Thomas P. and Ermina A. Krukowski, Petitioners v. Commissioner OF Internal Revenue, Respondent, 114 T.C. 366

OPINION Laro, Judge: This case is before the Court on cross-motions for

summary judgment. Respondent determined a $28,184 deficiency in petitioner’s 1994 Federal income tax and a $5,637 accuracy-related penalty under

section 6662(a). Petitioner, while residing in Greendale, Wisconsin, petitioned the Court to redetermine respondent’s determination. Following respondent’s concession that petitioner is not liable for the accuracy-related penalty, we must decide whether petitioner may offset the income and loss that he realized on his separate rental activities. We hold he may not. Unless otherwise stated,

section references are to the Internal Revenue Code applicable to 1994. Rule references are to the Tax Court Rules of Practice and Procedure. We refer to Thomas P. Krukowski as the sole petitioner. Background Petitioner is the president and sole shareholder of two sub-chapter C corporations. One corporation (the health club) operates a health club. The other corporation (the law firm) operates a law firm. Petitioner actively works for the law firm as an attorney. Petitioner rents a building (the club) to the health club, and he rents a second building (the office building) to the law firm. Petitioner’s 1994 Federal income tax return reported that:

(1) He realized a $69,100 loss on the rental of the club, (2) he realized income of $175,149 on the rental of the office building, (3) the rental of the club and the rental of the office building were separate passive activities under

section 469, and (4) the loss from one activity offset an equal amount of the income from the other activity, resulting in the inclusion in petitioner’s 1994 taxable income of $106,049 of rental income. Respondent determined that the rental income could not partially be offset by the rental loss; respondent determined that the income was recharacterized as nonpassive income under

section 1.469-2(f)(6), Income Tax Regs., because petitioner materially participated in the law firm’s business activity. Respondent determined that petitioner’s 1994 taxable income includes $175,149 (rather than the reported $106,049) of rental income. Petitioner leased the office building to the law firm on March 1, 1987, pursuant to a written, 5-year lease (the 1987 lease) that provided for monthly rent of $17,500. The 1987 lease contained the following renewal provision: 24.

OPTION TO RENEW Lessor grants to Lessee three (3) consecutive options to renew this Lease, each for a term of three (3) years, at a rental to be mutually agreed to by Lessor and Lessee prior to the commencement of a renewal term with respect to that renewal term, with all other terms and conditions of the renewal lease to be the same as those herein. To exercise this option, Lessee must: (1) give Lessor written notice of the intention to do so at least 60 days before initial term expires, and (2) agree with Lessor on rental for renewal period at least 30 days before initial term expires.

In Lessor’s sole discretion, failure to comply with either (1) or (2) above shall cause the option to renew to become null and void. On December 27, 1991, petitioner and the law firm executed a document entitled “Lease Renewal” (the 1991 lease), pursuant to the option provision in the 1987 lease. The 1991 lease provided in full: Lease Renewal Lease Renewal made this 27 day of December 1991 between Thomas P. Krukowski, of Greendale, Wisconsin, herein referred to as “Lessor” and Krukowski & Costello, S.C., of Milwaukee, Wisconsin, herein referred to as “Lessee”.

Pursuant to Paragraph 24 entitled “Option to Renew” in the Lease dated March 1, 1987 between Lessor and Lessee (the “Lease”), Lessee hereby gives written notice of its intention to exercise the first three year option to renew the Lease. The term of the Lease will be extended from March 1, 1992 until February 28, 1995 and all other terms and conditions of the Lease shall remain the same including the monthly rent of $17,500.00. LESSEE: KRUKOWSKI & COSTELLO, S.C. BY: s/_ Timothy G. Costello, Secretary Agreed to and Accepted this 27 day of December 1991 s/_ Thomas P.

Krukowski, Lessor Discussion The parties agree that we may decide this case by way of

summary judgment because, they assert, the dispositive issues are purely legal. We agree that our decision herein turns entirely on legal determinations, and, hence,, that we may decide this case summarily.

Summary judgment is appropriate where, as here, “the pleadings, answers to interrogatories, depositions, admissions, and any other acceptable materials, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law.” Rule 121(b); see P & X Mkts., Inc. v. Commissioner, 106 T.C. 441, 443 (1996), affd. without published opinion 139 F.3d 907 (9th Cir. 1998); see also Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247-251 (1986).

Petitioner challenges the ability of the Commissioner to apply the recharacterization rule to the rental income from the office building. Petitioner argues primarily that the re-characterization rule is invalid because it conflicts with explicit statutory text as to the characterization of income derived from a rental activity. Petitioner observes that

section 469(c)(2) and (4) provides that a rental activity is generally passive and that the recharacterization rule provides that certain rental income is nonpassive. We disagree with petitioner that the recharacterization rule is invalid. The recharacterization rule is a legislative regulation, see Schwalbach v. Commissioner, 111 T.C. 215, 220 (1998) (the Secretary had to comply with the Administrative Procedure Act (apa), 5 U.S.C. sec. 553(

b) and (c) (1994), when he prescribed sec. 1.469-2(f)(6), Income Tax Regs., because the rules contained therein are legislative rather than interpretative); see also Fransen v. United States, 191 F.3d 599, 600 (5th Cir. 1999); thus, it is invalid only if it is arbitrary, capricious, or manifestly contrary to the statute, see Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984); see also McKnight v. Commissioner, 99 T.C. 180, 183 (1992). The rechacterization rule is not arbitrary, capricious, or manifestly contrary to the statute.

It was prescribed by the Secretary pursuant in part to the specific grant of authority stated in section 469(1) that allows him to prescribe all necessary or appropriate regulations to carry out the provisions of

section 469, including regulations:

(1) Defining the terms “activity” and “material participation”, sec. 469(1)(1), and (2) “requiring net income or gain from a limited partnership or other passive activity to be treated as not from a passive activity”, sec. 469(1)(3). The rule is tied directly to the following passage set forth by the conferees in their report as to the Secretary’s regulatory authority under

section 469: Regulatory authority of Treasury in defining non-passive income.— The conferees believe that clarification is desirable regarding the regulatory authority provided to the Treasury with regard to the definition of income that is treated as portfolio income or as otherwise not arising from a passive activity. The conferees intend that this authority be exercised to protect the underlying purpose of the passive loss provision, i.e., preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities.

Examples where the exercise of such authority may (if the Secretary so determines) be appropriate include the following * * * (2) 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 (Vol. II), at 11-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147.] Petitioner also argues that, the recharacterization rule is inapplicable to this case by virtue of

section 1.469—11(c)(1)(ii), Income Tax Regs., which provides that the rule does not apply to income “attributable to the rental of * * * property pursuant to a written binding contract entered into before February 19, 1988.” Petitioner asserts that the office building lease in effect during 1994 was the 1987 lease, or, in other words, that he leased the office building to the law firm during 1994 pursuant to a pre-February 19, 1988, written binding contract. We disagree.

As discussed below, we conclude that the office building lease in effect during 1994 was the 1991 lease and, moreover, that the 1991 lease and the 1987 lease are separate contracts. Applicable State (Wisconsin) law characterizes the 1991 lease as a renewal (as opposed to an extension) of the 1987 lease, which, in turn, means that the 1991 lease is a contract separate from the 1987 lease. See Seefeldt v. Keske, 111 N.W.2d 574, 575-576 (Wis. 1961).

We look at three critical factors to determine whether a contract is renewed or extended under Wisconsin law and conclude therefrom that the 1991 lease is a renewal of the 1987 lease. First, the language used in both leases by the parties thereto leads to the conclusion that the 1991 lease is a renewal of the 1987 lease. See id. at 576-577. The leases refer several times to a renewal; they refer only once to an extension. Second, the parties’ conduct leads to the same conclusion. See id.

The 1991 lease was signed by an officer of the law firm (other than petitioner) as “Lessee”, and it was signed by petitioner as “Lessor”, under the heading “Agreed to and Accepted”. If the parties to the leases had intended that the lessee could extend the 1987 lease at its option, petitioner’s signature and agreement would have been unnecessary. Third, the fact that petitioner, as the office building’s lessor, had to perform a further act to lengthen the term of the 1987 lease also leads to the conclusion that the 1987 lease was renewed through the 1991 lease. Compare Milwaukee Hotel Wis. Co. v.

Aldrich, 62 N.W.2d 14 (Wis. 1953) (lease providing for initial term of 3 years could be extended at lessee’s option for 3 more years at rent stated in lease; held, lease is a 6-year lease because no further act required of lessor once lessee makes election), with St. Regis Apt. Corp. v. Sweitzer, 145 N.W.2d 711 (Wis. 1966) (2-year lease automatically renews for 2 more years if neither party gives contrary notice; held, lease is 2-year lease because either party can prevent renewal by giving notice). See also Sheppard v. Rosenkrans, 85 N.W. 199 (Wis. 1901).

Petitioner, as lessor, had to agree with the lessee/law firm as to the rent that would be payable for any additional rental period after the first 5 years. Moreover, if they were unable to reach such an agreement at least 30 days before the 5-year period expired, petitioner possessed the sole discretion to declare the option to renew null and void. We also bear in mind that the absence in the 1987 lease of an agreed-upon rent for the renewal period made the 1987 lease unenforceable for any period after the 5-year period expired. See Wis. Stat.

Ann. sec. 704.03(1) (West 1998) (Wisconsin statute of frauds provides that a lease for more than a year, or a contract to make such a lease, is unenforceable unless it sets forth the amount of rent or other consideration). In fact, an enforceable contract for the additional period did not exist until December 27, 1991, when the parties agreed on a rent for the renewal period and created a writing memorializing that new agreement. See Borkin v. Alexander, 132 N.W.2d 587 (Wis. 1965); Ratcliff v. Aspros, 35 N.W.2d 217 (Wis. 1948).

Petitioner also argues that he is not subject to the re-characterization rule by virtue of

section 1.469-11(b)(1), Income Tax Regs., which allows taxpayers, at their option, to use certain proposed regulations to ascertain their tax liability for years ending after May 10, 1992, and beginning before October 4, 1994. See sec. 1.469-11(b)(1), Income Tax Regs. These proposed regulations (the 1992 proposed regulations) were prescribed by the Secretary in 1992 to define the word “activity” for purposes of the passive loss rules. Notice of Proposed Rulemaking, PS-1-89, 1992-1 C.B. 1219, 57 Fed. Reg. 20802 (May 15, 1992).

Petitioner argues that the 1992 proposed regulations preclude a shareholder from participating in the activities of a C corporation, which, petitioner concludes, means that the recharacterization rule cannot be applied to his 1994 income from the office building. We disagree with petitioner’s assertion that

section 1.469-11(b)(1), Income Tax Regs., precludes taxpayers from participating in activities conducted by C corporations. Our conclusion is driven by a plain reading of the relevant text; namely,

section 469(a)(2)(

A) and (h)(1) and

section 1.469-2(f)(6)(i), Income Tax Regs. See Commissioner v. Soliman, 506 U.S. 168, 174 (1993); Crane v. Commissioner, 331 U.S. 1, 6 (1947); Venture Funding, Ltd. v. Commissioner, 110 T.C. 236, 241-242 (1998), affd. without published opinion 198 F.3d 248 (6th Cir. 1999).

Section 469(a)(2)(

A) provides in relevant part that the passive activity rules apply to “any individual”.

Section 469(h)(1) provides in relevant part that an individual is treated as materially participating in an activity when he or she “is involved in the operations of the activity on a basis which is * * * regular, * * * continuous, and * * * substantial”.

Section 1.469-2(i)(6)(i), Income Tax Regs., provides in relevant part that rental income is recharacterized as non-passive income if the underlying property “Is rented for use in a trade or business activity * * * in which the taxpayer materially participates”. Nowhere in

section 469 or the regulations thereunder do we read, as petitioner asks us to hold, that an individual’s “regular”, “continuous”, and “substantial” involvement in the operations of an activity is not treated as materially participating in that activity when the activity is operated by a C corporation. Petitioner correctly observes that the Secretary had set forth such an exception in two sets of temporary regulations that he had prescribed before 1992. In 1988, the Secretary prescribed

section 1.469-5T(f)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988) (the 1988 temporary regulations), providing that “any work done by an individual * * * in connection with an activity in which the individual owns (directly or indirectly, other than through a C corporation) an interest at the time the work is done shall be treated for purposes of this

section as participation of such individual in the activity.” One year later, in 1989, the Secretary prescribed

section 1.469-4T(b)(2)(ii)(B), Temporary Income Tax Regs., 54 Fed. Reg. 20543 (May 12, 1989) (the 1989 temporary regulations), providing that “For purposes of applying

section 469 and the regulations thereunder, a taxpayer’s activities do not include operations that a taxpayer conducts through one or more entities (other than passthrough entities).” As part of the regulatory project underlying the 1989 temporary regulations, the Secretary also amended the 1988 temporary regulations (the amended 1988 temporary regulations) to delete the parenthetical exception “(directly or indirectly, other than through a C corporation)” from

section 1.469-5T(f)(1), Temporary Income Tax Regs., supra. On May 15, 1992, the Secretary finalized the amended 1988 temporary regulations as

section 1.469-5(f)(1), Income Tax Regs, (the 1992 final regulations), leaving them virtually unchanged in their final form. Two years later, in 1994, the Secretary finalized a substantially revised version of the 1992 proposed regulations as

section 1.469-4, Income Tax Regs, (the 1994 final regulations). The 1988 temporary regulations (prior to the 1989 amendment) and the 1989 temporary regulations are not applicable to the year at bar. The applicable rules are found in:

(1) The 1992 proposed regulations, (2) the 1992 final regulations, and (3) the 1994 final regulations. The 1994 final regulations do not help petitioner’s cause because they provide specifically 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. Nor are the 1992 final regulations of any help to petitioner; as mentioned above, the parenthetical exception “(directly or indirectly, other than through a C corporation)” does not appear in those regulations. The 1992 proposed regulations also do not help petitioner’s cause; the 1992 proposed regulations do not contain the exception set forth in the 1989 temporary regulations.

Petitioner looks to the fact that the 1992 proposed regulations did not affirmatively and expressly disavow the exception set forth in the 1989 temporary regulations, and he discerns therefrom that the exception continued to exist in 1992. We disagree. The fact that the Secretary did not re-prescribe that exception as part of the 1992 proposed regulations is persuasive evidence that he revoked the exception at that time. See Keppel v. Tiffin Sav.

Bank, 197 U.S. 356, 373 (1905) (“it cannot in reason be said that the omission * * * gives rise to the implication that it was the intention of Congress to reenact it”); Independent Ins. Agents of Am.., Inc. v. Clarke, 955 F.2d 731, 735 (D.C. Cir. 1992) (“Under traditional rules of statutory construction, * * * material omitted on reenactment is deemed repealed.”), revd. on other grounds sub nom. United States Natl. Bank v. Independent Ins. Agents of Am., Inc., 508 U.S. 439 (1993). See generally Singer, Sutherland Statutory Construction, sec. 23.28, at 413 (5th ed. 1993). As we observed in Schwalbach v.

Commissioner, 111 T.C. 215, 228 (1998): “Although the * * * [1992 proposed regulations were] silent on this rule, including whether the Commissioner was considering abandoning it, we read nothing in * * * [those] regulations that would lead us to believe that the Commissioner was proposing to retain the rule.” The facts of Schwalbach v. Commissioner, supra, are similar to the facts at bar.

There, the taxpayers challenged the Commissioner’s application of the recharacterization rule to income they had realized in 1994 on their rental of property to a corporation owned by two shareholders, one of whom was one of the taxpayers. The taxpayers argued primarily that the recharacterization rule was invalid because the Secretary did not comply with the APA when he prescribed

section 1.469-4(a), Income Tax Regs.; if the Secretary had not complied with the APA, the taxpayers argued, then the re-characterization rule was invalid as applied to them. We concluded that the Secretary met the APA’s requirements; in so doing, we analyzed the statutory text, relevant legislative history, and various regulations prescribed under

section 469. The taxpayers in Schwalbach also advanced an alternative argument that is the same argument that petitioner advances herein. The taxpayers in Schwalbach argued on brief: in the event it is redetermined the provisions of Treas. Reg. Sec. 1.469(d)(5) [sic] apply, the provisions of Treas. Reg. Sec. 1.469-4T(b)(2)(ii)(

B) should be available to petitioners through 1994 due to the continued confusion with respect to provisions of the May, 1992, proposed regulations and the absence of a definitive statement as regards a non-passthrough entity not conducting passive activities through itself. See, effective date and transition rules under Treas. Reg. Sec. 1.469-11(b)(1). We rejected this argument summarily, holding that nothing in

section 1.469-11, Income Tax Regs., allowed us to apply the exception appearing in the pre-1992 regulations under which a taxpayer would not be considered to be a material participant of an activity conducted through a C corporation. See Schwalbach v. Commissioner, supra at 230. We stated: we decline petitioners’ invitation to allow them to apply the rules of

section 1.469-4T(b)(ii)(B), Temporary Income Tax Regs., 54 Fed. Reg. 20543, in lieu of the rules stated in

section 1.469-4(a), Income Tax Regs. Simply put, the effective date and transition rules related to the regulatory rules under

section 469 do not allow them to use it [i.e., the only rule stated in sec. 1.469-4T(b)(ii)(B), Temporary Income Tax Regs., 45 Fed. Reg. 20543 (May 12, 1989), namely, that “a taxpayer’s activities do not include operations that the taxpayer conducts through one or more entities (other than pass-through entities).”]. See sec. 1.469-11, Income Tax Regs. [M.] Although we recognize that

section 1.469-11(b)(1), Income Tax Regs., does not explicitly reference

section 1.469-4T(b)(ii)(B), Temporary Income Tax Regs., supra, but, instead, allows taxpayers to use the rules set forth in the 1992 proposed regulations, we believe that this distinction is meaningless under the facts herein. Whereas

section 1.469-4T(b)(ii)(B), Temporary Income Tax Regs., supra, contains an explicit rule under which a taxpayer is not considered to participate in a C corporation’s activities, petitioner effectively asks the Court to imply the same rule in the 1992 proposed regulations by virtue of the fact that those regulations are silent as to the inapplicability of such a rule. We decline to do so. Accord Sidell v. Commissioner, T.C. Memo. 1999-301; Connor v. Commissioner, T.C. Memo. 1999-185.

We conclude that petitioner may not offset part of the income that he realized on his rental of the office building to the law firm, by the loss that he realized on his rental of the club to the health club. We have considered all arguments in this case and, to the extent not discussed above, find those arguments to be without merit or irrelevant. To reflect the foregoing, An appropriate order will be issued, and decision will be entered for respondent. Reviewed by the Court. Cohen, C.J., and Wells, Ruwe, Colvin, Chiechi, Foley, Vasquez, and Thornton, JJ., agree with this majority opinion.

Petitioner asserts that he treated the separate rental activities as a single activity under sec. 1.469-4(c)(1), Income Tax Regs. The record does not support this assertion. To the contrary, the record reveals that petitioner treated his rental activities as separate activities. The recharacterization rule of sec. 1.469-2(0(6), Income Tax Regs., provides: (f)

(6) 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 (within the meaning of sec. 1.469-5T) for the taxable year * * * The Court of Appeals for the Fifth Circuit has so concluded. See Fransen v. United States, 191 F.3d 599 (5th Cir. 1999). Although we understand the words “regular”, “continuous”, and “substantial” to support a finding that petitioner materially participated in the law firm’s business activity, we note that petitioner also meets the definition of the term “material participation” as set forth in the applicable regulations.

Sec. 1.469-5T(a), (d), Temporary Income Tax Regs., 53 Fed. Reg. 5686 (Feb. 25, 1988) (an individual materially participates in an activity if, inter alia, he or she participates in an activity for more than 500 hours in the taxable year, he or she participates in the activity for more than 100 hours in the taxable year and no other individual spends more time in the activity, or the activity involves the performance of legal services and the individual had materially participated in the activity during any 3 years prior to the year in question).

For completeness, we note that the Secretary allowed the 1989 temporary regulations to expire on May 11, 1992, under the sunset provision of sec. 7805(e)(2). See 57 Fed. Reg. 20803 (May 15, 1992). Neither party disputes that the corporation operating the law firm is a C corporation subject to sec. 469. See sec. 1.469-1T(b)(4) and (5), Temporary Income Tax Regs., 53 Fed. Reg. 5686, 5701 (Feb. 25, 1988) (a C corporation is subject to sec. 469 if it is a “Personal service” or “Closely held” corporation).