Opinion ID: 199081
Heading Depth: 2
Heading Rank: 1

Heading: Validity of the Final Regulations.

Text: 9 The regulations at issue -- Treas. Reg. § 1.469-2(f)(6) and Treas. Reg. § 1.469-4(a) -- were issued by the Secretary of the Treasury under a specific grant of authority from Congress. See 26 U.S.C. § 469(l). We afford such legislative regulations a high degree of respect: an inquiring court must give legislative regulations controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute. Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984). The upshot is that a court should enforce such regulations as long as they have a rational basis and are reasonably related to the purposes of the enabling legislation. See P. Gioioso & Sons, Inc. v. OSHRC, 115 F.3d 100, 107 (1st Cir. 1997). Against this backdrop, the taxpayers' claim of invalidity gains little traction. 10 The starting point for a reasoned appraisal of that claim is 26 U.S.C. § 469(l), which empowers the Secretary, in relevant part, to 11 prescribe such regulations as may be necessary or appropriate to carry out provisions of [Sec. 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 . . . . 12 The taxpayers suggest that Congress, through this language, only intended the Secretary to promulgate regulations that required net passive income derived from certain pass-through entities, such as partnerships or S corporations, to be treated as nonpassive. The Secretary, however, went further; after considerable backing and filling, discussed infra, he released the final regulations here at issue. 13 The first of these regulations -- embodying what is sometimes called the self-rental rule -- instructs taxpayers on how rental income is to be characterized for tax purposes. It states: 14 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 - 15 (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). 16 Treas. Reg. § 1.469-2(f)(6) (1992). 17 The second regulation -- which embodies what is sometimes called the attribution rule -- reads: 18 A taxpayer's activities include those conducted through C corporations that are subject to section 469, S corporations, and partnerships. 19 Treas. Reg. § 1.469-4(a) (1994). This regulation hardly could be clearer: it makes the self-rental rule applicable to transactions between closely-held C corporations and their owners. 20 The taxpayers' argument on this point prescinds from the uncontroversial premise that, apart from persons whose primary trade or business is real estate, a taxpayer's receipt of rent typically comprises passive income. The Secretary's newly-devised regulatory regime alters this treatment in a certain class of cases, and the taxpayers argue that Congress intended to limit the Secretary's power to effect such alterations to activities conducted by pass-through entities (like partnerships or S corporations). The ultimate question, then, is whether the Secretary had the authority under section 469(l) to stretch the bounds of coverage to include income or gain received from entities which, like C corporations, are not pass-through entities. We conclude that the Secretary acted appropriately in setting the parameters of the regulatory scheme. 21 The authority given to the Secretary, as illustrated by the statutory text, is quite broad. The statute empowers him to promulgate any regulations that he deems necessary or appropriate to further the goals of section 469. Importantly, this includes the explicit power to treat what normally would be passive income as nonpassive if he believes that such a shift is warranted. Although the statute mentions limited partnerships as one possible subject of regulation, the category is open-ended, not closed, as witness Congress's use of the inclusive phrase or other. Accord Fransen v. United States, 191 F.3d 599, 600-01 (5th Cir. 1999). Given the apparent breadth of authority ceded to the Secretary, and the congruence between the final regulations and the statute's evident goal (eliminating tax shelters), it is exceedingly difficult to imagine how the application of the self-rental rule to shareholders of closely-held C corporations (which the Tax Court accurately called the epitome of self-renting transactions, see Sidell, T.C. Memo. 1999-301, at 20) can be considered arbitrary, capricious, or contrary to Congress's will. 22 The legislative history points unerringly in the same direction. The House Conference Report affords valuable insight into the purposes behind the broad delegation of authority: 23 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 of where the exercise of such authority may . . . be appropriate include the following . . . (2) related property 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 . . . . 24 H. Conf. Rept. 99-841, at 147, reprinted in 1986 U.S.C.C.A.N. 4075, 4235. This clear statement of congressional intent fits hand and glove with the expansive language of the statute itself. One may question the wisdom of the policy choice embodied in the regulatory scheme, but one hardly can question the Secretary's authority to choose that policy. 25 To be sure, the tax structure of a C corporation differs from that of a pass-through entity. Despite this difference, however, embracing the taxpayers' rationale would run a grave risk of contradicting congressional intent. If the recharacterization rules were invalidated, individuals in the Sidells' position would be able to avoid application of the self-rental rule by the simple expedient of structuring businesses that they controlled as C corporations and siphoning off the profits as rent (and, therefore, as passive income). Insofar as the possibility of converting earned income into rental payments is concerned, the dangers of manipulation are essentially the same as those that attend pass-through entities. We think it reasonable to assume that Congress wanted to enable the Secretary to restrict the opportunity for such manipulative behavior across the board. 26 Our conclusion comports with that of other courts. The Fifth Circuit has determined that the attribution rule, as framed, is a valid outgrowth of the Secretary's power under section 469. See Fransen, 191 F.3d at 601. So too the Tax Court. See Krukowski v. Commissioner, 114 T.C. No. 25 (2000) (en banc) [2000 U.S. Tax Ct. LEXIS 31, at -]; Schwalbach v. Commissioner, 111 T.C. 215, 220 (1998). These decisions reinforce our conclusion that the treasury regulations here at issue reflect a proper exercise of the Secretary's duly delegated authority. Hence, we reject the taxpayers' challenge to their legitimacy. 27