                            118 T.C. No. 17



                     UNITED STATES TAX COURT



          DAVID H. AND SUZANNE HILLMAN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent*



     Docket No. 19893-97.              Filed April 9, 2002.



          P’s S corporation (S) performed management
     services for real estate partnerships in which P had
     direct and indirect interests. P actively participated
     in S by performing management services that S had
     contracted to perform for the partnerships. P was not
     an active participant in any of the partnerships. On
     the Schedule K-1 issued to P from S, P’s portion of the
     management income was reduced by the portion of the
     corresponding management fee expense paid by the
     partnerships to S in an amount proportionate to P’s
     ownership percentage in each partnership. The
     reduction from the management income was treated as a
     loss from a trade or business. R disallowed the
     management fee expense deductions on the grounds that
     the expenses were passive within the meaning of sec.
     469, I.R.C., and that P was not entitled to treat the


     *
      This Opinion supplements a previously released opinion:
Hillman v. Commissioner, 114 T.C. 103 (2000).
                               - 2 -

     income and expenses as “self-charged” items under sec.
     469, I.R.C., and sec. 1.469-7, Proposed Income Tax
     Regs., 56 Fed. Reg. 14036 (Apr. 5, 1991).
          Held: The management fee expense is passive and
     may not be deducted from petitioner’s passthrough
     management fee income which is nonpassive within the
     meaning of sec. 469, I.R.C.



     Stefan F. Tucker, for petitioners.

     Wilton A. Baker,   for respondent.



                        SUPPLEMENTAL OPINION

     GERBER, Judge:   In an earlier Opinion filed by the Court in

this case we decided that petitioners were entitled to treat

management fees as offsetting self-charged items for purposes of

section 469.1   The Court of Appeals for the Fourth Circuit

disagreed and reversed our holding.    Hillman v. Commissioner, 263

F.3d 338 (4th Cir. 2001), revg. 114 T.C. 103 (2000).2


     1
       All section references are to the Internal Revenue Code in
effect for the years in issue, unless otherwise indicated.
     2
       Petitioner had a self-charged item with the same
attributes, in terms of economic substance, as provided for in
sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14036 (Apr.
5, 1991), with the difference being that it involved self-charged
management fees instead of interest. This Court held that the
same treatment should be afforded petitioner. In the reversal of
our holding, the Court of Appeals for the Fourth Circuit decided
that sec. 469(a) prohibited petitioner from a deduction or offset
until and unless it is specifically permitted by law (e.g., by
the issuance of an enabling regulation). Hillman v.
Commissioner, 250 F.3d 228 (4th Cir. 2001), revg. 114 T.C. 103
(2000). The Court of Appeals, however, was sympathetic to
petitioner’s plight, finding the situation to be an inequity, but
                                                   (continued...)
                                 - 3 -

     Due to the reversal, we must now consider petitioners’

alternative argument concerning whether they correctly reported

the management fee items.    In general we consider whether

petitioners’ reporting position should be sustained.     Petitioners

contend that the real estate activity of the passthrough entities

may be segregated into separate rental and trade or business

activities; i.e., passive and nonpassive.

                              Background3

     During 1993 and 1994 David H. Hillman (petitioner) owned 100

percent and 94.34 percent, respectively, of the stock of Southern

Management Corporation (SMC).     SMC, an S corporation, provided

real estate management services to approximately 90 passthrough

entities (including joint ventures, limited partnerships, and S

corporations) that were involved in real estate rental activities

(passthrough entities).     Petitioner held direct and indirect

interests in the passthrough entities.      The general partner of

each partnership is either petitioner or an upper tier

partnership or S corporation in which petitioner owns an

interest.



     2
      (...continued)
one that only “Congress or the Secretary (as the holder of the
delegated authority from Congress) has the authority to
ameliorate.” Id. at 234.
     3
       This case was submitted fully stipulated, and the factual
background discussed in Hillman v. Commissioner, 114 T.C. 103
(2000), is incorporated by this reference.
                               - 4 -

     During 1993 and 1994, petitioner did not participate in the

passthrough entities’ activities, but he did actively participate

in SMC by performing management services that SMC had contracted

to perform for the passthrough entities.   Petitioner treated his

involvement with SMC’s real estate management activity as a

separate activity from any other activities carried on by SMC.

During 1993 and 1994 petitioner materially participated in SMC’s

real estate management activity in excess of 500 hours.    During

those same years, SMC also conducted other operations in addition

to real estate management services, such as recreational

services, medical insurance plan underwriting, credit/collection

services, and a maintenance training academy.   Petitioner did not

materially participate in any of these other operations of SMC.

     Petitioner reported his SMC salary as income, and SMC

deducted those amounts as an expense for compensation paid to

petitioner for services related to the conduct of the real estate

management activity for the 1993 and 1994 taxable years.    SMC

separately reported management fee income (after deduction of

expenses, including petitioner’s salary from SMC) on petitioners’

1993 and 1994 Schedules K-1.   The portion of the management fee

paid by the passthrough entities to SMC (and allocable to

petitioner’s ownership percentage in each passthrough entity) was

deducted as a loss from a trade or business on either

petitioner’s Schedules K-1 for the 1993 and 1994 taxable years or
                                - 5 -

on the Schedules K-1 of upper tier passthrough entities for the

1993 and 1994 taxable years.

     In computing their 1993 and 1994 taxable income, petitioners

treated the proportionate ownership share of the passthrough

entities’ management fee deduction as a reduction from

petitioners’ gross income from activities characterized as

nonpassive under section 469.

     In the notice of deficiency, respondent disallowed the

characterization of the management fee expense as nonpassive,

referencing section 1.469-7, Proposed Income Tax Regs., 56 Fed.

Reg. 14036 (Apr. 5, 1991), which provides that lending

transactions (i.e., any transaction involving loans between

persons or entities) may be treated as self-charged.

                           Discussion

     Enacted by Congress as part of the Tax Reform Act of 1986,

Pub. L. 99-514, 100 Stat. 2085, the passive activity loss rules

were designed to limit a taxpayer’s ability to use deductions

from one activity to offset income from another activity.    In

particular, under the section 469 passive activity loss rules,

income generated from nonpassive activities cannot be offset by

deductions generated from passive activities.4


     4
       Nonpassive losses may be carried to future years and
applied against future passive income. Congress mandated in
section 469(l) that the Secretary issue regulations to implement
section 469. Under that mandate, sec. 1.469-7, Proposed Income
                                                   (continued...)
                              - 6 -

     Accordingly, to be successful here, petitioner would have to

show that the management fee income received and some portion of

the management fee deductions claimed by the real estate

passthrough entities were both passive or nonpassive.

Petitioners reported that the deductions (proportionate in amount

to their ownership in the passthrough entities) were nonpassive

and deductible from the management fee income.   In order to

sustain that reporting position, petitioners must show that part

of the real estate pass-through entities’ deductions (expenses)

were incurred in a separate trade or business rather than from

the real estate activity, which is defined as passive by statute.

     With that backdrop, we consider petitioners’ alternative

position that the real estate entities reported two separate

activities in connection with the payment of the management fees.

Petitioners describe the circumstances, as follows:

     In this case, the Real Estate Entities separately, and
     consistently, reported two K-1 line items: (1)Hillman’s
     share of the management fee expense as “ordinary loss
     from trade or business”, to the extent that he received
     a distributive share of management fee income from SMC,
     and (2) a line item from rental real estate income or
     loss (which included the management fee expense in
     excess of Hillman’s distributive share).




     4
      (...continued)
Tax Regs., was issued in 1991 to provide, in certain situations,
for the offset of passive interest deductions against nonpassive
interest income. The offset avoided an inequity where a taxpayer
incurred nonpassive income and passive loss from the same
transaction (self-charged) in the same year.
                               - 7 -

Petitioner distinguishes himself from other partners because he

was the only partner/interest holder who received substantial

management fee income.5

     In the notice of deficiency, respondent determined that

petitioner was not entitled to “recharacterize * * * [his] share

of the passive management expense of the Passthrough Entities as

nonpassive so as to match it against * * * [his] share of

nonpassive management income of * * * [SMC].”     Respondent argues

that the payment of management fees by the real estate entities

cannot constitute a trade or business separate from the

associated income for purposes of section 469.     We agree with

respondent.

     In effect, petitioner’s reporting approach treated his

management income and the corresponding management fee deductions

as a “self-charged” item in the same manner as provided for by

sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14036 (Apr.

5, 1991).   The Court of Appeals for the Fourth Circuit, however,

did not approve the self-charged approach for petitioner’s

management fee income and expense.     As an alternative to the

self-charged approach, petitioners argue that the real estate

entities’ management fee deductions, relative to SMC’s nonpassive



     5
       Petitioners do not dispute that the real estate entities
were engaged in rental (generally passive) activities or that
petitioner’s management income earned through SMC was nonpassive
in nature.
                                 - 8 -

management income, are a part of a separate trade or business of

the real estate entities.    It should be noted that the management

fee deduction, as it related to taxpayers other than petitioner

(partners and interest holders in the same pass-through

entities), was treated as part of the passive income regime.

         Accordingly, we must decide whether the deducted portion of

the passthrough entities’ management fee deductions constitutes a

separate “trade or business”; i.e., are nonpassive deductions.

Section 1.469-4(b),6 Income Tax Regs., contains the following

definition of “trade or business activities” for purposes of

section 469:

          (1) Trade or business activities. Trade or
     business activities are activities, other than rental
     activities or activities that are treated under sec.
     1.469-1T(e)(3)(vi)(B) as incidental to an activity of
     holding property for investment, that–-

          (i) Involve the conduct of a trade or business
     (within the meaning of section 162);

          (ii) Are conducted in anticipation of the
     commencement of a trade or business; or

          (iii) Involve research or experimental
     expenditures that are deductible under section 174
     * * * .

     To be engaged in a trade or business within the meaning of

section 162, a “taxpayer must be involved in the activity with

continuity and regularity and * * * the taxpayer’s primary



     6
       These regulations were amended in 1995, but they were
intended to apply retroactively to the years before the Court.
                               - 9 -

purpose for engaging in the activity must be for income or

profit.”   Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).

In order to hold for petitioners on this argument we would have

to decide that the real estate entities’ payment of management

fees, by itself, constituted a trade or business and/or an

activity separate from the real estate rental activity in which

they were engaged.

     On the facts presented, we hold that the payment of

management fees by the real estate entities did not constitute a

trade or business or separate activity from the rental activity

of those entities.   The management fees were incurred by the

entities in connection with rental activity and, therefore, would

be a deduction attributable to the rental income/activity.   See

sec. 1.469-2T(d)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg.

5716 (Feb. 25, 1988).   We, accordingly, hold that respondent’s

determination that petitioners were not entitled to reduce

management income by the management fee deduction of the real

estate entities was not in error.

     Petitioners, as additional support for their attempt to

treat the real estate entities’ management fee deductions as

nonpassive items, generally argue that respondent’s disallowance

of the deductions contravenes certain fundamental or established

principles of taxation.   For example, petitioners argue that, in

effect, they had no accession to wealth because the corresponding
                                - 10 -

income and deductions result in no economic significance.      For

that proposition, petitioners reference section 61 and cases,

including Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431

(1955).

     Petitioners also argue that respondent’s disallowance is

inconsistent with the fundamental and global principle of

matching income and expenses for purposes of taxation.    In

addition, they question whether there is some form of ordering of

various Code provisions so that, for example, partnership

provisions should not be preempted by section 469.    Finally,

petitioners argue that section 469 was not intended to negate

these fundamental principles.

     The principles referenced by petitioners are not being

obviated or eclipsed by respondent’s application of section 469.

Such principles (i.e., the question of what is income, rules of

subchapter K, etc.) precede the congressionally imposed section

469 limitation on reductions of nonpassive income by passive

deductions.    To the extent that the passive losses cannot be

used, Congress has provided that they may be carried into the

future to apply against a future year’s passive income.    Section

469 expressly limits petitioners’ ability to offset the real

estate entities’ passive management fee deductions against SMC’s

(petitioner’s) nonpassive management fee income from the same

transaction.    SMC and the real estate entities are, for purposes
                              - 11 -

of section 469, unrelated.   SMC provides services for the real

estate entities and receives income in exchange.   The real estate

entities’ correlative expense or deductions are not costs

incurred by SMC in the performance of the management services.

Finally, petitioner’s ownership in the real estate entities is

not exclusive, and it was not exclusive in all years for SMC.

     Unfortunately, petitioners have been snared by the reach of

section 469 in, what appears to be, most inequitable

circumstances.   As we discussed in our prior opinion, section 469

was designed to limit the use of losses generated by passive

activities to offset unrelated income generated by nonpassive

activities.   Although section 469 was designed to stop these

practices, Congress recognized that it would be inappropriate to

treat certain transactions between related taxpayers as giving

rise to passive expense and nonpassive income.

     The Secretary was charged with issuing regulations to

implement section 469.   Commentary contained in the legislative

history suggests that self-charged items should be provided for

in the regulations.   In 1991, regulations were proposed that

provided for self-charged interest.    Although more than 15 years

have passed since the enactment of section 469 and 10 years have

passed since the self-charged regulation for interest was

proposed, no action has been taken to relieve inequity that may
                             - 12 -

be suffered with respect to self-charged items other than

interest.

     Although we find petitioners’ plight lamentable, the Court

of Appeals for the Fourth Circuit has held that the courts are

incapable of providing relief in this situation.

     To reflect the foregoing,

                                      A decision will be entered

                                 for respondent.
