IRS Not Allowed to Reclassify Passive Activity Income

By James A. Beavers, J.D., LL.M., CPA, CGMA

Tax Accounting

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.


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.

In addition, the IRS recharacterized the land-only rental income as nonpassive-activity income under the 30% test of Temp. Regs. Sec. 1.469-2T(f)(3). Under this test, income from rental property of which less than 30% of the unadjusted basis is subject to depreciation under Sec. 167 must be recharacterized as nonpassive.

Dirico challenged the IRS’s determination in Tax Court. Dirico argued that ICE did not use the leased tower and land properties in a trade or business, so the self-rental rule did not apply to them. With respect to the land-only leases, Dirico argued that in determining whether the 30% test was met, the IRS should have taken into account all the properties leased to ICE, not just the real property in the land-only leases. If this was done, the 30% test would not be met for the land-only leases, and the income from them would remain passive rental income.

The Tax Court’s Decision

The Tax Court held for Dirico with respect to the tower and land leases and for the IRS on the land-only leases. The court found that ICE did not use the tower and land lease properties in a trade or business activity, so it held that the income from the properties was passive, regardless of whether Dirico materially participated in the activity. However, it found that the IRS was correct in not aggregating all of the property leased to ICE in the 30% test. Treating the land-only properties separately, the 30% test was met, so the court held that the income from them should be recharacterized as nonpassive.

The tower and land leases: The court determined that the leasing of the land and tower properties to unrelated third parties were rental activities as defined in Sec. 469. The court found that the fact that these rental activities complemented ICE’s other trade or business activities and that ICE provided a small number of relatively insignificant services under the leases did not change the nature of the activities or cause them to fall under any of the exceptions to the definition of rental activity in the regulations under Sec. 469.

The IRS also argued that ICE had properly reported all its activities as a single activity on its return and, therefore, Dirico must treat them as a single activity. According to the IRS, ICE’s tower rental activity and its other trade or business activities formed an “appropriate economic unit” that could not be treated separately under Regs. Sec. 1.469-4(d)(1)(i)(C) because Dirico had the same proportionate ownership interest in all the activities, including the rental activity. The court disagreed, noting that according to the express language of the regulation, this rule applies only to the portion of a taxpayer’s rental activity that involves the rental of items of property for use in the taxpayer’s trade or business activity.

The court found that ICE’s use of the towers in its SMR business was de minimis compared with their use by ICE’s tower rental customers, and ICE’s use was on a rent-free basis. Consequently, the court found that no portion of the income from ICE’s rental activity was from ICE’s use of the towers in its SMR business. Thus, the court determined that Regs. Sec. 1.469-4(d)(1)(i)(C) did not support the application of the self-rental rule to recharacterize any portion of Dirico’s income from his tower and land rental activities as nonpassive income.

The IRS further argued that under Regs. Sec. 1.469-4(d)(5)(i), Dirico, as a shareholder of ICE, could not treat activities that ICE had reported as a single activity as separate trade or business and rental activities. The court stated that Dirico derived his income from leasing property in his capacity as a lessor to ICE, not as a shareholder of ICE. As a result, Regs. Sec. 1.469-4(d)(5)(i) did not apply.

Finally, the IRS claimed that Regs. Sec. 1.469-4(e)(1), which prohibits the regrouping of activities by “the taxpayer,” prevented Dirico from reporting the tower and land leases as a separate passive rental activity. The court found that since the taxpayer in this case, for purposes of Regs. Sec. 1.469-4(e)(1), was ICE, the regulations section only limited how ICE reported its income and had no effect on how Dirico reported ICE’s lease payments to him.

The land-only leases: With respect to the land rentals, Dirico contended that because all of his rentals to ICE involved the same landlord, the same tenant, and the same general types of property used for the same purpose, there was no basis for applying the 30% test separately to the land-only rentals. The IRS argued that the test should not be applied to all of Dirico’s properties because, under Regs. Sec. 1.469-4(d)(2), a taxpayer cannot group a real property rental activity and a personal property rental activity, other than personal property provided in connection with the real property or real property provided in connection with the personal property.

The court agreed with the IRS because neither of the exclusions from Regs. Sec. 1.469-4(d)(2) applied. The court found that the land was not “provided in connection with” any personal property on the land, and it was not “provided in connection with” the towers situated on other parcels of land where Dirico provided both a tower and land, one “in connection with” the other. Thus, the court concluded that the IRS had properly treated the land-only rentals separately for purposes of the 30% test and had correctly determined that the income from them was nonpassive.


Based on the particular facts of this case, the court properly distinguished between the taxpayer’s roles as ICE owner and property lessor when it ruled that he received the rental income as a lessor and not as a shareholder of ICE. This allowed him to treat the activities ICE had grouped as separate (passive) sources of income and, therefore, he could net the losses from those activities against his other passive income. This case illustrates that taxpayers need to be aware of, and careful about, the ramifications not only of material participation, but of their passive activity groupings. For more, see Rowe, “Activity Grouping: The Impact of Recent Developments.”

Dirico, 139 T.C. No. 16 (11/13/2012)


Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.