and children's apparel under

private labels for such customers as Nordstrom, Talbots, and

Dillards.

      During the years in issue, petitioner was the president,

treasurer, and sole director of KGR.          With the exception of its

retail sales operation, which was managed by Mrs. Sidell, Mr.

Sidell managed every facet of KGR's day-to-day activities.
                                          - 6 -


Rehabilitation of Everett Mill/Kunhardt Mill Properties

     On     May    16,    1986,     Mr.     Sidell   submitted     a    historical

preservation application to the U.S. Department of the Interior

requesting certification that the Everett Mill property was a

"certified historic structure".               Certification was subsequently

granted by the National Park Service (Park Service).                   Thereafter,

in   1989   and    1990,    substantial         rehabilitation,    repairs,    and

modifications were made to the Everett Mill property.                  Petitioners

claimed rehabilitation credits for the rehabilitation expenditures

in 1989 and 1990.        The rehabilitation credits for these years were

allowed and are not at issue in this case.

     Seeking similar tax treatment for the Kunhardt Mill property,

and concurrently with its acquisition, Mr. Sidell (on behalf of CFS

Realty    Trust)   instituted       a   major     rehabilitation   project    with

respect to the property.          After repairs and renovations had begun

on the Kunhardt Mill property, Mr. Sidell submitted a historic

preservation certification application on March 23, 1993, to the

U.S. Department of the Interior seeking a determination that the

work previously done on the property conformed with its "Standards

for Rehabilitation". After Mr. Sidell completed the rehabilitation

project, the Park Service preliminarily determined that the work

performed on the Kunhardt Mill property was eligible for "certified

rehabilitation" status.           Subsequently, on September 23, 1994, Mr.

Sidell submitted a "Historic Preservation Certification Application
                                - 7 -


Request for Certification of Completed Work" to the Park Service.

Rehabilitation costs totaling $1,701,988 in 1993 and $84,435 in

1994 were incurred with regard to the rehabilitated Kunhardt Mill

property.1     An additional $200,000 was incurred in related costs

associated with obtaining "qualified rehabilitation" status.

Petitioners' 1993 and 1994 Federal Income Tax Returns

     Petitioners timely filed their 1993 and 1994 Federal income

tax returns.    On their returns, petitioners reported the following

net rental income:

         Property                       Net Rental Income/(Loss)

                                             1993       1994

Manche/Everett Mill property             $122,139    $45,936
CFS/Kunhardt Mill property                138,451     (5,335)
FLS property                              (42,758)    57,894
GES property                               (2,272)   (25,315)
RMS property                                N/A      (11,855)

Rental activities with net income         260,590    103,830
Rental activities with net loss           (45,030)   (42,505)

Net rental income                         215,560     61,325

     Petitioners also claimed rehabilitation credits of $85,361 in

1993 and $24,284 in 1994 with regard to the Kunhardt Mill property

renovations.




     1
          The record does not enable us to account for the
discrepancy between the stipulated amounts of rehabilitation
costs for 1993 ($1,701,988) and 1994 ($84,435) and the amounts
reflected on petitioners' Federal tax returns for 1993
($1,734,163) and 1994 ($89,725).
                                    - 8 -


Notice of Deficiency

     In the notice of deficiency dated March 11, 1998, respondent

recharacterized the positive 1993 income from the Everett Mill and

Kunhardt Mill properties and the positive 1994 income from the

Everett Mill and FLS Realty Trust properties from passive to

nonpassive pursuant to section 1.469-2(f)(6), Income Tax Regs.; the

recharacterization resulted in petitioners' 1993 and 1994 taxable

income being increased by $45,030 and $42,505, respectively. In

addition, as a consequence of respondent's recharacterization,

respondent    determined   that    petitioners'   regular       tax   liability

allocable    to   all   passive    activities   for     1993   and    1994   was

insufficient to enable them to use the rehabilitation credits

claimed for those years.      See sec. 469(d)(2).

                                   OPINION

     Central to the dispute in this case is the validity of the so-

called   self-rented    property    rule    contained    in    section   1.469-

2(f)(6), Income Tax Regs., which provides:

          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 * * * for the taxable
             year.

Pursuant to this rule, and by virtue of the attribution rule of
                                   - 9 -


section 1.469-4(a), Income Tax Regs.,2 respondent recharacterized

the rental income Mr. Sidell received in 1993 and 1994 from the

three properties leased to his wholly owned C corporation from

passive to nonpassive.

     As a consequence of this recharacterization, petitioners were

neither able to reduce such rental income by the losses from other

rental   properties   nor   able   to   utilize   certain   rehabilitation

credits.

Section 469 and the Self-Rented Property Rule

     Pursuant to section 469(a), in general, a taxpayer is denied

both a passive activity loss and a passive activity credit for the

taxable year in which they arise.          A passive activity loss is

defined as the amount by which the aggregate losses from all

passive activities exceeds the aggregate income from all passive

activities for such years.         See sec. 469(d)(1).        Likewise, a

passive activity credit is defined as the amount by which the sum

of all allowable credits from passive activities exceeds the

regular tax liability of the taxpayer allocable to all passive

activities.   See sec. 469(d)(2).

     Section 469 specifically excludes certain transactions and


     2
          Sec. 1.469-4(a), Income Tax Regs., provides, among
other things, that for grouping a taxpayer's trade or business
activities and rental activities for purposes of applying the
passive activity loss and credit limitations rules of sec. 469, a
taxpayer's activities include those conducted through C
corporations that are subject to sec. 469.
                                     - 10 -


activities     from    its    purview.     Where   a    taxpayer    "materially

participates" in a trade or business, the activity is excluded from

being classified as "passive".                Sec. 469(c)(1).       Ultimately,

neither a passive activity loss nor a passive activity credit is

permanently disallowed.            Rather, they are suspended until the

taxpayer either has offsetting passive income or disposes of his

entire interest in the passive activity.               See sec. 469(b), (g).

      The passive activity rules reflect Congress' concern over the

widespread use of tax shelters that allowed taxpayers to avoid

paying tax on unrelated income.           See Schaefer v. Commissioner, 105

T.C. 227, 230 (1995).        In large part, section 469 was intended to

"restore public confidence in the Federal tax system" by limiting

the ability of taxpayers to derive tax preferences from activities

in   which    they    did    not   have   a   "substantial    and    bona   fide

involvement". Adler v. United States, 32 Fed. Cl. 736, 738 (1995);

see S. Rept. 99-313, at 713 (1986), 1986-3 C.B. (Vol. 3) 1, 713-

714; see also St. Charles Inv. Co. v. Commissioner, 110 T.C. 46,

49-50 (1998).         As noted previously, pursuant to section 469,

passive losses are allowed only to the extent of passive income.

Congress gave the Secretary broad authority to promulgate rules and

regulations under section 469. See Schwalbach v. Commissioner, 111

T.C. 215, 220 (1998),3 wherein this Court held that neither the


     3
             In Schwalbach v. Commissioner, 111 T.C. 215 (1998), the
                                                      (continued...)
                               - 11 -


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

nor the attribution rule of section 1.469-4(a), Income Tax Regs.,

is invalid because of an alleged failure to comply with the

procedural notice and comment requirements of the Administrative

Procedure Act, 5 U.S.C. sec. 553(b) and (c) (1994), with respect to

section 1.469-4(a), Income Tax Regs.

     It was envisioned that by promulgating regulations regarding

"related party leases or sub-leases", the Secretary would be acting

consistently with section 469.    See Fransen v. United States, 82

AFTR 2d 6621, 98-2 USTC par. 50776 (E.D. La. 1998) (quoting H.

Conf. Rept. 99-841 (Vol. II), at II-146 (1986), 1986-3 C.B. (Vol.

4) 1, 147).   The court in Fransen (in granting summary judgment for

the Government) upheld the Commissioner's determination that rental

income received by the taxpayer husband, an attorney, from his



     3
      (...continued)
taxpayer husband (Dr. Schwalbach) practiced dentistry and was
employed by a personal service corporation (Associated Dentists)
he owned equally with another dentist. Dr. Schwalbach owned a
building that he rented to Associated Dentists for use in its
dentistry practice. The taxpayers reported $50,556 in 1994 as
the net income from the rental of the building to Associated
Dentists. The taxpayers attempted to offset this income with
certain losses derived from unrelated activities, namely: (a) A
rental loss from a commercial building apparently rented to an
unrelated tenant; (b) a passive loss from an investment in an S
corporation unrelated to the dentistry practice; and (c) a
passive loss from an investment in a partnership also unrelated
to the dentistry practice. In the aggregate, the losses claimed
totaled $18,115. The Commissioner applied the self-rented
property rule and thereby disallowed the losses. We sustained
the Commissioner's determination.
                               - 12 -


wholly   owned   personal   service     C   corporation   had   to   be

recharacterized as nonpassive because the building was rented to a

trade or business in which the taxpayer materially participated.4

In doing so, the court upheld the validity of the self-rented

property rule, citing the following portion of the preamble to

section 1.469-2T(f)(6), Temporary Income Tax Regs., 53 Fed. Reg.

5694 (Feb. 25, 1988):5

               In the absence of regulations, a taxpayer
          could derive passive activity gross income
          from an active business in which tangible
          property is used by renting the property to an
          entity conducting the activity (or by causing
          an entity holding the property to rent the


     4
          In Fransen v. United States, 82 AFTR 2d 6621, 98-2 USTC
par. 50776 (E.D. La. 1998), the taxpayer husband was the sole
shareholder of Fransen & Hardin, a personal service corporation.
The taxpayers leased a building (in which each had an undivided
one-half interest) to Fransen & Hardin. The taxpayers reported
$29,902 of net rental income which they sought to offset with
passive activity losses from other activities in the aggregate
amount of $32,606. The taxpayers argued that sec. 1.469-2(f)(6),
Income Tax Regs., "flatly contradicts the plain language of the
statute it purports to enforce: the statute deems rental activity
income passive with a minor exception, and the regulation's
allowance of recharacterization of that income as non-passive
renders the regulation invalid."
     5
          We note that the preamble further states:

     the Conference Report accompanying the Act states that
     it would be appropriate for the Service to exercise its
     regulatory authority under sec. 469(l)(3) in the case
     of "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, 99th Cong., 2d
     Sess., Vol. II, at 147 (1986) [53 Fed. Reg. 5725 (Feb.
     25, 1988).]
                                     - 13 -


             property to the taxpayer). It would be
             inconsistent with the purposes of section 469
             to treat rental income as passive activity
             gross income in such cases * * *

        In successive attempts to define the scope of the self-rented

property rule, numerous sets of regulations were promulgated.                 In

both sets of temporary regulations, promulgated on February 25,

1988, and May 12, 1989, respectively, activities conducted through

a   C   corporation    were    excluded   from    being   attributed    to   the

taxpayer/shareholder          for   purposes     of   determining     "material

participation".       See sec. 1.469-5T(f), Temporary Income Tax Regs.,

53 Fed. Reg. 5686, 5725 (Feb. 25, 1988), T.D. 8175, 1988-1 C.B.

191, 235; sec. 1.469-4T(b)(2)(ii)(B), Temporary Income Tax Regs.,

54 Fed. Reg. 20527, 20543 (May 12, 1989), T.D. 8253, 1989-1 C.B.

121.6 Pursuant to the sunset provisions of section 7805(e)(2),7 the

second      set   of      temporary       regulations      (section     1.469-

4T(b)(2)(ii)(B)), expired on May 11, 1992.

        On May 15, 1992, section 1.469-4, Proposed Income Tax Regs.,

57 Fed. Reg. 20802, 20804 (May 15, 1992), PS-1-89, 1992-1 C.B.


        6
          Proposed regulations adopting the definition of
"activity" for purposes of applying the limitations on passive
activity losses and passive activity credits as set forth in the
second set of temporary regulations were issued concurrently
(i.e., May 12, 1989) with the promulgation of the second set of
temporary regulations. See PS-001-89, 54 Fed. Reg. 20606 (May
12, 1989), 1989-1 C.B. 1057.
        7
          Sec. 7805(e)(2) provides: "Any temporary regulation
shall expire within 3 years after the date of issuance of such
regulation."
                                   - 14 -


1219, 1221, was promulgated.          In the text of these proposed

regulations,    the    Secretary     removed   the    explicit     statement

prohibiting attribution from a C corporation to the corporation's

shareholders.    No further specific guidance as to the Secretary's

ultimate    position   on   this   subject   matter   was   then   provided.

However, the preamble to the regulation stated that "[The proposed

regulation] propose to replace § 1.469-4T with a new § 1.469-4,

which will provide a modified definition of the term activity."

Id. at 20802.

     In 1994, the proposed regulations issued in 1992 were replaced

by the final version of section 1.469-4(a), Income Tax Regs., which

included the following sentence: "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.   This represented a reversal of the Secretary's position

enunciated in the temporary regulations published in 1989.            It is

worth noting that the preamble to the final regulations stated:

          A commentator requested clarification on whether
     activities conducted through a C corporation may be
     grouped with activities not conducted through the C
     corporation.    The final regulations clarify that in
     determining    whether   a    taxpayer   materially    or
     significantly participates in an activity, a taxpayer may
     group that activity with activities conducted through C
     corporations that are subject to section 469 (that is,
     personal service and closely held C corporations). [59
     Fed. Reg. 50485 (Oct. 4, 1994), T.D. 8565, 1994-2 C.B. at
     82.]

See Schwalbach v. Commissioner, supra at 225.
                                    - 15 -


      The   final   regulations     were    generally    made       effective   for

taxable years beginning after May 10, 1992.                    See sec. 1.469-

11(a)(1), Income Tax Regs. However, section 1.469-11(b)(1), Income

Tax Regs., provides transitional relief for taxable years that end

after May 10, 1992, and begin before October 4, 1994.                   Under the

transitional rules, taxpayers are allowed to determine their tax

liability in accordance with the proposed regulations promulgated

in 1992.    See sec. 1.469-11(b)(1), Income Tax Regs.

Positions of the Parties

      The parties disagree as to the proper characterization of the

rental income from the Everett Mill, Kunhardt Mill, and FLS Realty

Trust properties.

      Petitioners seek to have the income Mr. Sidell received in

1993 and 1994 from the rental of these properties characterized as

income from a passive activity in order to use (1) passive losses

from the rental of other properties, and (2) rehabilitation credits

(claimed    on    their   1993    and   1994    returns)      with    respect    to

renovations made to the Kunhardt Mill property.

      Respondent relies on the self-rented property rule contained

in   section     1.469-2(f)(6),    Income      Tax   Regs.,    to    support    his

characterization of the rental income from these properties as

nonpassive (or active) income.          Respondent maintains that pursuant

to section 469(l), the Secretary had the authority to prescribe

regulations necessary or appropriate to carry out the provisions of
                                     - 16 -


section 469, including regulations requiring net income or gain

from a limited partnership or other passive activity to be treated

as not from a passive activity.           See sec. 469(l)(3).      Continuing,

respondent posits that pursuant to that authority, the Secretary

properly     promulgated     the     self-rented     property   rule,    which

recharacterizes rental income as nonpassive (or active) income when

a taxpayer rents property to an activity in which the taxpayer

materially participates.

     Petitioners    challenge       respondent's     determinations,    making

three arguments.     First, petitioners assert that section 1.469-

2(f)(6), Income Tax Regs., is invalid insofar as it recharacterizes

rental income     received    from    a   C   corporation   from   passive   to

nonpassive     (hereinafter        this   argument    is    referred    to   as

petitioners' validity argument).              Petitioners maintain that in

order for the self-rented property rule to apply, (1) the property

must be rented for use in a trade or business activity in which the

taxpayer materially participates, and (2) the activities of a C

corporation cannot be attributed to a taxpayer/shareholder in

determining whether that taxpayer has materially participated in

the corporation's business activity.             According to petitioners,

application of section 1.469-2(f)(6), Income Tax Regs., to a C

corporation is contrary to the plain language, origin, and purpose

of the passive activity rules.
                                - 17 -


     Second, petitioners argue that even if the application of the

self-rented rule to a closely held C corporation is deemed valid,

attribution/recharacterization cannot apply to any taxable year

beginning before October 4, 1994, when the final regulations

(discussed infra) were adopted.        Thus, petitioners contend that

they may determine their 1993 and 1994 tax liability under the

proposed regulations promulgated in 1992 (section 1.469-4, Proposed

Income Tax Regs., 57 Fed. Reg. 20802 (May 15, 1982), PS-1-89, 1992-

1 C.B. 1219), thereby avoiding the self-rented property rule and

rendering the rental income in question as passive (hereinafter

this argument is referred to as petitioners' proposed regulations

argument). Respondent acknowledges that under the transitional

relief provided in section 1.469-11(b), Income Tax Regs., taxpayers

are permitted to determine their tax liability in accordance with

the 1992 proposed regulations for taxable years ending after May

10, 1992, and beginning before October 4, 1994.             Nevertheless,

respondent    asserts   that   under     those   proposed    regulations

petitioners' 1993 and 1994 tax liability would be the same as under

the final regulations because under the proposed regulations a C

corporation's activities would be attributed to its shareholders,

resulting in the rental income in question being characterized as

nonpassive.

     Finally, petitioners assert that, assuming arguendo the rental

income from the Everett Mill, Kunhardt Mill, and FLS Realty Trust
                                 - 18 -


properties is properly recharacterized as nonpassive (or active)

income under section 1.469-2(f)(6), Income Tax Regs., nonetheless,

respondent   was   without    authority   to   disallow   the   claimed

rehabilitation credit (hereinafter this argument is referred to as

petitioners' credit argument). According to petitioners, denial of

the rehabilitation credit defeats the express legislative policy

goal underlying the enactment of section 47; namely, to preserve

historic landmarks and to provide an economic stimulus to areas

susceptible to abandonment.

     Petitioners maintain a distinction between recharacterizing

income, on the one hand, and recharacterizing the underlying

activity, on the other.      In this regard, petitioners contend that

section 1.469-2(f)(6), Income Tax Regs., authorizes respondent only

to recharacterize income, not to disallow the section 47 credit.

Respondent counters by asserting that once petitioners' net rental

income is recharacterized as nonpassive, the limitation on passive

activity credits (rather than section 1.469-2(f)(6), Income Tax

Regs.) mechanically disallows the rehabilitation credit.

Standard of Review of Section 1.469-2(f)(6), Income Tax Regs.

     Petitioners invite us to invalidate a portion of a regulation,

section 1.496-2(f)(6), Income Tax Regs.        This we do only in the

gravest of circumstances.      A regulation must be sustained unless

unreasonable, plainly inconsistent with the Internal Revenue Code,

arbitrary, or capricious.      See Commissioner v. South Tex. Lumber
                                       - 19 -


Co., 333 U.S. 496, 501 (1948); Tate & Lyle, Inc. v. Commissioner,

103 T.C. 656 (1994), revd. on other grounds 87 F.3d 99 (3d Cir.

1996); Jablonski v. Commissioner, T.C. Memo. 1998-396. Ultimately,

the validity of a regulation is determined by its reasonableness

and whether it harmonizes with the plain language of the statute,

its   origin,    and    its      purpose.     See   National    Muffler     Dealers

Association, Inc. v. United States, 440 U.S. 472, 477 (1979); Coca

Cola Co. &       Includible Subs. v. Commissioner, 106 T.C. 1, 19

(1996); Estate of Bullard v. Commissioner, 87 T.C. 261, 269 (1986).

      The starting point in determining the deference given to a

regulation is whether the regulation is legislative or interpretive

in nature.       See Mordkin v. Commissioner, T.C. Memo. 1996-187

(citing Dresser Indus., Inc. v. Commissioner, 911 F.2d 1128, 1137-

38 (5th Cir. 1990), affg. in part and revg. in part 92 T.C. 1276

(1989)).   A legislative regulation is one that is issued under a

specific grant of authority to define a term or prescribe a method

of executing a statutory provision.                 See id.     An interpretive

regulation is one that is promulgated under the general authority

of section 7805(a).         See id.

      Congress       authorized      the    Secretary   to     promulgate     "such

regulations     as    may   be    necessary   or    appropriate   to   carry    out

provisions of [sec. 469] * * * which specify what constitutes an

activity, material participation, or active participation" for

purposes of section 469, and "requiring net income or gain from a
                                        - 20 -


limited partnership or other passive activity to be treated as not

from a passive activity."           Sec. 469(l)(1), (3) (emphasis added).

This Court has already determined that section 1.469-2(f)(6),

Income Tax Regs., is a legislative regulation promulgated under

section 469(l).      See Schwalbach v. Commissioner 111 T.C. at 220-

221. Accordingly, we give that regulation the highest level of

judicial deference.        See Chevron U.S.A., Inc. v. Natural Resources

Defense Council, Inc., 467 U.S. 837, 843-844 (1984); Fransen v.

United States, 82 AFTR 2d 6621, 98-2 USTC par. 50776 (E.D. La.

1998);   Schwalbach         v.     Commissioner,        supra;    Jablonski      v.

Commissioner, supra.

Analysis of Parties' Arguments

     Petitioners maintain in their validity argument that the self-

rented property rule cannot apply to reclassify their rental income

as   nonpassive     because       KGR's    business     activities     cannot    be

attributed to Mr. Sidell for purposes of determining "material

participation". We disagree. Mr. Sidell's transaction with KGR is

the epitome of a self-renting transaction.               Mr. Sidell is the sole

shareholder    of    KGR    and     manages      its    operations     in   various

capacities.8        At   the     same   time     that   Mr.   Sidell    materially


     8
          Petitioners acknowledge that Mr. Sidell materially
participated in KGR. However, they argue that there is a
distinction between materially participating in KGR and
materially participating in the activities of KGR. Petitioners
cite no authority to support this distinction. Regardless of any
                                                   (continued...)
                                        - 21 -


participated in KGR's operations, through his grantor trusts he

rented several pieces of real property to KGR.               KGR used the leased

property in conducting its apparel business.                 By being in effect

both the lessor and lessee of the properties in question, Mr.

Sidell established the amounts of rent, and, unless the resulting

rental income is deemed nonpassive, he could have used all of his

passive losses to offset that income.

       Moreover,    there      is    ample   legislative    history   and   proper

delegation under section 469(l) supporting respondent's attribution

of     KGR's    activities      to    Mr.    Sidell.   Specifically,     Congress

authorized the Secretary to promulgate regulations that specify

what       constitutes    an   "activity"     and   what   constitutes   material

participation.           Further,     Congress   permitted    the   Secretary   to

promulgate regulations that permitted recharacterization of "net

income or gain from a limited partnership or other passive activity

as [being] not from a passive activity."               Sec. 469(l)(1), (3).     We

believe "other passive activity" encompasses activities of a C

corporation engaged in a trade or business.




       8
      (...continued)
distinction, Mr. Sidell's day-to-day management of KGR's only
line of business would constitute material participation in all
the activities of KGR, which consequently would trigger the self-
rented property rule. See sec. 1.469-5T(a), Temporary Income Tax
Regs., 53 Fed. Reg. 5686, 5700 (Feb. 25, 1988), T.D. 8175, 1988-1
C.B. 191, 234.
                                    - 22 -


     In enacting section 469, Congress was specifically concerned

with both related party leases and the possibility of abuse by the

formation of closely held corporations. See, e.g., sec. 469(e); S.

Rept. 99-313, at 714 (1986), 1986-3 C.B. (Vol. 3) 1, 713-714; H.

Conf. Rept. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol.

4) 1, 147; 53 Fed. Reg. 5686, 5694 (Feb. 25 1988).              On brief,

petitioners assert that no potential for abuse exists in this case

because they own no tax shelters. They claim that their Lawrence,

Massachussetts, properties are the only rental properties they have

and that these properties are either contiguous to or located

across the street from each other.       Moreover, petitioners maintain

that ownership of the real properties was separated from the

business   of   KGR   for   valid   business   reasons--to   insulate   the

properties from potential liabilities arising from the operation of

KGR's business and to insulate KGR from potential liabilities

arising from the ownership of the property.          In addressing these

assertions, respondent states on brief:

          The petitioners' assertion that no abuse potential
     is present in the present case because they own no "tax
     shelters"   begs   the   question.    Furthermore,   the
     unquestioned legitimate business needs that prompted the
     purchases of the various properties that caused
     petitioners to incur losses do not mean that the
     petitioners' case is not the sort against which the
     strictures of section 469 should be aimed. * * *

          The self-rental rule as a matter of administrative
     convenience is a bright line rule. The rule does not
     look to a taxpayer's motives in structuring transactions.
                                 - 23 -


We   are   persuaded   by   respondent's   responses   to   petitioners'

assertions.

     Consequently, we conclude that the self-rented property rule

in section 1.469-2(f)(6), Income Tax Regs., is valid pursuant to

the Secretary's delegated regulation-making authority.

     We now turn our attention to petitioners' proposed regulation

argument.     The taxpayers in Connor v. Commissioner, T.C. Memo.

1999-185, advanced a similar argument.9 We rejected the taxpayers'

argument in that case and for the reasons expressed both therein

and hereinafter do so in this case.

     As in Connor, petitioners herein assert that the proposed

regulations promulgated in 1992 did not specifically disavow the

provisions in the temporary regulations issued in 1989, which

provided that "a taxpayer's activities do not include operations



     9
          In Connor v. Commissioner, T.C. Memo. 1999-185, the
taxpayer husband practiced dentistry and was employed by a
professional service corporation in which he was a shareholder.
(Until Oct. 31, 1993, the corporation was known as Michael F.
Connor, D.D.S., S.C.; after that date, the corporation was known
as Drs. Connor & McKeever, S.C.). The professional service
corporation leased the building (the Rochester Street building)
in which it conducted its business activities from taxpayer wife.
The taxpayers reported net income from the rental of the
Rochester Street building as $10,503 and $15,937 in 1993 and
1994, respectively. They reported losses from the rental of
another property and losses from a partnership, which they used
to offset the rental income from the Rochester Street building.
The Commissioner determined that the rental profits from the
Rochester Street building constituted nonpassive income and
consequently could not be used to offset the taxpayers' passive
losses. We sustained the Commissioner's determination.
                                 - 24 -


that a taxpayer conducts through one or more entities (other than

pass through entities)."10     Sec. 1.469-4T(b)(2)(ii)(B), Temporary

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

petitioners maintain:

     It is abundantly clear that Proposed Regulation sec.
     1.469-4 was not intended to, and in fact did not change
     the rule from the * * * Temporary Regulations that a
     taxpayer's activities did not include those conducted
     through a C corporation. Consequently, it is clear that
     under Proposed Regulation sec. 1.469-4, the self rented
     property rule does not apply to the rental of property to
     a C corporation.

     Petitioners' proposed regulation argument is founded upon the

transitional relief set forth in section 1.469-11(b)(1), Income Tax

Regs.,    which,   as   applicable   herein,   permits   petitioners   to

determine their tax liability for 1993 and 1994 using the rules set

forth in the proposed regulations promulgated in 1992 (rather than

the final regulations).        As previously stated, these proposed


     10
          At trial, petitioners introduced over respondent's
objection a multitude of Internal Revenue Service internal
documents and memoranda purporting to show intent on the part of
the drafters of sec. 1.469-4, Proposed Income Tax Regs., 57 Fed.
Reg. 20802 (May 15, 1992), to maintain the exclusion on
attribution of activities from C corporations. We find these
documents to be of little probative value inasmuch as they do not
state the final position of either the Commissioner or the
Secretary. See Connecticut Gen. Life Ins. Co. v. Commissioner,
109 T.C. 100, 110 (1997), affd. 177 F.3d 136 (3d Cir. 1999).
Normally, such internal memoranda are not binding on the
Secretary and cannot be used to determine intent. See id. at
109-111 (observing that material from administrative work files
generally reflects only personal views of various Government
representatives, not official statements of the Commissioner or
the Secretary); Armco, Inc. v. Commissioner, 87 T.C. 865, 867-868
(1986).
                                     - 25 -


regulations   are     silent    as   to    whether   the   activities     of    a   C

corporation are attributable to the corporation's shareholders.

Contrary to petitioners' assertion, the silence of the proposed

regulations   on    this     subject      cannot   be    equated   to   providing

petitioners with relief from the attribution rules set forth in the

final regulations.      Simply put, the proposed regulations' silence

means nothing, not something.           Moreover, the rule of nonattribution

set forth in the temporary regulations issued in 1989 is not

relevant    because    the     relief     afforded      petitioners     under   the

transitional rules is based solely on the rules set forth in the

proposed regulations of 1992, not in the temporary regulations.

      We are mindful that:

      (1)   The 1992 proposed regulations eliminated the specific

statement found in section 1.469-4T(b)(2)(ii)(B), Temporary Income

Tax Regs., 54 Fed. Reg. 20527, 20543 (May 12, 1989), T.D. 8253,

1989-1 C.B. 121, 139 (the second set of temporary regulations),

which stated:

           For purposes of applying section 469 and the
      regulations thereunder, a taxpayer's activities do not
      include operations that the taxpayer conducts through one
      or more entities (other than passthrough entities).

      (2)   The preamble to the 1992 proposed regulations states:

                 This document proposes to replace section
            1.469-4T with a new section 1.469-4, which
            will provide a modified definition of the term
            activity.

and
                                     - 26 -


      (3)    The preamble to the final regulations, 59 Fed. Reg.

50485, 50486 (Oct. 4, 1994), T.D. 8565, 1994-2 C.B. 81, 83, states:

           The final regulations clarify that in determining
      whether   a   taxpayer   materially    or   significantly
      participates in an activity, a taxpayer may group that
      activity with activities conducted through C corporations
      that are subject to section 469 (that is, personal
      service and closely held C corporations). [Emphasis
      added.]

It   is   inferable   from    the    elimination     of    the   aforementioned

statement in the temporary regulations of 1989 and the preamble to

the proposed regulations of 1992 that the Secretary did not intend

in those proposed regulations to adhere to the position previously

taken in the temporary regulations.           As we noted in Schwalbach v.

Commissioner,    supra,      there   is   nothing    in    the   1992    proposed

regulations that would lead us to believe that the Secretary was

proposing to retain the rule set forth in the 1989 temporary

regulations that the activities of a C corporation are not to be

attributable to the corporation's shareholders.              See Schwalbach v.

Commissioner, 111 T.C. at 228.

      Because the proposed regulations are silent as to whether the

activities of a C corporation are or are not attributable to the

corporation's shareholders, the 1992 proposed regulations are of no

benefit to petitioners in determining their 1993 and 1994 tax

liability.

      Finally,   we   turn     our   attention      to    petitioners'    credit

argument.    A passive activity credit is defined as "the amount * *
                                    - 27 -


* by which * * * the sum of the credits from all passive activities

allowable for the taxable year under subpart D of part IV of

subchapter A * * * exceeds the regular tax liability of the

taxpayer for the taxable year allocable to all passive activities."

Sec. 469(d)(2) (emphasis added).          The rehabilitation credit is a

credit allowable under subpart D of part IV of subchapter A.                 See

secs. 46, 38(b)(1).

     In determining the existence and amount of a passive activity

credit,    the   regular    tax   liability    allocable      to   all   passive

activities   must   be     ascertained.       The   regular    tax   liability

allocable to passive activities is defined in section 1.469-3T(d),

Temporary Income Tax Regs., 53 Fed. Reg. 5724 (Feb. 25, 1988), as

follows:

                 (d) Regular tax liability allocable to
            passive   activities--(1)   In   general.--For
            purposes of paragraph (a)(2) of this section,
            the taxpayer's regular tax liability allocable
            to all passive activities for the taxable year
            is the excess (if any) of --

                       (i) The taxpayer's regular tax
                  liability for such taxable year;
                  over

                       (ii) The amount of such regular
                  tax liability determined by reducing
                  the taxpayer's taxable income for
                  such year by the excess (if any) of
                  the taxpayer's passive activity
                  gross income for such year over the
                  taxpayer's     passive     activity
                  deductions for such year.
                                 - 28 -


Thus, in order to utilize a tax credit allocated to a passive

activity, a taxpayer must have passive income in excess of passive

deductions.    See sec. 1.469-3T(g), Examples (2) and (3), Temporary

Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).             Because

petitioners'    net   rental   income   has   been    recharacterized   as

nonpassive for 1993 and 1994, petitioners have no passive income.

Without passive income, petitioners have no "regular tax liability

allocable to passive activities."       Any rehabilitation credit would

be in excess of such regular tax liability.          Accordingly, we hold

that respondent properly disallowed the rehabilitation credit for

the years in issue.

     In reaching our conclusions herein, we have considered all

other arguments presented and, to the extent not discussed above,

find them to be irrelevant or without merit.
                        - 29 -


To reflect the foregoing and respondent's concession,



                                     Decision with respect to

                              the deficiencies for 1993 and

                              1994   will   be   entered   for

                              respondent;    decision      with

                              respect to the accuracy-related

                              penalty under section 6662(a)

                              with respect to 1994 will be

                              entered for petitioners.
