REVISED, October 22, 1999

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

 

No. 98-30984

 

A. REMY FRANSEN, JR., and

EUGENIE B. FRANSEN,

Plaintiffs-Appellants,

versus

UNITED STATES OF AMERICA,

Defendant-Appellee.

 

Appeal from the United States District Court

For the Eastern District of Louisiana

 

October 1, 1999

Before REYNALDO G. GARZA, JOLLY, and HIGGINBOTHAM, Circuit Judges.

PATRICK E. HIGGINBOTHAM, Circuit Judge:

Today we examine the validity of Treasury Regulation § 1.469-

2(f)(6). A. Remy Fransen, Jr. and Eugenie B. Fransen appeal the

district court’s judgment upholding the regulation as a valid

interpretation of Internal Revenue Code § 469 and as applied to

them. We AFFIRM.

 I.

The essential facts are not disputed. During the 1995 tax

year, the Fransens, a married couple, owned an undivided one-half
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interest in a building. The Fransens leased that building to a

single tenant, Fransen & Hardin, a law firm organized as a “C”

corporation. Mr. Fransen was the sole shareholder of the

corporation. 

On their amended 1995 joint federal income tax return, the

Fransens treated the rental income as passive activity income. The

Fransens also had substantial, unrelated passive activity losses.

Because § 469 of the Internal Revenue Code allows deductions for

passive activity losses up to the amount of passive activity

income, the Fransens’ characterization of the rental income allowed

them to maximize the amount of passive activity losses that they

could deduct. 

The IRS rejected the Fransens’ treatment of their rental

income and denied their request for a refund. The Fransens sued

for a refund, and the District Court granted summary judgment to

the government. 

II.

The Fransens claim that the Treasury regulation relied upon by

the government is invalid. The disputed Treasury regulation is a

legislative regulation. As such, it must be upheld unless 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); Dresser Indus., Inc. v.

Commissioner, 911 F.2d 1128, 1137 (5th Cir. 1990). 

The disputed regulation, called the “self-rental rule,”

provides as follows:
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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 (within the meaning of

paragraph (e)(2) of this section) in which the taxpayer

materially participates (within the meaning of § 1.469-

5T) for the taxable year; and (ii) Is not described in

§ 1.469-2T(f)(5).

Treas. Reg. § 1.469-2(f)(6) (1994). In essence, the regulation

provides that when a taxpayer rents property to his own business,

the income is not passive activity income.

The regulation stems from Internal Revenue Code § 469.

Section 469(c) sets forth provisions which define passive activity

as including rental activity. I.R.C. § 469(c)(2) (1999). Section

469(l)(3), however, authorizes the Secretary to promulgate

regulations that treat passive activity as non-passive:

The Secretary shall prescribe such regulations as may be

necessary or appropriate to carry out provisions of [§

469] including regulations -- (3) requiring net income or

gain from a limited partnership or other passive activity

to be treated as not from a passive activity.

I.R.C. § 469(l) (1999). The tax court has described the IRS’s

authority to regulate under § 469 as “broad.” See Schwalbach v.

Commissioner, 111 T.C. 215, 220 (1998).

Here, the parties dispute the scope of passive activity the

IRS may treat as non-passive. The point of uncertainty lies with

the word “other” in § 469(l)(3). The Fransens suggest that “other”

refers to activity not elsewhere defined in § 469 as passive.

Grammatically, however, the more persuasive reading of the

provision is that a regulation may treat any kind of passive

activity as non-passive. The phrase “or other” appears to refer
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back to “limited partnership” and thus to include any passive

activity other than a limited partnership. 

The legislative history supports this view: it provides

examples of situations in which the Secretary may treat activities

defined as passive under § 469(c), including rental activity, as

non-passive. The report includes these examples as illustrations

rather than as an exclusive list. See H.R. CONF. REP. NO. 99-841,

at 147 (1986), reprinted in 1986 U.S.C.C.A.N. 4075, 4235. 

The Fransens suggest that the regulation defeats the statutory

purpose of privileging rental income. The statute, however, does

not seek to privilege rental income by generally classifying it as

passive. Instead, the purpose animating the statute is to

foreclose tax shelters. See STAFF OF THE JOINT COMM. ON TAXATION, GENERAL

EXPLANATION OF THE TAX REFORM ACT OF 1986, 99th CONG., at 209-210

(J.Comm.Print 1987). In most cases, a classification of income as

passive achieves this result. Tellingly, professional real estate

lessors sought and obtained an exception from the passive

designation in the 1993 amendments because a non-passive

classification would be more favorable to them. See I.R.C.

§ 469(c)(7); Scott P. Greiner, The Real Estate Professional’s Tax

Relief Act of 1993, 23 COLO. LAW. 1317, 1318 (1994).

In some cases, however, the opposite is true: the treatment

of income as passive may create a shelter opportunity. The

inclusion of § 469(l) allows for such situations by granting the

IRS the authority to treat income as non-passive. See H.R. CONF.

REP. NO. 99-841, at 147 (1986), reprinted in 1986 U.S.C.C.A.N. 4075,
5

4235. Here, the IRS identified self-rentals as such a case and

promulgated the regulation at issue.

We conclude that the regulation is a valid interpretation of

§ 469 under the Chevron standard. The IRS’s interpretation of the

statutory language is not “arbitrary or capricious.” Moreover, the

legislative history indicates that Congress envisioned the

Secretary as redefining passive activity as non-passive. Finally,

the stated purpose of the regulation is not manifestly contrary to

the statute under Chevron.

III.

The Fransens argue in the alternative that the regulation does

not apply to them because the law firm is a C corporation, and

because Mrs. Fransen is not a stockholder, officer, or employee of

the corporation. These arguments are unpersuasive. 

As to the type of corporation, the regulation does not limit

itself to pass-through entities, and the Fransens do not explain

why application of the regulation to a C corporation would be

inconsistent with the intent of the statute. The tax court

recently rejected a challenge to the self-rental rule as applied to

C corporations; the court noted that the taxpayer, who rented his

property to the C corporation of which he was the sole shareholder,

was the “epitome” of a self-renting transaction. See Sidell v.

Commissioner, T.C.M. 1999-301 (1999). 

Regarding Mrs. Fransen, Treasury Regulation § 1.469-5T(f)(3)

provides that participation by one spouse shall be treated as

participation by the other spouse in the activity during the
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taxable year. Temp Treas. Reg. § 1.469-5T(f)(3). This regulation

is a reasonable interpretation of Internal Revenue Code § 469(h),

which provides that “[i]n determining whether a taxpayer materially

participates, the participation of the spouse of the taxpayer shall

be taken into account.” § 469(h)(5). Because Mrs. Fransen did

participate in the business for tax purposes, the IRS could

properly apply the regulation to her.

The Treasury regulation is a valid interpretation of Internal

Revenue Code § 469 and was properly applied to the Fransens.

AFFIRMED.