Cross References
- Williams, 5th Cir., February 2, 2016

The taxpayer was a 100% owner of an S corporation, and 100% owner of a C corporation. The S corporation leased to the C corporation commercial real estate which the C corporation used in its business. The taxpayer materially participated in the C corporation, but did not materially participate in the S corporation. The S corporation generated flow through income to the taxpayer which the taxpayer characterized as passive income (both because the S corporation was a rental activity and because the owner did not materially participate in the activity). This passive income was then used to offset passive losses from other activities in which the taxpayer owned. The IRS disallowed this offset claiming the income generated by the S corporation was non-passive income under the self-rental rule. The Tax Court agreed with the IRS, and the taxpayer appealed the decision to the 5th Circuit Court of Appeals.

In general, rental activities are considered passive. However, under Regulation section 1.469-2(f)(6), if a taxpayer rents property to an activity in which the taxpayer materially participates, any net rental income for the year is treated as non-passive income, while any loss is treated as passive. The effect of this rule is to not allow self-rental income to offset passive losses from other activities.

The taxpayer argued that because IRC section 469 does not define "taxpayer" to include S corporations, the IRS lacked the authority to define "taxpayer" to include S corporations in the associated regulations. The court acknowledged that IRC section 469 does not refer to S corporations at all. The statute specifically applies to "taxpayers" who are individuals, estates, trusts, closely held C corporations, and personal service corporations.

The court said, however, that IRC section 469 did not need to specifically refer to S corporations because S corporations are merely pass-through entities, and its individual shareholders are the ultimate taxpayers. Because S corporations do not pay taxes directly, there was no need for IRC section 469 to include S corporations in its list of potential "taxpayers."

Author's Comment: The statute also does not name partnerships, but it is clear by this court's analysis that the individual partners of the partnership would be considered the "taxpayer" for purposes of the passive loss limitation rules.

The taxpayer also argued that the self-rental rule should not apply because the lessor S corporation did not materially participate in the trade or business of the lessee C corporation. Again, the court said the S corporation is not the taxpayer for purposes of IRC section 469. Rather, the S corporation's shareholder is the taxpayer. Since the S corporation leased property to the C corporation, and the S corporation shareholder also materially participated in the C corporation's trade or business, the self-rental rule applies. The income generated by the S corporation was characterized as non-passive income and thus could not be used to free up suspended passive losses from other passive activities owned by the taxpayer.