Appeal from the United States Tax Court. No. 7765-98--David Laro, Judge.
Before Harlington Wood, Jr., Kanne, and Rovner, Circuit Judges.
The opinion of the court was delivered by: Kanne, Circuit Judge
In 1994, the Commissioner of the Internal Revenue Service issued a deficiency notice to Thomas and Ermina Krukowski. The notice informed the Krukowskis that they had misclassified certain rental income as passive income on their 1994 federal income tax return. The Krukowskis challenged the deficiency charge, but the Tax Court granted summary judgment in favor of the Commissioner. On appeal, the Krukowskis argue (1) that they are entitled to characterize the particular rental activity as a passive activity, (2) that the Secretary of the Treasury's regulation recharacterizing the rental activity as a nonpassive activity is invalid, and finally, (3) that this particular rental activity should be treated as a single activity with their other rental activity, and this single activity should be characterized as a passive activity. For the reasons stated herein, we affirm.
The Krukowskis own two buildings in Milwaukee, Wisconsin. They lease these buildings and earn rental income from the leases. Housed in one of the buildings is S.R. & F.C., Inc., a health club wholly owned by Thomas Krukowski ("Club Building"). The other building houses Krukowski & Costello, S.C., a law firm ("Law Firm Building"). Thomas Krukowski is an attorney with Krukowski & Costello, S.C., and in 1994, served as its president and sole shareholder. Additionally, he received all of his earned income that year from his law practice with Krukowski & Costello, S.C.
On March 1, 1987, Thomas Krukowski and Krukowski & Costello, S.C., executed a five-year lease for the Law Firm Building. The lease contained a renewal clause that provided:
Lessor grants to Lessee three (3) consecutive options to renew this Lease, each for a term of three (3) years, at a rental to be mutually agreed to by Lessor and Lessee prior to the commencement of a renewal term with respect to that renewal term, with all other terms and conditions of the renewal lease to be the same as those herein. To exercise this option, Lessee must:
(1) give Lessor written notice of the intention to do so at least 60 days before initial term expires, and
(2) agree with Lessor on rental for renewal period at least 30 days before initial term expires.
In Lessor's sole discretion, failure to comply with either (1) or (2) above shall cause the option to renew to become null and void.
On December 27, 1991, Thomas Krukowski and Krukowski & Costello, S.C. signed a renewal for the Law Firm Building. The renewal provided that "[t]he term of the Lease will be extended from March 1, 1992 until February 28, 1995 and all other terms and conditions of the Lease shall remain the same including the monthly rent of $17,500."
On their 1994 federal income tax return, the Krukowskis reported a passive income of $175,149 from the Law Firm Building and a passive loss of $69,100 from the Club Building. The Krukowskis offset their gain from the Law Firm Building with the loss from the Club Building. The Commissioner of the Internal Revenue Service issued a notice of deficiency to the Krukowskis on March 11, 1998. TheCommissioner determined that the net income from the Law Firm Building was nonpassive income because the property was rented to a corporation in which Thomas Krukowski "materially participate[d]." For this reason, the ...