S Shareholder Cannot Offset Self-Charged Management Fees against Nonpassive Income

During 1993 and 1994, H was the majority shareholder of S corporation SMC, which provided real estate management services to approximately 90 entities involved in real estate rental activities. H owned, either directly or indirectly, interests in each of these entities.

H did not participate in the entities' activities, but did perform real estate management services on behalf of SMC for these entities.

H reported as income the compensation paid to him for his services offered through SMC. In computing taxable income, he deducted the total amount of the management fee expenses of the entities. The IRS denied this deduction, but the Tax Court allowed it. The Court of Appeals (opinion Hamilton, J.) reverses the Tax Court; under Sec. 469, the management fee expenses for 1993 and 1994 were not deductible from the related management fee income for those years.

Sec. 469(a) prohibits individuals, estates, trusts, closely held C corporations and personal service corporations from deducting passive activity losses or passive activity credits from nonpassive gains in an effort to lower taxable income. Specifically, Sec. 469(a) provides:

(a) Disallowance—
(1) In General—If for any taxable year the taxpayer is described in paragraph (2), neither—
(A) the passive activity loss, nor (B) the passive activity credit, for the taxable year shall be allowed.
(2) Persons described—The following are described in this paragraph:
(A) any individual, estate, or trust,
(B) any closely held C corporation, and
(C) any personal service corporation.

For Sec. 469 purposes, the term "passive activity" is defined as an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. With certain exceptions not relevant here, rental activity is a passive activity. Also for purposes of Sec. 469, the term "passive activity loss" is defined as "the amount (if any) by which—(A) the aggregate losses from all passive activities for the taxable year, exceed (B) the aggregate income from all passive activities for such year."

H does not dispute that straightforward application of the plain language of Sec. 469(a) prohibits him from deducting the management fee expenses of the entities for 1993 and 1994 from his related management fee income for those same years. However, he takes the position that the plain language of Sec. 469(a) should not so apply. H's position is based on the argument that, when Sec. 469(l)(2) is read together with certain portions of its legislative history, it is clear that Congress directed Treasury to issue a regulation excepting self-charged management fees resulting in no accretion of the taxpayer's actual wealth from operation of Sec. 469(a), and the failure to comply with this direction does not prevent him from avoiding operation of Sec. 469(a).

Sec. 469(l)(2) provides that Treasury "shall prescribe such regulations as may be necessary or appropriate to carry out provisions of [Sec. 469], including regulations...which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income)..." The House Conference Report for the Tax Reform Act of 1986 states:

Self-charged interest—A further issue with respect to portfolio income arises where an individual receives interest income on debt of a passthrough entity in which he owns an interest. Under certain circumstances, the interest may essentially be "self-charged," and thus lack economic significance. For example, assume that a taxpayer charges $100 of interest on a loan to an S corporation in which he is the sole shareholder. In form, the transaction could be viewed as giving rise to offsetting payments of interest income and passthrough interest expense, although in economic substance the taxpayer has paid the interest to himself.

Under these circumstances, it is not appropriate to treat the transaction as giving rise both to portfolio interest income and to passive interest expense. Rather, to the extent that a taxpayer receives interest income with respect to a loan to a passthrough entity in which he has an ownership interest, such income should be allowed to offset the interest expense passed through to the taxpayer from the activity for the same taxable year.

* * *

The conferees anticipate that Treasury regulations will be issued to provide for the above result. Such regulations may also, to the extent appropriate, identify other situations in which netting of the kind described above is appropriate with respect to a payment to a taxpayer by an entity in which he has an ownership interest. Such netting should not, however, permit any passive deductions to offset nonpassive income except to the extent of the taxpayer's allocable share of the specific payment at issue.

Treasury has promulgated no permanent regulations exempting self-charged items of income and expenses from operation of Sec. 469(a), and has issued only one proposed regulation in this regard. Prop. Regs. Sec. 1.469-7 deals only with the self-charged interest situation specifically discussed in the just-quoted legislative history of and the reverse of that situation (i.e., when a passthrough entity loans money to its owner).

The problem with H's position is that nothing in the plain language of Sec. 469 suggests that an exception to its general prohibition against a taxpayer's deducting passive activity losses from nonpassive activity gains exists when (as in the present case) the taxpayer essentially paid a management fee to himself. Unless there is some ambiguity in the language of a statute, its language is conclusive.

David H. Hillman, 4th Cir., 4/17/01, rev'g 114 TC 103 (2000)