IRS not allowed to reclassify passive activity income.

• Author: Beavers, James A.

The Tax Court held that the IRS could not reclassify the taxpayer's income from the rental of cellphone towers and the land they were situated on to his wholly owned S corporation as nonpassive income under the self-rental rule because the S corporation used the towers and the land in a rental (not a trade or business) activity.

Background

Francis Dirico was the 100% owner of Industrial Communications & Electronics Inc. (ICE), an S corporation. Before and during the years at issue, ICE was engaged in a variety of radio-related activities, including construction of and leasing access to telecommunications towers (towers), sales and servicing of Motorola radios, and providing specialized mobile radio (SMR) services for a monthly subscriber fee. ICE constructed towers both for unrelated parties and for its own use, the latter for rental to customers, including Verizon, T-Mobile, AT&T, paging companies, and government entities.

Dirico leased land and telecommunication towers to ICE in exchange for a percentage of ICE's revenue from its leases of tower access to third parties. He also leased three parcels of land to ICE that did not have towers. ICE also sold and serviced radios and provided SMR services to customers for a monthly subscriber fee. Four of the towers leased to ICE housed antennas in free (unused) space for the rent-free use of ICE's SMR customers. ICE's tax returns for the years at issue did not separately report the income or loss from its various activities and reported its total net income as ordinary business income.

ICE also reported its income to Dirico as ordinary income on the S corporation K-1 it provided to him. Dirico reported this income as ordinary income on his individual return. He classified the net income from all his leases to ICE as passive activity rental income pursuant to Sec. 469(c)(2).

On audit, the IRS recharacterized Dirico's income from the profitable tower and land leases as nonpassive income under the self-rental rule in Regs. Sec. 1.469-2(f)(6). Under this rule, the net rental activity income for the year from an item of property is treated as nonpassive if the property is rented for use in a trade or business activity in which the taxpayer materially participates for the tax year. However, because the rule applies on a property-by-property basis, and only applies to property with net rental income, the IRS did not recharacterize the losses from the unprofitable tower and land rentals under the rule.

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