                  T.C. Memo. 2009-79



                UNITED STATES TAX COURT



     CARLOS A. AND ANA MARIA SENRA, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 10540-06.              Filed April 15, 2009.



      P-H owned 86.75 percent of Keys Granite, a C
corporation, and 100 percent of Keys Holdings, a
limited liability company that was treated as a
disregarded entity for tax purposes. Keys Holdings
rented property to Keys Granite. On their 2001 and
2002 tax returns, Ps reported losses from Keys
Holdings’ rental activity and offset those losses
against wages they received from Keys Granite. R
disallowed the losses pursuant to sec. 469, I.R.C.
1986.

     Ps contend their activities in Keys Granite and P-
H’s activity in Keys Holdings constitute an appropriate
economic unit that may be treated as a single activity
for purposes of measuring gain and loss under sec. 469,
I.R.C. 1986.

     Held: Because Keys Granite is “a C corporation
subject to section 469”, Ps may group their activities
in Keys Granite with P-H’s activities in Keys Holdings
                                   - 2 -

        “but only for purposes of determining whether the
        taxpayer [P-H] materially or significantly participates
        in” P-H’s activities in Keys Holdings. Sec. 1.469-
        4(d)(5)(ii), Income Tax Regs. (emphasis added).
        Because in this case P-H’s activities in Keys Holdings
        are passive even if he materially participated in them,
        the regulation precludes grouping these activities with
        Ps’ activities in Keys Granite for purposes of
        offsetting the passive losses from Keys Holdings
        against Ps’ nonpassive wage income from Keys Granite.
        Sec. 469, I.R.C. 1986.



        Robert L. Trescott and Joshua E. Schoen, for petitioners.

        Justin L. Campolieta, for respondent.



                            MEMORANDUM OPINION


        CHABOT, Judge:    Respondent determined deficiencies in

Federal individual income taxes against petitioners as follows:

                         Year              Deficiency

                         2001               $34,917
                         2002                43,087

        The issue for decision is whether petitioners are permitted

to group their activities in a C corporation with petitioner

husband’s activities in a disregarded entity to form an

appropriate economic unit that may be treated as a single

activity for purposes of measuring gain and loss under section

469.1

        1
      Unless indicated otherwise, all section references are to
sections of the Internal Revenue Code of 1986 as in effect for
the years in issue.

                                                        (continued...)
                                 - 3 -

                              Background

     The instant case was submitted fully stipulated; the

stipulations and the stipulated exhibits are incorporated herein

by this reference.2

     When the petition was filed in the instant case, petitioners

resided in Florida.

     During 2001 and 2002 petitioner Carlos Senra (hereinafter

sometimes referred to as Carlos) was an 86.75-percent shareholder

of Keys Granite, Inc. (hereinafter sometimes referred to as Keys

Granite), a C corporation.3    Carlos also served as president of

Keys Granite in 2001 and 2002.    During these years Carlos and

petitioner Ana Maria Senra (hereinafter sometimes referred to as

Ana Maria) were employees of Keys Granite; they received, and

reported on their tax returns, wages from Keys Granite as shown

in table 1.




     1
      (...continued)
     Petitioners do not dispute the correctness of the deficiency
amounts if we hold for respondent on the issue for decision.
     2
      The instant case was filed as a small tax case under sec.
7463. Before the case was submitted, petitioners filed a motion
to remove the case from small tax case status, respondent stated
no objection, and the Court granted the motion. Accordingly, the
instant case was submitted and has been treated as a “regular”
case.
     3
      The record does not show who owned the remaining 13.25
percent of Keys Granite; this does not appear to affect the
results or analyses.
                                - 4 -

                               Table 1

                                                Amounts
               Year                      Carlos      Ana Maria

               2001                  $494,485        $86,977
               2002                   329,471         65,141

During these years Keys Granite was solely in the business of the

retail sale of granite and marble.

     Also during 2001 and 2002 Carlos owned 100 percent of Keys

Holdings and Investments Co., LC (hereinafter sometimes referred

to as Keys Holdings), a single-member limited liability company,

a disregarded entity for Federal income tax purposes.

Petitioners reported all of Keys Holdings’ income and expenses on

Schedule C, Profit or Loss From Business, of their 2001 and 2002

tax returns.    During these years Keys Holdings’ only tangible

business asset was a warehouse in Miami, Florida, and a tract of

land on which the warehouse was situated (hereinafter sometimes

collectively referred to as the Miami property).      During these

years Keys Holdings rented the Miami property solely to Keys

Granite; this rental activity was Keys Holdings’ only business

activity, and Keys Granite used the Miami property solely as a

place to store its inventory and as a showroom where its

potential customers could view that inventory.      During these

years Keys Granite paid rent to Keys Holdings for the use of the

Miami property; Keys Holdings was engaged in a rental activity

within the meaning of section 469(j)(8).      See infra note 5.
                                - 5 -

      Table 2 shows the Keys Holdings income, expenses, and net

losses petitioners reported on the Schedule C of their 2001 and

2002 tax returns.

                               Table 2

                                         2001            2002

              Income                $324,000           $432,000
              Expenses               410,701            544,328
                Net (Loss)         ( 86,701)          ( 112,328)

All of the income shown in table 2 for both years was rental

income paid by Keys Granite to Keys Holdings with respect to Keys

Granite’s rental of the Miami property.

                             Discussion4

1.   Parties’ Contentions

      Respondent does not dispute the correctness of the numbers

on petitioners’ Schedules C, nor Keys Holdings’ status as a

disregarded entity.   See supra table 2.        Petitioners do not

contend Keys Holdings’ losses are deductible against any income

other than petitioners’ compensation income from Keys Granite.

See supra table 1.    Both sides deal only with the application of



      4
      Sec. 7491, relating to burden of proof, was not drawn into
issue by either side; accordingly, the burden of proof remains on
petitioners. See Rule 142(a). Also, the parties’ presentation
of the instant case fully stipulated does not change the burden
of proof or the effect of a failure of proof. See Rule 122(b);
Borchers v. Commissioner, 95 T.C. 82, 91 (1990), affd. 943 F.2d
22 (8th Cir. 1991).

     Unless indicated otherwise, all Rule references are to the
Tax Court Rules of Practice and Procedure.
                               - 6 -

section 469 to the instant case, and so will we.    See Estate of

Fusz v. Commissioner, 46 T.C. 214, 215 n.2 (1966).

     Petitioners contend (1) the activities conducted by Keys

Granite and the activities conducted by Keys Holdings are related

activities; (2) these activities constitute an appropriate

economic unit and therefore a single activity; and (3) Carlos’s

ownership of both of these activities results in Carlos’s being

permitted to net his Keys Holdings losses against his and Ana

Maria’s Keys Granite wages.

     Respondent contends (1) the losses of Keys Holdings result

from a rental activity, which is a passive activity, and so these

losses can be deducted only against passive income; (2)

petitioners did not have any passive income (other than the

rental receipts of Keys Holdings); and so (3) petitioners are not

permitted to net the Keys Holdings losses against Carlos’s wages

or any other income of petitioners.

     Both sides direct our attention to section 1.469-4, Income

Tax Regs.   Respondent contends section 1.469-4(d)(5)(ii), Income

Tax Regs., permits the grouping of a C corporation’s activities

with another activity of the taxpayer, but only for purposes of

determining whether the taxpayers materially or significantly

participates in the other activity.    Respondent contends that,

because Keys Holdings is a rental activity, which is per se a

passive activity regardless of the extent of Carlos’s
                                 - 7 -

participation, it follows that the regulation’s limited material

participation exception does not apply, and so all that remains

is the regulation’s prohibition on the grouping of Keys Granite’s

activities with the activities of Keys Holdings for any other

purpose under section 469.     Petitioners contend that the

prohibitions of section 1.469-4(d)(5)(ii), Income Tax Regs.,

apply only to the grouping of unrelated activities, and that

related activities that constitute an appropriate economic unit

may be grouped so as to consider such grouped activities as a

single activity under section 1.469-4(c)(2), Income Tax Regs.

      We agree with respondent’s conclusion and much of

respondent’s analysis.

2.   The Statutory Framework

      In general, section 4695 provides that losses from passive



      5
       Sec. 469 provides, in pertinent part, as follows:

      SEC. 469.   PASSIVE ACTIVITY LOSSES AND CREDITS LIMITED.

           (a) Disallowance.--

                (1) In general.--If for any taxable year the
           taxpayer is described in paragraph (2), neither--

                      (A) the passive activity loss, nor

                      (B) the passive activity credit,

           for the taxable year shall be allowed.

                (2) Persons described.--The following are
           described in this paragraph:


                                                      (continued...)
                            - 8 -

5
 (...continued)
                  (A) any individual, estate, or trust,

                  (B) any closely held C corporation, and

                  (C) any personal service corporation.

         *        *    *     *      *    *     *

     (c) Passive Activity Defined.--For purposes of
this section--

          (1) In general.--The term “passive activity”
     means any activity--

               (A) which involves the conduct of any
          trade or business, and

               (B) in which the taxpayer does not
          materially participate.

          (2) Passive activity includes any rental
     activity.--Except as provided in paragraph (7),
     the term “passive activity” includes any rental
     activity.

         *        *    *     *      *    *     *

          (4) Material participation not required for
     paragraphs (2) and (3).--Paragraphs (2) and (3)
     shall be applied without regard to whether or not
     the taxpayer materially participates in the
     activity.

         *        *    *     *      *    *     *

     (d) Passive Activity Loss and Credit Defined.--For
purposes of this section--

          (1) Passive activity loss.--The term
     “passive activity loss” means the amount (if
     any) by which--

               (A) the aggregate losses from all
          passive activities for the taxable year,
          exceed

                                                   (continued...)
                               - 9 -

activities for a year may offset only income from passive

activities for that year; losses so disallowed may be carried


     5
      (...continued)
                    (B) the aggregate income from all
               passive activities for such year.

              *        *   *    *      *    *     *

          (j) Other Definitions and Special Rules.--For
     purposes of this section--

              *        *   *    *      *    *     *

               (8) Rental activity.--The term “rental
          activity” means any activity where payments are
          principally for the use of tangible property.

              *        *   *    *      *    *     *

          (l) Regulations.--The Secretary shall prescribe
     such regulations as may be necessary or appropriate to
     carry out provisions of this section, including
     regulations--

               (1) which specify what constitutes an
          activity, material participation, or active
          participation for purposes of this section,

               (2) which provide that certain items of
          gross income will not be taken into account
          in determining income or loss from any
          activity (and the treatment of expenses
          allocable to such income),

               (3) requiring net income or gain from a
          limited partnership or other passive activity
          to be treated as not from a passive activity,

               (4) which provide for the determination
          of the allocation of interest expense for
          purposes of this section, and

               (5) which deal with changes in marital
          status and changes between joint returns and
          separate returns.
                                - 10 -

over to later years.   The term “passive activity” is broadly

defined in section 469(c)(1) as any activity involving the

conduct of a trade or business and in which the taxpayer does not

“materially participate.”   But rental activities are passive

regardless of whether the taxpayer materially participates.      Sec.

469(c)(2), (4).

      Section 469(j)(8) provides that, for purposes of section

469, any activity where payments are principally for the use of

tangible property is a rental activity.   The parties have

stipulated--and we have found--that during 2001 and 2002 Keys

Holdings was engaged in a rental activity within the meaning of

section 469(j)(8).   It is clear from the record herein (and

neither side suggests the contrary) that all of Keys Holdings’

losses in 2001 and 2002 were from a rental activity and thus, by

operation of the statute, were losses from passive activities.

3.   The Treasury Regulations

      The statute (section 469(l)) requires the Secretary (see

section 7701(a)(11)(B)) to prescribe regulations dealing with

certain matters (presumably in addition to the general

authorization granted in section 7805(a)).   In the instant case,

both sides rely on the relevant Treasury regulations; no question

is raised as to the extent to which deference is due to these
                                   - 11 -

regulations or as to whether these regulations are authorized by

section 7805(a) or by section 469(l).       See T.D. 8565, 1994-2 C.B.

81, 83.

        Section 1.469-4, Income Tax Regs., provides rules for

grouping a taxpayer’s activities for purposes of applying section

469.6       Under paragraph (c)(1) of this regulation, activities may


        6
      Sec. 1.469-4, Income Tax Regs., provides, in pertinent
part, as follows:

             § 1.469-4. Definition of activity.--(a) Scope and
        purpose.--This section sets forth the rules for
        grouping a taxpayer’s trade or business activities and
        rental activities for purposes of applying the passive
        activity loss and credit limitation rules of section
        469. A taxpayer’s activities include those conducted
        through C corporations that are subject to section 469,
        S corporations, and partnerships.

                   *     *     *     *      *    *     *

             (c) General rules for grouping activities.--(1)
        Appropriate economic unit.--One or more trade or
        business activities or rental activities may be treated
        as a single activity if the activities constitute an
        appropriate economic unit for the measurement of gain
        or loss for purposes of section 469.

                  (2) Facts and circumstances test.--Except as
        otherwise provided in this section, whether activities
        constitute an appropriate economic unit and, therefore,
        may be treated as a single activity depends upon all
        the relevant facts and circumstances. * * *

                   *     *     *     *      *    *     *

             (d) Limitation on grouping certain activities.--
        The grouping of activities under this section is
        subject to the following limitations:

                    (1) Grouping rental activities with other
                                                        (continued...)
                        - 12 -



6
 (...continued)
trade or business activities.--(i) Rule.--A rental
activity may not be grouped with a trade or business
activity unless the activities being grouped together
constitute an appropriate economic unit under paragraph
(c) of this section and--

                    (A) The rental activity is
insubstantial in relation to the trade or business
activity;

                    (B) The trade or business activity
is insubstantial in relation to the rental activity; or

                    (C) Each owner of the trade or
business activity has the same proportionate ownership
interest in the rental activity, in which case the
portion of the rental activity that involves the rental
of items of property for use in the trade or business
activity may be grouped with the trade or business
activity.

               (ii) Examples.--The following examples
illustrate the application of paragraph (d)(1)(i) of
this section:

               Example 1. (i) H and W are married and
file a joint return. H is the sole shareholder of an S
corporation that conducts a grocery store trade or
business activity. W is the sole shareholder of an S
corporation that owns and rents out a building. Part
of the building is rented to H’s grocery store trade or
business activity (the grocery store rental). The
grocery store rental and the grocery store trade or
business are not insubstantial in relation to each
other.

               (ii) Because they file a joint return, H
and W are treated as one taxpayer for purposes of
section 469. See § 1.469-1T(j). Therefore, the sole
owner of the trade or business activity (taxpayer H-W)
is also the sole owner of the rental activity.
Consequently, each owner of the trade or business
activity has the same proportionate ownership interest
in the rental activity. Accordingly, the grocery store
                                               (continued...)
                                  - 13 -

be treated as a single activity “if the activities constitute an

appropriate economic unit for the measurement of gain or loss for

purposes of section 469.”    The remainder of paragraph (c)

provides rules for determining whether activities constitute an

appropriate economic unit.       Paragraph (d) of this regulation

provides “limitations” on the grouping of activities under this

section of the regulations.       One of these limitations, specified

in paragraph (d)(5)(ii) of this regulation, is--




     6
      (...continued)
     rental and the grocery store trade or business activity
     may be grouped together (under paragraph (d)(1)(i) of
     this section) into a single trade or business activity,
     if the grouping is appropriate under paragraph (c) of
     this section.

              *     *        *       *     *     *     *

               (5) Activities conducted through section 469
     entities.--(i) In general.--A C corporation subject to
     section 469, an S corporation, or a partnership (a
     section 469 entity) must group its activities under the
     rules of this section. Once the section 469 entity
     groups its activities, a shareholder or partner may
     group those activities with each other, with activities
     conducted directly by the shareholder or partner, and
     with activities conducted through other section 469
     entities, in accordance with the rules of this section.
     A shareholder or partner may not treat activities
     grouped together by a section 469 entity as separate
     activities.

                    (ii) Cross reference.--An activity that
     a taxpayer conducts through a C corporation subject to
     section 469 may be grouped with another activity of the
     taxpayer, but only for purposes of determining whether
     the taxpayer materially or significantly participates
     in the other activity. * * *
                              - 14 -

      An activity that a taxpayer conducts through a C
      corporation subject to section 469 may be grouped with
      another activity of the taxpayer, but only for purposes
      of determining whether the taxpayer materially or
      significantly participates in the other activity. * * *
      [Emphasis added.]

4.   Application to the Instant Case

      During the years in issue, Keys Granite, a C corporation

subject to section 469,7 was solely in the business of the retail

sale of granite and marble.

     The parties stipulated, and we have found, that during the

years in issue, Keys Holdings (1) was owned 100 percent by Carlos

and (2) was engaged in a rental activity within the meaning of

section 469(j)(8).




      7
      Sec. 469 applies to “any closely held C corporation”. Sec.
469(a)(2)(B). Sec. 469(j)(1) defines “closely held C
corporation” by directing us to sec. 465(a)(1)(B), which in turn
directs us to “the stock ownership requirement of paragraph (2)
of section 542(a)”. That requirement is met as to a corporation
if “At any time during the last half of the taxable year more
than 50 percent in value of its [the corporation’s] outstanding
stock is owned, directly or indirectly by or for not more than 5
individuals.” The parties stipulated, and we have found, that
during the years in issue, Carlos was an 86.75-percent
shareholder of Keys Granite. Consequently, the stock ownership
requirement of sec. 542(a)(2) has been met as to Keys Granite for
the years in issue. Thus, for these years, Keys Granite was
subject to sec. 469. This analysis may seem like a minicruise
with many ports of call, but the result of the cruise is clear
and the reason for the result of the cruise becomes apparent when
we apply the regulations, infra.

     For discussions of the advantages and disadvantages of such
statutory drafting devices, see, e.g., Dickerson, The
Fundamentals of Legal Drafting 130-134 (1986); Hirsch, Drafting
Federal Law, sec. 5.17 (3d ed. 1992).
                              - 15 -

      To determine whether section 469 limits a taxpayer’s

deductions in real-world settings, one generally must consider

the parameters of the “activities” that the taxpayer has engaged

in.   The “ground rules” for setting parameters are found in

section 1.469-4, Income Tax Regs., paragraph (c) of which focuses

on “appropriate economic unit”.   Petitioners make an appealing

argument that Keys Granite and Keys Holdings constitute an

appropriate economic unit within these ground rules.

      But in the instant case we need not, and we do not, decide

whether the two Keys fit into one lock under paragraph (c).    This

is because paragraph (d)(5)(ii) of this regulation presents an

impassible barrier to petitioners’ paragraph (c) contention.

      Because Keys Granite is “a C corporation subject to section

469” (see the detailed analysis supra note 7), petitioners’

activities conducted through Keys Granite may be grouped with

Carlos’s activities conducted through Keys Holdings, but only for

the purpose of determining whether Carlos materially or

significantly participated in the Keys Holdings activities.

      Section 469(c)(2) provides that any rental activity (the

parties stipulated that Keys Holdings was engaged in a rental

activity) is a passive activity “Except as provided in paragraph

(7)”.   Under section 469(c)(7) it would be relevant to determine

whether Carlos materially or significantly participated in the

Keys Holdings activities.   But petitioners do not contend that
                               - 16 -

section 469(c)(7) applies.    Petitioners have not directed our

attention to, and we have not found, any other provision

(relevant to the instant case) to which the material or

significant participation provision could apply.    Consequently,

it appears that the restriction of section 1.469-4(d)(5)(ii),

Income Tax Regs., precludes petitioners from grouping the Keys

Holdings activities with the Keys Granite activities for purposes

of section 469 in the instant case.

     We are then left with section 469 mandating that Keys

Holdings’ passive losses are not deductible against petitioners’

income from nonpassive sources.    This requires us to hold for

respondent.   See supra note 1.

5.   Petitioners’ Arguments

      a.   Petitioners’ Interpretation of the Regulations Section

      Petitioners contend that because their activities satisfy

the facts and circumstances test of section 1.469-4(c)(2), Income

Tax Regs., their activities in Keys Granite and Carlos’s

activities in Keys Holdings constitute an appropriate economic

unit and thus are entitled to treatment as a single activity for

purposes of measuring gain and loss under section 469.

Petitioners further contend that the “but only for” restriction

in section 1.469-4(d)(5)(ii), Income Tax Regs., “applies only to
                               - 17 -

the grouping of unrelated activities not to activities that

constitute an appropriate economic unit and are thus treated as a

single activity.”

     Paragraph (d) of the regulation is not so limited.

Paragraph (c) of the regulation provides the authority for

grouping activities.   The opening language of paragraph (d) of

the regulation states:    “The grouping of activities under this

section [i.e., all of section 1.469-4, Income Tax Regs.,

including, of course, paragraph (c) thereof] is subject to the

following limitations”.    The limitation of paragraph (d)(5)(ii)

of the regulation by its terms applies to all groupings under

paragraph (c).   We have no reason to believe the regulation does

not mean what it plainly states.8


     8
      In the instant case we have not been directed to, and we
have not found, any legislative history--or regulatory
equivalent--suggesting that we should give other than a plain
meaning effect to the “but only for” language of par. (d)(5)(ii).

     For completeness, we present the only history we have found
on this matter, the preamble to T.D. 8565, 1994-2 C.B. 81, 82,
which states as follows:

          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).

                                                     (continued...)
                               - 18 -

     Accordingly, we reject petitioners’ contention that

paragraph (d)(5)(ii) does not apply “to activities that

constitute an appropriate economic unit”.

     b.    Petitioners’ Hypothetical

     Petitioners also argue that “Even though the parties have

stipulated the losses were from a rental activity, that would not

cause them to be disallowed had [the Miami property] been owned

directly by Keys Granite instead of being owned by a disregarded

single member LLC”.    They assert that “Holdings’ legal existence

(vs. Keys Granite owning the warehouse directly) is for asset

protection and not for any tax motivation purposes”.

     Petitioners base their argument on a hypothetical scenario

involving an ownership structure that is meaningfully different

from the facts in the instant case:     Keys Granite did not own the

Miami property.    Moreover, Carlos had substantial control over

his business affairs.    Carlos owned 86.75 percent of Keys Granite

and served as its president at the same time as his wholly owned

limited liability company rented the Miami property to Keys

Granite.    In essence, Carlos sat on both sides of the table in

the rental agreement between Keys Granite and Keys Holdings,

substantially controlling the terms of the lease and the amount

of the rent.


     8
      (...continued)
     This explanation is consistent with our reading of the
regulation.
                                - 19 -

     Absent proof that the form of the transaction does not

properly represent its substance, we will not relieve a party

from the tax consequences of the form in which he or she appears

to have molded a transaction.    Don E. Williams Co. v.

Commissioner, 429 U.S. 569, 579-580 (1977); Commissioner v. Nat.

Alfalfa Dehydrating, 417 U.S. 134, 149 (1974) (“while a taxpayer

is free to organize his affairs as he chooses, nevertheless, once

having done so, he must accept the tax consequences of his

choice, whether contemplated or not * * * and may not enjoy the

benefit of some other route he might have chosen to follow but

did not.”); Yamamoto v. Commissioner, 73 T.C. 946, 954 (1980),

affd. without published opinion 672 F.2d 924 (9th Cir. 1982).

Petitioners’ hypothetical does not apply to the instant case, and

their argument in this regard is without merit.

     c.   Petitioners’ Argument Regarding Their Wages From Keys
          Granite

     Petitioners maintain that, if we were to agree with their

economic unit analysis, then the Keys Holdings losses should be

netted against their Keys Granite wages because those wages were

really the income of Keys Granite.       When asked to explain that

point, petitioners stated:

          Had the Taxpayers’ two entities been
     parent/subsidiary C corporations the losses of Keys
     Holdings would have been netted against the income of
     Keys Granite by filing a consolidated income tax return
     (I.R.C. § 1502). The Taxpayers’ wages reported on
                                - 20 -

     their Form W2 would have been reduced.[9] The fact that
     Keys Holdings is a disregarded entity should not change
     the result.

     Again, petitioners seek a tax treatment that is inconsistent

with the structure that Carlos created for his business dealings.

Petitioners received wages from Keys Granite, and according to

section 469(e)(3), wages are not passive income.      As we

previously discussed, (1) petitioners are bound by the structure

Carlos created (b. Petitioners’ Hypothetical), and (2)

petitioners’ losses from Keys Holdings constituted a passive

activity loss (a. Petitioners’ Interpretation of the Regulations

Section).   Under section 469, petitioners may not offset their

passive losses against their nonpassive income.

     d.   Caselaw

     Both sides direct our attention to Kessler v. Commissioner,

T.C. Memo. 2003-185.     Respondent tells us:   “The facts in this

case are similar to those presented in Kessler”; petitioners

counter that the small factual differences between the two cases

are sufficient to cause “Kessler to lack the precedent setting

the Respondent draws.”    In Kessler we held that the activity we


     9
      We note that the amounts set forth supra table 1 are
reported on the “Wages, salaries, tips, etc.” lines of
petitioners’ tax returns, and not on the “dividends” lines.
Petitioners do not seek to recharacterize the status of these
amounts on their tax returns. The record in the instant case
does not indicate any dispute between respondent and Keys Granite
as to whether these amounts are deductible compensation or
nondeductible distributions of profits. See Estate of Fusz v.
Commissioner, 46 T.C. 214, 215 n.2 (1966).
                              - 21 -

were examining was not excepted from the definition of a rental

activity, and so the taxpayer could not offset the income and

losses.   In our Kessler opinion, we stated that, because of the

“but only for” language in section 1.469-4(d)(5)(ii), Income Tax

Regs., the attribution rule (i.e., the rule under which the

corporation’s activities could be attributable to the

corporation’s owner) could not apply so as to permit the

corporation’s owner to offset the income and losses.    See Kessler

v. Commissioner, T.C. Memo. 2003-185, 85 TCM (CCH) 1543, 1547,

2003 RIA T.C. Memo. par. 2003-185, 988, 992.

     Our focus in the instant case on the effect of the “but only

for” language in section 1.469-4(d)(5)(ii), Income Tax Regs., is

consistent with what we did in Kessler.

     Petitioners contend that Gregg v. United States, 186 F.

Supp. 2d 1123 (D. Or. 2000), supports their position because in

Gregg the District Court allowed a--

     grouping (a C corporation with a limited liability
     company) for material participation purposes even when
     the two activities existed entirely independently of
     each other and the activities did not occur
     simultaneously. In Gregg the activities were not an
     appropriate economic unit and did not constitute a
     single activity.

Respondent rejoins as follows:

          In their brief, petitioners attempt to distinguish
     Gregg on the grounds that the activities in Gregg “were
     not an appropriate economic unit and did not constitute
     a single activity.” See Petitioners’ Brief at p. 7.
     Petitioners are incorrect. In Gregg, the Court
     specifically held that the taxpayer could “group his
                              - 22 -

     activities in [the C corporation] and [the LLC] as a
     single activity for determining whether he materially
     participated in the activities of [the LLC] in tax year
     1994.” Gregg v. United States, 186 F. Supp. 2d at 1133
     (emphasis added). Thus, the activities were considered
     a “single activity”, but only for a single purpose:
     determining participation.

     Gregg involved a taxpayer who created networks of health

care professionals for use by insurance companies.   The taxpayer

initially did business through Ethix--a C corporation.   He later

sold Ethix and formed Cadaja--a limited liability company that

was in a substantially similar business.   To prevail, the

taxpayer in Gregg needed to show that he materially participated

in Cadaja.   So the District Court considered whether he was able

to do so under section 1.469-4, Income Tax Regs.   Citing section

1.469-4(d)(5)(ii), Income Tax Regs., the District Court allowed

grouping, but “only for purposes of determining whether the

taxpayer materially participates in the other activity.”     Gregg

v. United States, 186 F. Supp. 2d at 1132 (emphasis added).     The

District Court concluded, on the facts in Gregg, that the

taxpayer should be treated as having materially participated in

Cadaja.   As a result, the taxpayer’s activities in Cadaja were

not defined as passive.   The District Court concluded that, in

those circumstances, Ethix and Cadaja constituted an appropriate

economic unit for purposes of the rules of section 1.469-4(c),

Income Tax Regs.
                               - 23 -

     Petitioners contend that they have a stronger “appropriate

economic unit” argument than did the taxpayer in Gregg.     But they

overlook the fact that Carlos’s activities in Keys Holdings would

be passive even if Carlos were to have actively participated in

Keys Holdings.   Consequently, we are left in the instant case

with a passive activity and a nonpassive activity, and the

regulation’s prohibition on combining the two.   Thus the District

Court’s application in Gregg of section 1.469-4(d)(5)(ii), Income

Tax Regs., is consistent with our analysis in the instant case

and does not advance petitioners’ argument.

6.   Holding

     We hold for respondent.   Petitioners may not group their

activities in Keys Granite with Carlos’s activity in Keys

Holdings to form an appropriate economic unit that may be treated

as a single activity for purposes of measuring gain and loss

under section 469.

     In light of the foregoing,


                                              Decision will be

                                         entered for respondent.
