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IRS Relies on Self-Rental Rule to Treat S Corp's Rental Income as Nonpassive.

(Parker Tax Publishing April 26, 2015)

The Tax Court held that income taxpayers received through their S corporation for property rented to their C corporation was nonpassive income, and could not be used to offset their passive losses. Williams v. Comm'r, T.C. Memo. 2015-76.

Background

Larry and Dora Williams were the sole owners of BEK Real Estate Holdings, LLC, an S Corporation, and of BEK Medical, Inc., a C corporation. Mr. Williams worked full time for BEK Medical, and materially participated in the business, though the couple did not materially participate in the activities of BEK Real Estate.

In 2009 and 2010, BEK Real Estate leased to BEK Medical commercial real estate which BEK Medical used in its trade or business activities. BEK Real Estate had net rental income of $53,285 and $48,657 from the rental of commercial real estate to BEK Medical in those years. The taxpayers reported those amounts as passive income on Schedules E, Supplemental Income and Loss, attached to their tax returns for 2009 and 2010, and offset the amounts with passive losses from other S corporations, partnerships, and rental properties.

In a notice of deficiency, the IRS reclassified BEK Real Estate's rental income for the two years as nonpassive income pursuant to Reg. Sec. 1.469-2(f)(6), and disallowed the taxpayers' passive losses that that exceeded their passive income.

Analysis

Code Sec. 469 prevents taxpayers from using losses from passive activities to offset nonpassive income. With certain exceptions, the term "passive activity" includes any rental activity, regardless of the level of a taxpayer's material participation in such activity (Code Sec. 469(c)(2)). Reg. Sec. 1.469-2(f)(6) generally recharacterizes as nonpassive the net rental activity income from an item of property if (1) the property is rented for use in a trade or business activity and (2), the taxpayer materially participates in the trade or business. This is commonly referred to as the "self-rental rule."

The IRS claimed that during 2009 and 2010, the taxpayers received income through BEK Real Estate from property that was rented to BEK Medical, in which Mr. Williams materially participated. The IRS argued the income could be recharacterized as nonpassive because the Williams satisfied the two components of Reg. Sec. 1.469-2(f)(6).

The taxpayers made two counterarguments, claiming that Code Sec. 469 does not apply to S corporations, and that the self-rental rule did not apply because BEK Real Estate did not materially participate in the trade of business of BEK Medical.

The Tax Court acknowledged that Code Sec. 469 does not specifically refer to S corporations, but pointed out that because passthrough entities do not pay tax, the individual shareholders of an S corporation are the taxpayers to whom Code Sec. 469 applies. The court noted it had previously recognized that income and losses from passthrough entities are subject to the passive activity limitations (Harnett v. Comm'r, T.C. Memo. 2011-191). Thus, the court held Code Sec. 469 applied to the Williams, who conducted real estate activities through their S corporation, BEK Real Estate.

The taxpayers based their second argument, in part, on Dirico v. Comm'r, 139 T.C. 396 (2012), in which the court had phrased the second prong of the self-rental rule as "the lessor-taxpayer must materially participate in the trade or business." The Williams claimed that because BEK Real Estate, as the lessor, did not participate in the trade or business of the lessee, BEK Medical, Reg. Sec. 1.469-2(f)(6) was inapplicable. The tax court disagreed with this interpretation, reasoning the case did not add to the requirements of the self-rental rule, and was merely a statement of the rule in the context of that particular case.

Instead, the court found the requirements of the self-rental rule were clearly met. The first prong was met because the property owned by BEK Real Estate was rented to BEK Medical for use in its trade or business. The second prong was satisfied because the Williams, not BEK Real Estate, were taxpayers subject to the requirements of Code Sec. 469, and they received passthrough income in 2009 and 2010 from property that was rented for use in a trade or business in which Larry materially participated.

Finding that the two requirements of Reg. Sec. 1.469-2(f)(6) were met, the Tax Court sided with the IRS and held that the income the Williams received from the rental of property by BEK Real Estate to BEK medical must be recharacterized as nonpassive income, which the taxpayers could not offset with passive losses.

For a discussion of the difference between passive and nonpassive income, see Parker Tax ¶ 247,145. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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