                                T.C. Memo. 2015-76


                         UNITED STATES TAX COURT



          LARRY WILLIAMS AND DORA WILLIAMS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 23883-12.                          Filed April 16, 2015.



      David Palmer Leeper, for petitioners.

      Brock E. Whalen and Daniel N. Price, for respondent.



                           MEMORANDUM OPINION


      NEGA, Judge: Respondent determined deficiencies in petitioners’ income

tax for tax years 2009 and 2010 of $8,712 and $17,610, respectively.1 Petitioners

were married and resided in El Paso, Texas, at the time they filed their petition.


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. All monetary amounts are rounded to
the nearest dollar.
                                        -2-

[*2] This case was submitted fully stipulated under Rule 122. We incorporate by

reference the parties’ stipulation of facts and accompanying exhibits. The

stipulation disposes of one of the issues before the Court, namely, that petitioners

received but did not report retirement income totaling $13,656 for tax year 2010,

that this income is includable in petitioners’ gross income for tax year 2010, and

further, that this income is subject to the additional tax under section 72(t). The

Court considers petitioners to have conceded this issue and will not discuss the

retirement income issue further in this report.

      Following the parties’ stipulations, the only issue remaining for the Court to

decide is whether income petitioners received through an S corporation in tax

years 2009 and 2010 should be recharacterized from passive to nonpassive

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

                                    Background

      This case was submitted on the pleadings and stipulated facts under Rule

122. The stipulation of facts and the attached exhibits are incorporated herein by

this reference.

      During the years in issue petitioners owned 100% of BEK Real Estate

Holdings, LLC, an S corporation (BEK Real Estate), and 100% of BEK Medical,

Inc., a C corporation (BEK Medical). Petitioner husband worked full time for
                                        -3-

[*3] BEK Medical during the years in issue and materially participated in its trade

or business activities for purposes of section 469. Petitioners did not materially

participate in the activities of BEK Real Estate or the rental of commercial real

estate to BEK Medical during 2009 and 2010. During 2009 and 2010 petitioners

were not engaged in a “real property trade or business” as described in section

469(c)(7)(B) and (C).

      In 2009 and 2010 BEK Real Estate leased to BEK Medical commercial real

estate which BEK Medical used in its trade or business activities. BEK Real

Estate had net rental income of $53,285 and $48,657 in 2009 and 2010,

respectively, from the rental of commercial real estate to BEK Medical in those

years. Petitioners reported these amounts as passive income on Schedules E,

Supplemental Income and Loss, attached to their Federal income tax returns for

2009 and 2010. Petitioners offset these amounts with passive losses from other S

corporations, partnerships, and personally owned rental properties.

      In the notice of deficiency respondent reclassified BEK Real Estate’s rental

income as nonpassive income pursuant to section 1.469-2(f)(6), Income Tax

Regs., and disallowed petitioners’ passive losses that were claimed in excess of

their adjusted passive income for tax years 2009 and 2010.
                                         -4-

[*4]                                  Discussion

I.     Burden of Proof

       Because there are no facts to be found, only issues of law as applied to

undisputed facts, it is unnecessary to assign burden of proof in this case. See, e.g.,

Dirico v. Commissioner, 139 T.C. 396, 402 (2012).

II.    Applicable Law

       A.    General Principles

       Section 469(a), (b), and (g) generally suspends the passive activity losses of

an individual taxpayer until the taxpayer either has offsetting passive income or

disposes of the taxpayer’s entire interest in the passive activity. A “passive

activity” is any activity involving the conduct of a trade or business in which the

taxpayer does not materially participate. Sec. 469(c)(1). With certain exceptions,

the term “passive activity” includes any rental activity, regardless of the level of a

taxpayer’s material participation in such activity. Sec. 469(c)(2), (4); Carlos v.

Commissioner, 123 T.C. 275, 278 (2004). Section 469(l) grants the Commissioner

the authority to prescribe regulations that “specify what constitutes an activity,

material participation, or active participation” for purposes of section 469. The

Commissioner prescribed section 1.469-4(a), Income Tax Regs., pursuant to his

“broad regulatory authority that Congress delegated to him through sections 469(l)
                                         -5-

[*5] and 7805, T.D. 8565, 1994-2 C.B. 81, 83”. Schwalbach v. Commissioner,

111 T.C. 215, 221 (1998). Section 1.469-4(a), Income Tax Regs., specifies that a

taxpayer’s “activities” include those conducted through an S corporation.

      An eligible small business that elects S corporation status is generally

exempt from corporate taxation. Sec. 1363(a). Instead, the shareholders of an S

corporation report pro rata shares of the S corporation’s taxable income, losses,

deductions, and credits. Sec. 1366(a)(1)(A); sec. 1.1366-1(a), Income Tax Regs.

With certain exceptions, the taxable income of an S corporation is computed in the

same manner as in the case of an individual, and items of S corporation income

retain their character for each shareholder. Secs. 1363(b), 1366(b). Thus S

corporations are passthrough entities and, like partnerships, do not directly pay tax

on items of income but rather pass items of income through to each shareholder.

      B.     Recharacterization of Passive Income

      In certain situations, a taxpayer must treat income from passive activities as

income from nonpassive activities. Sec. 1.469-2(f)(6), Income Tax Regs.; sec.

1.469-2T(f), Temporary Income Tax Regs., 53 Fed. Reg. 5721 (Feb. 25, 1988).

Specifically, section 1.469-2(f)(6), Income Tax Regs., generally recharacterizes as

nonpassive the net rental activity income from an item of property if the property

is rented for use in a trade or business activity in which the taxpayer materially
                                          -6-

[*6] participates. Section 1.469-2(f)(6), Income Tax Regs., is commonly referred

to as the “self-rental rule” or “recharacterization rule”. See, e.g., Dirico v.

Commissioner, 139 T.C. at 404; Veriha v. Commissioner, 139 T.C. 45, 46 (2012).

The Court noted in Dirico that section 1.469-2(f)(6), Income Tax Regs., has been

“upheld repeatedly” by this Court and others. Dirico v. Commissioner, 139 T.C. at

404 n.5 (citing Krukowski v. Commissioner, 279 F.3d 547, 552 (7th Cir. 2002),

aff’g 114 T.C. 366 (2000), Sidell v. Commissioner, 225 F.3d 103, 107-108 (1st

Cir. 2000), aff’g T.C. Memo. 1999-301, Fransen v. United States, 191 F.3d 599,

601 (5th Cir. 1999), and Shaw v. Commissioner, T.C. Memo. 2002-35).

III.   Summary of Parties’ Arguments

       Respondent argues that during 2009 and 2010 petitioners received income

through BEK Real Estate from property that was rented to BEK Medical, in which

petitioner husband materially participated.2 Therefore, petitioners have satisfied

the two components of section 1.469-2(f)(6)(i), Income Tax Regs., that (1) the

property was rented for use in BEK Medical’s trade or business activity, and (2)

petitioner husband materially participated in that trade or business activity. In

accordance with this determination, respondent recharacterized the rental income

       2
      Petitioner wife is also treated as materially participating in BEK Medical
pursuant to sec. 469(h)(5) and sec. 1.469-5T(f)(3), Temporary Income Tax Regs.,
53 Fed. Reg. 5727 (Feb. 25, 1988).
                                         -7-

[*7] from BEK Real Estate as nonpassive income and disallowed the portion of

petitioners’ passive losses that exceeded their passive income.

      Petitioners make two counterarguments. First, petitioners argue that section

469 does not, on its face, apply to S corporations, and consequently, section 1.469-

4(a), Income Tax Regs., defining a taxpayer’s activities to include those conducted

through an S corporation, “is contrary to the statutory instructions given by

Congress when it enacted section 469”. Petitioners cite Chevron, U.S.A., Inc. v.

Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), for their contention that

section 1.469-4(a), Income Tax Regs., is invalid. Second, petitioners argue that

section 1.469-2(f)(6), Income Tax Regs., does not apply since the lessor, BEK

Real Estate, did not materially participate in the trade or business of the lessee,

BEK Medical.

IV.   Analysis and Conclusions

      A.     Section 469 and Section 1.469-4(a), Income Tax Regs.

      We note that petitioners first raised the validity of section 1.469-4(a),

Income Tax Regs., in their opening brief. Generally, issues that are raised for the

first time on brief will not be considered by the Court when doing so would

surprise or prejudice the opposing party. DiLeo v. Commissioner, 96 T.C. 858,

891-892 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992); Markwardt v. Commissioner,
                                        -8-

[*8] 64 T.C. 989, 997 (1975); Estate of Horvath v. Commissioner, 59 T.C. 551,

555 (1973). Prejudice or surprise arises when the opposing party would be

prevented from presenting evidence that might have been offered if the issue had

been timely raised. DiLeo v. Commissioner, 96 T.C. at 891; Estate of Horvath v.

Commissioner, 59 T.C. at 555-556. We do not think respondent is prejudiced or

surprised here because the parties’ disagreement is over the validity of section

1.469-4(a), Income Tax Regs., rather than any factual dispute which could be

resolved through the presentation of evidence. See, e.g., Ware v. Commissioner,

92 T.C. 1267, 1268-1269 (1989) (“The rule that a party may not raise a new issue

on brief is not absolute. Rather, it is founded upon the exercise of judicial

discretion in determining whether considerations of surprise and prejudice require

that a party be protected from having to face a belated confrontation which

precludes or limits that party’s opportunity to present pertinent evidence.”); Estate

of Lassiter v. Commissioner, T.C. Memo. 2000-324. Accordingly, we decline to

rest our disposition of this issue on procedural grounds alone, and we proceed to

consider the merits of the parties’ arguments on this issue.

      Petitioners are correct that section 469 does not specifically refer to S

corporations as within the class of persons to whom it applies. Section 469(b)(2)

enumerates individuals, estates, trusts, closely held C corporations, and personal
                                        -9-

[*9] service corporations as the taxpayers for whom passive activity losses are

suspended. However, we agree with respondent that section 469 nonetheless

applies to petitioners’ S corporation activity in determining the character of

income petitioners received from BEK Real Estate.

      Since S corporations and other passthrough entities do not pay tax, section

469 need not identify them as “taxpayers” to whom it applies, because the

individual shareholders of an S corporation are the taxpayers to whom section 469

applies. The Court has previously recognized that income and losses from

passthrough entities are subject to section 469, even though passthrough entities

are not specifically included in the list of “taxpayers” to whom section 469 is

applicable. See, e.g., Harnett v. Commissioner, T.C. Memo. 2011-191 (applying

section 469 to losses attributable to rental properties owned by an S corporation),

aff’d, 496 Fed. Appx. 963 (11th Cir. 2012); Dunn v. Commissioner, T.C. Memo.

2010-198 (analyzing the grouping rules of section 469 with respect to various

entities, including an S corporation); Shaw v. Commissioner, T.C. Memo. 2002-35

(applying section 469 and section 1.469-2(f)(6), Income Tax Regs., in various

contexts, including the context of property leased by an S corporation); Sidell v.

Commissioner, T.C. Memo. 1999-301 (holding income received via grantor trusts

and reported as a passthrough item on taxpayers’ Federal income tax returns was
                                        - 10 -

[*10] subject to section 469). The law is well settled in this area, and in numerous

cases the Court has applied the passive loss limitations of section 469 to

individuals who receive income from passthrough entities. Thus, section 469

applies to petitioners, who conducted real estate activities through their S

corporation, BEK Real Estate.

      In addition, section 1.469-4(a), Income Tax Regs., is a valid interpretation

of “activity” as used in section 469, a matter we considered at length in

Schwalbach v. Commissioner, 111 T.C. 215. Schwalbach involved a challenge to

sections 1.469-4(a) and 1.469-2(f)(6), Income Tax Regs., the same regulations at

issue in this case. The taxpayers argued that the recharacterization rule of section

1.469-2(f)(6), Income Tax Regs., was invalid because the Secretary did not

comply with the Administrative Procedure Act (APA) when he prescribed section

1.469-4(a), Income Tax Regs. The Court concluded that the requirements of the

APA had been met, and in so doing, conducted an extensive analysis of various

regulations prescribed under section 469. We concluded that “[t]he linchpin of

section 469 is the determination of each activity in which a taxpayer participates,

and Congress delegated to the Commissioner the responsibility of prescribing the

meaning of the word ‘activity’”. Schwalbach v. Commissioner, 111 T.C. at 223.

In accordance with our discussion in Schwalbach, section 1.469-4(a), Income Tax
                                         - 11 -

[*11] Regs., does not violate the principles laid out in Chevron because it is not

arbitrary, capricious, or manifestly contrary to section 469. Chevron 467 U.S. at

844. We hold that petitioners’ BEK Real Estate rental activity is subject to the

passive activity rules of section 469.

      B.     Section 1.469-2(f)(6), Income Tax Regs.

      Section 1.469-2(f)(6), Income Tax Regs., requires that: (1) property be

rented for use in a trade or business and (2) the taxpayer materially participate in

the trade or business. The first requirement is clearly met because the property

owned by BEK Real Estate was rented to BEK Medical for use in its trade or

business. Petitioners admit that petitioner husband materially participated in BEK

Medical’s trade or business but argue that the recharacterization rule is

inapplicable because BEK Real Estate, as the lessor, did not participate in the

trade or business of the lessee, BEK Medical. Section 1.469-2(f)(6), Income Tax

Regs., does not contain the words “lessor” or “lessee”, but petitioners cite Dirico

v. Commissioner, 139 T.C. at 404, in which the Court phrased the second prong of

the recharacterization rule as “the lessor-taxpayer must materially participate in

the trade or business.” Petitioners seem to understand the use of the term “lessor-

taxpayer” in Dirico as adding a requirement to section 1.469-2(f)(6), Income Tax

Regs. We disagree. The Court was merely stating the requirements of the self-
                                        - 12 -

[*12] rental rule in the context of the facts specific to that case. The Court did not

add a requirement to section 1.469-2(f)(6), Income Tax Regs., which clearly states

that “the taxpayer” must materially participate in the trade or business.

      We find no authority in the plain language of section 1.469-2(f)(6), Income

Tax Regs., to support petitioners’ argument that the lessor, as a legally distinct

passthrough entity, must participate in the trade or business of the lessee.

Petitioners, as individual taxpayers subject to the requirements of section 469,

received passthrough income in 2009 and 2010 from property that was rented for

use in a trade or business in which petitioner husband materially participated.

Accordingly, the requirements of section 1.469-2(f)(6), Income Tax Regs., have

been met, and the income petitioners received from the rental of property by BEK

Real Estate to BEK Medical must be recharacterized as nonpassive income, which

they may not offset with passive losses. See, e.g., Shaw v. Commissioner, T.C.

Memo. 2002-35 (stating that taxpayer “controlled both sides of the rental

transactions” for various leases, including one in which his business rented

property from an S corporation of which he was the sole shareholder); Sidell v.

Commissioner, T.C. Memo. 1999-301 (stating that taxpayer’s rental of properties

through grantor trusts of which he was the sole beneficiary to a wholly owned C
                                        - 13 -

[*13] corporation was the “epitome of a self-renting transaction” because he was

“in effect both the lessor and lessee of the properties”).

         In reaching our holding, we have considered all arguments made, and, to the

extent not mentioned above, we conclude they are moot, irrelevant, or without

merit.

         To reflect the foregoing,


                                                 Decision will be entered

                                        for respondent.
