S shareholder cannot offset self-charged management fees against nonpassive income.

• Author: Fiore, Nicholas J.

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(1)(2) is read together...