A federal appellate court has considered whether property owners could classify income derived from property they owned as passive income on their tax return when the income received was rental payments made by a law firm controlled by one of the taxpayers.
Thomas and Ermina Krukowski ("Taxpayers") owned two buildings in Milwaukee, Wisconsin. On their 1994 tax return, the Taxpayers offset passive income received from one building ("Law Firm Building") with a passive income loss from the other building. The Commissioner of the Internal Revenue Service ("IRS") sent the Taxpayers a deficiency notice, determining that the income received from the Law Firm Building was not passive income because one of the Taxpayers had "materially participate[d]" in the business leasing the space in the Law Firm Building, as Thomas Krukowski was the president and sole shareholder of the law firm that rented space in the Law Firm Building. The Taxpayers challenged the IRS decision in the Tax Court, but the Tax Court ruled in favor of the IRS. The Taxpayers appealed.
The United States Court of Appeals, Seventh Circuit, affirmed the rulings of the Tax Court. At issue was a Treasury regulation ("Regulation") that defines what types of "passive" activities do not fall under the passive income tax rules. There was no dispute that Thomas Krukowski "materially participate[d]" in the law firm's business. In general, passive income is income that a taxpayer receives for an activity in which the taxpayer does not materially participate and includes all rental activities (note the exception to this definition for real estate professionals). The Regulation was created in response to the Tax Reform Act of 1986, in which Congress attempted to abolish tax shelters. As part of the legislation, Congress directed the IRS to create regulations defining what types of "passive" activities would not be subject to the Tax Code's treatment of passive income. The Regulation states that income received from a property which is used "in a trade or business activity...in which the taxpayer materially participates" cannot be characterized as passive income. The Regulation did not effect transactions which occurred prior to February 19, 1988.
The Law Firm Building lease was signed on March 1, 1987. The initial term was for five years, with a renewal clause that stated that the law firm had three consecutive options to renew the lease for three-year terms, at a "mutually agreed" rent and all other terms of the initial lease remaining the same. In 1991, the law firm renewed the lease for the same rent as the initial term. The Taxpayers argued that since the law firm was simply exercising its option to renew the lease, it was not a new lease between the parties and thus the lease dated back to 1987, which predated the Regulation and so the Regulation's rules on passive income did not apply to the Taxpayers. The court rejected this argument, ruling that the renewal constituted a new lease and so was subject to the Regulation, since the 1991 renewal occurred after the date the Regulation took effect. Looking at existing law, the court found that an option which merely extends the lease will not constitute a new lease, but an option for renewal does require a new lease for execution. Since this lease was an option for renewal and also required the parties to negotiate a "mutually agreed" rental price, the court found that this lease was subject to the Regulation.
Next, the court considered the Taxpayers remaining two arguments. First, the Taxpayers argued that the Treasury lacked the authority to create the Regulation because Congress had already defined "passive income" within the Tax Code. The court rejected this argument, finding that Congress had specifically directed the Treasury to create rules defining what types of activities would not qualify for the passive income rules. The court also found that other federal courts had rejected the same argument. Second, the court rejected the Taxpayers' argument that the rental income from both buildings should be treated as a single activity. The court found that the Taxpayers were barred from making this argument at this stage, since they had already separated the rental income from the two properties on their income tax returns. Thus, the court affirmed the rulings of the Tax Court in favor of the IRS.
Krukowski v. Comm'r, 279 F.3d 547 (7th Cir. 2002).
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