                        T.C. Memo. 1999-185



                      UNITED STATES TAX COURT



          MICHAEL F. & JANE H. CONNOR, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3552-98.                        Filed June 7, 1999.



     David J. Bohl, for petitioners.

     Christa A. Gruber, for respondent.



                        MEMORANDUM OPINION


     PAJAK, Special Trial Judge:   This case was heard pursuant to

section 7443A(b)(3) and Rules 180, 181, and 182.   All section

references are to the Internal Revenue Code in effect for the

years in issue.   All Rule references are to the Tax Court Rules

of Practice and Procedure.
                                 - 2 -

       Respondent determined the following deficiencies and

accuracy-related penalties:

                                 Accuracy-related Penalty
Year        Deficiency                Sec. 6662(a)
1993          $3,616                       $723
1994           6,089                      1,218

       The issues we must decide are: (1)   Whether respondent

properly recharacterized rental income petitioners received

during the taxable years at issue as nonpassive income pursuant

to section 469, and (2) whether petitioners are liable for

accuracy-related penalties for the taxable years at issue.

       The parties submitted this case fully stipulated pursuant to

Rule 122, and the stipulated facts are so found.     Petitioners

resided in Mukwonago, Wisconsin, at the time they filed their

petition.

       On November 1, 1979, petitioner Jane H. Connor (Ms. Connor),

lessor, executed a 3-year standard office lease (Lease) with

Michael F. Connor, D.D.S., S.C., lessee, through petitioner

Michael F. Connor (Dr. Connor).     Dr. Connor is the president and

a shareholder of a personal service corporation named Michael F.

Connor, D.D.S., S.C.     The office was located at 603 Rochester

Street, Mukwonago, Wisconsin (Rochester Street building).

       The terms of the Lease required the lessee to make monthly

rental payments in the amount of $900, for a total rent of

$32,400 for the 3-year period ending October 31, 1982.      On

October 31, 1982, Ms. Connor executed an Addendum to Lease dated
                               - 3 -

Nov. 1, 1979 (Addendum), with Michael F. Connor, D.D.S., S.C.

The Addendum provides that:

           This lease will continue in force between Michael F.
     Connor, D.D.S., S.C. "Lessee" and Jane H. Connor "Lessor"
     until either party terminates such with written notice of 90
     days.

          Rental increase can be made only upon agreement of both
     parties.

     During 1993 and 1994, Ms. Connor owned the Rochester Street

building and rented it to Michael F. Connor, D.D.S., S.C.

     On October 31, 1993, a portion of Michael F. Connor, D.D.S.,

S.C., was sold for $110,000 to Dr. McKeever.

     Dr. Connor practiced dentistry at the Rochester Street

building.   In 1993 and 1994, he was employed full-time by Drs.

Connor & McKeever, S.C.   In 1993 and 1994, Dr. Connor received

wages in the amounts of $168,808.87 and $181,382.84,

respectively, from Drs. Connor & McKeever, S.C.

     On their 1993 and 1994 Schedules E, Supplemental Income and

Loss, petitioners reported rents received from Michael F. Connor,

D.D.S., S.C., in the amounts of $22,000 and $24,000 for 1993 and

1994, respectively, from the rental of the Rochester Street

building.   After deducting expenses, petitioners reported income

in the amounts of $10,503 and $15,937 for 1993 and 1994,

respectively, from the rental of the Rochester Street building.

Petitioners also reported rental real estate losses in the

amounts of $33,214 and $5,679 for 1993 and 1994, respectively,
                               - 4 -

from the rental of another property listed as Jefferson Manor

Apartments.   They reported carryover passive losses of $23,106

and $45,830 for 1993 and 1994, respectively.

     Petitioners used $10,490 and $15,906 of the passive losses

to offset the Rochester Street building rent and reduced the

amounts of rent to the amounts of $13 and $31 for 1993 and 1994,

respectively.   Petitioners further reduced the amounts of rent to

$0 for both years after deduction of passive losses from a

partnership listed as Dodge Corners Inv. Cl. in the amounts of

$13 and $31 for 1993 and 1994, respectively.   Thus, petitioners

used total passive losses of $10,503 ($10,490 + $13) and $15,937

($15,906 + $31) to offset the rental incomes from the Rochester

Street building for 1993 and 1994, respectively.

     Respondent determined that the rental profits from the

Rochester Street building are nonpassive income and therefore

were not allowable to offset petitioners' passive losses.    As

respondent stated in the notice of deficiency:

     On Schedule E of your 1993 AND [sic] 1994 returns, you
     reported net profits from your rental properties in the
     amounts of $10,503 in 1993 and $15,937 in 1994. You treated
     these profits as passive income which you than [sic] used to
     offset passive losses. It has been determined that these
     rental net profits are nonpassive income and therefore
     unallowable to offset your passive losses. Therefore, your
     taxable incomes for 1993 and 1994 are increased by $10,503
     and $15,937, respectively.

Respondent also adjusted petitioners' itemized deductions for

both years, child care credit for 1993, and the exemptions
                                - 5 -

deduction for 1994.   Respondent also determined that petitioners

were liable for the accuracy-related penalties for both years.

     Respondent used the recharacterization rule of section

1.469-2(f)(6), Income Tax Regs., to characterize petitioners'

income from the Lease as nonpassive.    Under this rule:

          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; * * *

The recharacterization rule was issued on May 15, 1992, and it

reads nearly verbatim as it appeared when it was proposed on

February 25, 1988.    See Schwalbach v. Commissioner, 111 T.C. 215,

220-221 (1998).

     Petitioners argue that the recharacterization rule does not

apply for the subject years to recharacterize their income from

the Lease because, petitioners state, the effective date and

transition rules in section 1.469-11(b)(1), Income Tax Regs.,

operate to prevent characterizing Dr. Connor as a material

participant of the dental activity of his personal service

corporation.   Section 1.469-11, Income Tax Regs., provides in

relevant part:

          § 1.469-11. Effective date and transition
     rules.--(a) Generally applicable effective dates.
     Except as otherwise provided in this section--
                              - 6 -

                    (1) The rules contained in
               § § 1.469-1, 1.469-1T, 1.469-2,
               1.469-2T, 1.469-3, 1.469-3T,
               1.469-4, 1.469-5, and 1.469-5T
               apply for taxable years ending
               after May 10, 1992.

                    *    *    *       *   *     *    *

               (b) Additional effective dates--(1)
          Application of 1992 amendments for taxable
          years beginning before October 4, 1994. * *
          * for taxable years that end after May 10,
          1992, and begin before October 4, 1994, a
          taxpayer may determine tax liability in
          accordance with Project PS-1-89 published at
          1992-1 C.B. 1219 * * *.

Project PS-1-89, supra, generally contains:     (1) The second set

of regulations that the Commissioner issued to define the word

"activity", see Schwalbach v. Commissioner, supra at 220-225, for

a detailed discussion of the three sets of regulations which the

Commissioner issued on that subject, and (2) the effective date

rule in section 1.469-11(a)(1), Income Tax Regs.

     Petitioners rely on the fact that the second set of

regulations made no mention of attributing the activity of a

corporation to a shareholder, see 57 Fed. Reg. 20802 (May 15,

1992), and that the first set of regulations provided that "a

taxpayer's activities do not include operations that a taxpayer

conducts through one or more entities (other than passthrough

entities)", see sec. 1.469-4T(b)(2)(ii)(B), Temporary Income Tax

Regs., 54 Fed. Reg. 20543 (May 12, 1989).     According to

petitioners, the fact that the second set of regulations did not
                                - 7 -

specifically disavow the rule of nonattribution as stated in the

first set of regulations means that the nonattribution rule

continued to apply up until the time that the Commissioner issued

the third set of regulations which provided explicitly that "A

taxpayer's activities include those conducted through C

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

Income Tax Regs.

     We disagree with petitioners' assertion that Dr. Connor

cannot be a material participant of the dental activity of his

personal service corporation in a taxable year for which the

effective date and transition rules apply.    In Schwalbach v.

Commissioner, supra, a setting strikingly similar to the setting

at hand, the taxpayers argued similarly that the effective date

and transition rules of section 1.469-11(b)(1), Income Tax Regs.,

coupled with no mention of attribution in the second set of

regulations, allowed them to apply a nonattribution rule similar

to that appearing in the first set of regulations.    We disagreed.

See id. at 230.    Petitioners' attempt to dismiss as dicta our

quick disposition of that issue is unavailing.    That the

taxpayers in Schwalbach could not escape the moorings of the

attribution rule flowed naturally from our discussion of the

primary issue.    As we had observed, an attribution rule appears

in the third set of regulations, the preamble to those

regulations clarifies that the silence as to attribution in the

second set of regulations indicates that attribution was meant to
                                - 8 -

apply, and an attribution rule in section 469 is consistent with

that section and its legislative history.      Id. at 223-229.

     The same result follows here.      Because Dr. Connor could, and

did, materially participate in the dental activity of his

personal service corporation, the recharacterization rule of

section 1.469-2(f)(6), Income Tax Regs., operates during the

subject years to characterize petitioners' income from the Lease

as nonpassive.    We sustain respondent's determination on this

issue.

     Finally, we must decide whether petitioners are liable for

accuracy-related penalties for the years in issue.     Section

6662(a) imposes an accuracy-related penalty in the amount of 20

percent of the portion of an underpayment of tax attributable to

negligence or disregard of rules or regulations.     Sec. 6662(a)

and (b)(1).    Negligence is any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue

laws.    Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.

Moreover, negligence is the failure to exercise due care or the

failure to do what a reasonable and prudent person would do under

the circumstances.    Neely v. Commissioner, 85 T.C. 934, 947

(1985).    Disregard includes any careless, reckless, or

intentional disregard of rules or regulations.     Sec. 6662(c);

sec. 1.6662-3(b)(2), Income Tax Regs.

     Under section 6664(c), no penalty will be imposed with

respect to any portion of any underpayment if it is shown that
                               - 9 -

there was a reasonable cause for such portion and that the

taxpayer acted in good faith with respect to such portion.        This

determination is based on all of the facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.

     On the record before us, we find that there was reasonable

cause for petitioners to take the position they did and that they

acted in good faith with respect to that position.     Accordingly,

we find that the penalties under section 6662(a) should not be

imposed with respect to the years in issue.

     We have considered all arguments made by the parties and to

the extent not discussed above, we find these arguments to be

without merit or irrelevant.

                                            Decision will be entered

                                       for respondent as to the

                                       deficiencies and for

                                       petitioners as to the

                                       accuracy-related penalties.
