COUPLE NOT ALLOWED TO GROUP DIFFERENT ENTITIES' ACTIVITIES AS A SINGLE UNIT.

Justin L. Campolieta, for respondent.

 Year           Deficiency

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.

                 Table 1

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.

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

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 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.

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.

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 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 --

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).

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 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.

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

Accordingly, we reject petitioners' contention that paragraph (d)(5)(ii) does not apply "to activities that constitute an appropriate economic unit".

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.

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.

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 --

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.

In light of the foregoing,

Decision will be entered for respondent.

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 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.

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

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).

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:

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).