114 T.C. No. 6
UNITED STATES TAX COURT
DAVID H. AND SUZANNE HILLMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19893-97. Filed February 29, 2000.
P’s S corporation (S) performed management services for real estate partnerships in which P had direct and indirect interests. P received passthrough nonpassive income from S and passthrough passive deductions from the partnerships. Sec. 469(l)(2), I.R.C., required R to promulgate regulations “which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income)”. Pursuant to sec. 469(l), I.R.C., R issued proposed regulations permitting the offsetting of “self-charged” interest incurred in lending transactions. Under the regulations, a taxpayer who was both the payer and recipient of the interest was allowed, to some extent, to offset passive interest deductions against nonpassive interest income. R, however, did not issue any regulation for self-charged items other than interest. See sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14034 (Apr. 5, 1991). - 2 -
Under circumstances identical to those in the regulation, except for the fact that the self-charged items were management fees rather than interest deductions and income, P offset passive deductions against nonpassive income. R determined that P was not entitled to such treatment because R did not issue a regulation for self-charged items other than interest. P contends that self-charged treatment was congressionally intended for interest and other appropriate items. R does not argue, as a matter of substance, that there is any distinction between interest and management fees within the self-charged regime.
Held: R’s decision not to or failure to issue regulations in this case is not a prohibition, per se, to P’s ability to treat self-charged items as intended by Congress. Held, further, P is entitled to offset the passive management deductions against the nonpassive management income.
Stefan F. Tucker and Kathleen M. Courtis, for petitioners.
Wilton A. Baker and Bettie N. Ricca, for respondent.
OPINION
GERBER, Judge: In a notice of deficiency addressed to
petitioners, respondent determined deficiencies of $294,556 and
$309,696 in petitioners’ Federal income tax for the years ended
December 31, 1993 and 1994, respectively. We consider here
whether petitioners are entitled to treat management fees that
generated nonpassive income and passive deductions and were paid
and received by passthrough entities in which petitioners held an - 3 -
interest as offsetting self-charged items for purposes of section
469.1
Background2
Petitioners resided in Bethesda, Maryland, at the time their
petition was filed. During the 1993 calendar year, David H.
Hillman (petitioner) owned 100 percent of the stock of Southern
Management Corporation (SMC). During the 1994 calendar year,
petitioner owned 94.34 percent of SMC’s stock. SMC was
classified as an S corporation during the 1993 and 1994 taxable
years. SMC provided real estate management services to
approximately 90 passthrough entities (including joint ventures,
limited partnerships, S corporations) that were involved in real
estate rental activities (partnerships). Petitioner owns, either
directly or indirectly, interests in each of the partnerships.
The general partner of each partnership is either petitioner or
an upper tier partnership or S corporation in which petitioner
owns an interest.
During the 1993 and 1994 taxable years, petitioners did not
participate in the activities of the partnerships. Petitioners
did, however, participate in the activities of SMC by performing
management services that SMC had contracted to perform for the
1 All section references are to the Internal Revenue Code in effect for the taxable years in issue. 2 This case was submitted fully stipulated. - 4 -
partnerships. SMC engaged in real estate management activity
which was treated by petitioners as a separate activity, not
aggregated with any other activities carried on by SMC. During
the 1993 and 1994 taxable years, petitioner materially
participated in SMC’s real estate management activity in excess
of 500 hours. During the 1993 and 1994 taxable years, SMC also
conducted other operations in addition to real estate management
services, such as recreational services, medical insurance plan
underwriting, credit/collection services, and a maintenance
training academy. Petitioner did not materially participate in
any of these other operations of SMC.
Petitioners reported as salary (income), and SMC deducted as
an expense, compensation paid to petitioners for services related
to the conduct of the real estate management activity for the
1993 and 1994 taxable years. SMC separately reported management
fee income (after deduction of expenses) on petitioners’ 1993 and
1994 Schedules K-1. The portion of the management fee paid by
the partnerships to SMC (and allocable to petitioner’s ownership
percentage in each partnership) was deducted and resulted in
ordinary losses from trade or business on either petitioner’s
Schedules K-1 for the 1993 and 1994 taxable years or on the
Schedules K-1 of upper tier partnerships and S corporations for
the 1993 and 1994 taxable years. In computing their taxable
income for the 1993 and 1994 years, petitioners treated the total - 5 -
amounts of the self-charged management fee deduction (the
deduction arising from the transaction between the partnerships
and SMC that gave rise to passive management fees expense and
nonpassive income) as a reduction from petitioners’ gross income
from activities characterized as nonpassive under section 469.
The notice of deficiency disallowed the characterization of
the management fee expense as nonpassive, referencing section
1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14034 (Apr. 5,
1991), which provides only that lending transactions (i.e., any
transaction involving loans between persons or entities) may be
treated as self-charged. No regulations were issued concerning
self-charged situations other than lending transactions.
Discussion
Respondent advances the unique position that the failure
(intentional or unintentional) to issue a regulation providing
for petitioners’ claimed tax treatment is sufficient to support
respondent’s disallowance. Ironically, respondent does not argue
that petitioners’ claimed treatment was incorrect, inappropriate,
or otherwise unjustified. More particularly, respondent contends
that Congress gave the Secretary the power and/or discretion to
issue legislative regulations, and, absent the issuance, there is
no entitlement to the tax treatment sought by petitioners.
In section 469(l), Congress mandated that the Secretary
issue such regulations as may be necessary or appropriate to - 6 -
carry out the provisions of section 469. The statute provides
for broad regulatory categories or subject matter, but it is
silent on the particular items or circumstances to be
specifically promulgated. Implementing a directive in the
legislative history regarding self-charged lending situations,
the Secretary issued a proposed regulation permitting offset of
passive interest deductions against nonpassive interest income.
See sec. 1.469-7, Proposed Income Tax Regs., 56 Fed. Reg. 14034
(Apr. 5, 1991). The legislative history also anticipated that
the Secretary would, to the extent appropriate, issue regulations
addressing other self-charged situations.
Petitioners contend that they should be allowed self-charged
treatment with respect to their pro rata share of the management
fees expense deducted by the partnerships and therefore be
allowed to offset it against their share of management income
received from SMC.3 Respondent does not dispute that the
circumstances in this case comport with the circumstances
described in the proposed regulation with the exception that the
regulatory subject matter is interest expense instead of
management fees expense.
3 Petitioners seek to offset their management fees expense against their management income by recharacterizing the expense as nonpassive. We note, however, that whether the offsetting items of income and expense are characterized both as passive or nonpassive makes no difference from a practical standpoint. - 7 -
Petitioners argue that respondent’s attempt to limit the
scope of the treatment of self-charged items to interest income
and deductions in section 1.469-7, Proposed Income Tax Regs., is
arbitrary, capricious, or manifestly contrary to section 469, the
underlying statute. Petitioners further argue that the proposed
regulations violate the congressional mandate as expressed in
section 469(l) insofar as such proposed regulations omitted
provisions addressing self-charged items other than self-charged
interest. Petitioners also contend that it was arbitrary,
capricious, and/or manifestly contrary to the underlying statute
for respondent, when applying section 469, to disallow the
characterization of petitioner’s pro rata share of the management
fees expense as nonpassive.
Respondent simply counters that there was an exercise of the
Secretary’s discretion not to issue regulations addressing
whether or not self-charged treatment and netting is clearly
appropriate in situations other than lending transactions.
Respondent further contends that in regard to self-charged
transactions, section 469 is not self-executing and therefore, in
the absence of regulations addressing self-charged treatment for
nonlending transactions, netting is unavailable.
A. Historical Background
Enacted by Congress as part of the Tax Reform Act of 1986,
Pub. L. 99-514, 100 Stat. 2085, the passive activity loss rules - 8 -
were specifically designed to limit a taxpayer’s ability to use
deductions from one activity to offset income from another
activity. These rules were designed to curtail the use of losses
generated by passive activities to offset unrelated income
generated by nonpassive activities.4 Under the section 469
passive activity loss rules, income generated from nonpassive
activities cannot be offset by deductions generated from passive
activities.
Although section 469 was designed to stop these practices,
Congress recognized that it would be inappropriate to treat
certain transactions between related taxpayers as giving rise to
one character of expense and another type of income. See H.
Conf. Rept. 99-841 (Vol. II), at II-146 to II-147 (1986), 1986-3
C.B. (Vol. 4) 1, 146-147. The House conference report, in the
4 Use of losses from one activity to offset income from another drove the “tax shelter industry” of the 1980’s. Transactions were fashioned to generate losses through the use of accelerated depreciation, interest, and other deductions that were used to offset the taxpayer’s other income such as salary, interest, and dividends. The passive activity loss rules in sec. 469 were designed to curtail the use of tax shelters by restricting a taxpayer’s ability to use the losses sustained in the operation of a trade or business to shelter unrelated income, unless the taxpayer materially participated in the operation of that trade or business. See Schaefer v. Commissioner, 105 T.C. 227, 230 (1995) (“Section 469 represents the congressional response to the widespread use of tax shelters by some taxpayers to avoid paying tax on unrelated income.”); S. Rept. 99-313, at 716 (1986), 1986-3 C.B. (Vol. 3) 1, 716. We note that in the present case, petitioners reported substantial taxable income from their activities and do not appear to be engaged in any tax sheltering activity. - 9 -
section concerning portfolio income, specifically focused on
situations where a payment of nonpassive interest income is
received by a taxpayer on a loan to an entity and a passive
deduction for the interest payment is passed through to the
taxpayer from the entity. See id. The legislative history
contains a specific example of a taxpayer who receives nonpassive
interest income on loans made to a taxpayer’s pass-through entity
from which passive interest deductions are passed through to the
taxpayer. See id. at II-146, 1986-3 C.B. (Vol. 4) at 146. Such
interest is considered “self-charged” interest and therefore
“[lacks] economic significance”. Id. The example involved a
taxpayer who charges $100 of interest on a loan to an S
corporation (engaged exclusively in passive activities) of which
he is the sole shareholder. Under the general application of the
passive loss rules, the taxpayer might be viewed as incurring
$100 of passive activity expense (interest expense passed through
by the S corporation), and having $100 of interest income, which
cannot be offset by the interest-expense deduction because it is
portfolio in nature. Thus, the taxpayer would have to recognize
$100 of taxable income from the transaction, although the
economic substance of the transaction was a payment of interest
to himself.
Likewise, the Staff of the Joint Committee on Taxation
focused on similar issues that could arise if a partnership makes - 10 -
loans to a partner (e.g., to finance a partner’s purchase of all
or part of his partnership interest, and the interest expense may
be treated as part of a passive activity). See Staff of Joint
Comm. on Taxation, General Explanation of the Tax Reform Act of
1986, at 233 n.26 (J. Comm. Print 1987). To avoid results that
lack economic significance in this type of transaction, it was
concluded that taxpayers should be permitted to offset the
interest income with respect to a loan to a pass-through entity
(in which he has an ownership interest) against the interest
expenses passed through to the taxpayer for the same taxable
year. See H. Conf. Rept. 99-841 (Vol. II), supra at II-146 to
II-147, 1986-3 C.B. (Vol. 4) at 146-147. While there is no
indication in the legislative history as to whether the
offsetting items of income and expense should both be treated as
passive or nonpassive, that point is irrelevant because the
income and deductions are netted.
The legislative history also contains the suggestion that
the amount of a taxpayer’s interest income from the loan that is
offset by the interest expense of a partnership should not exceed
the taxpayer’s allocable share of the interest expense (which
share for this purpose is not to be increased by a special
allocation). See id. at II-147, 1986-3 C.B. (Vol. 4) at 147.
Although the self-charged interest situation is specifically
recommended as a subject for regulations, the legislative history - 11 -
also contains the suggestion that other situations may be
appropriate for such netting treatment, as follows:
The conferees anticipate that Treasury regulations will be issued to provide for the above result. Such regulations may also, to the extent appropriate, identify other situations in which netting of the kind described above is appropriate with respect to a payment to a taxpayer by an entity in which he has an ownership interest. * * * [Id.; emphasis added.]
There was congressional recognition that transactions, other
than those involving lending, essentially can be self-charged,
and thus lack economic significance. Congress expressly
anticipated that the Secretary would issue regulations dealing
not only with self-charged interest but also other situations
where netting would be appropriate. Like the rules for self-
charged interest, relief from nonlending situations in which
self-charged transactions arise is based on the principle that
the passive loss rules should not apply if the income to be
offset against the passive activity loss is essentially a payment
by the taxpayer to himself.
Pursuant to section 469(l), which requires the Secretary to
promulgate regulations, respondent issued section 1.469-7,
Proposed Income Tax Regs., 56 Fed. Reg. 14034 (Apr. 5, 1991),
dealing with self-charged treatment for lending transactions.
The proposed regulation, however, solely addresses lending
transactions and does not, as Congress contemplated, address any
other self-charged income and deduction situations. There is no - 12 -
indication that the Secretary considered situations other than
lending transactions; i.e., that the Secretary specifically
decided that no other transactions should qualify. We do know
that the legislative history contains a directive that
regulations be promulgated to deal with self-charged lending
transactions. Thus, the Secretary’s actions were not necessarily
voluntary. In addition, nonlending transactions have not been
specifically addressed in any of the other passive activity loss
regulations.5
B. Self-Charged Rules and Nonlending Transactions
In the absence of regulatory guidance by the Secretary and
in light of the legislative history (committee report language)
petitioners have reasonably taken the position that the netting
of nonlending items may be permissible.
In the absence of regulations dealing with nonlending
transactions, we must decide which party’s litigating position
most reasonably comports with section 469. While petitioners
urge us to invalidate section 1.469-7, Proposed Income Tax Regs.,
we are unwilling to do so because that regulation addresses self-
5 We have located only one reference to the term “nonlending” in the context of sec. 469 and related regulations. Sec. 1.469-11T(a)(2)(iii)(B), Temporary Income Tax Regs., 56 Fed. Reg. 14034, 14040 (Apr. 5, 1991), is a proposed amendment that contains a reference to “nonlending transactions”. Neither party, however, referenced this proposed amendment, and we do not find it relevant to the issue before us. - 13 -
charged interest in accordance with the congressional mandate.6
Here, we are faced with the unusual situation where the Secretary
has promulgated regulations dealing with some, but not all, of
the issues intended and/or anticipated by Congress. Congress
anticipated the Secretary would issue regulations regarding self-
charged treatment in situations where, with respect to payment to
a taxpayer by an entity in which the taxpayer has an ownership
interest, netting would be appropriate. The Secretary, however,
addressed only self-charged interest in proposed regulations.
Had self-charged nonlending transactions been addressed in
regulations, respondent’s regulatory position would have been
afforded greater deference than as a litigating position.7 See
Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,
467 U.S. 837 (1984). Under Chevron, legislative regulations are
entitled to the highest level of judicial deference. See id. at
843-844. This deference, however, does not extend to a
litigating position taken by an administrative agency.
6 There is some question as to whether a proposed regulation is susceptible to “invalidation”. Fortunately, this question need not be addressed at this time. 7 In light of the legislative history, it is difficult to imagine the issuance of regulations denying self-charged treatment for appropriate nonlending situations. Respondent does not argue here that petitioners’ situation is inappropriate. Instead, respondent contends that the failure to address nonlending situations in the regulations results in taxpayers not being enabled to offset items other that the lending transactions covered in the proposed regulation. - 14 -
Respondent’s litigating position is that section 469 is not
self-executing. Therefore, in respondent’s view, taxpayers are
unable to claim self-charged offsets for items other than
interest, and, in the absence of specific regulations, courts
would not be permitted to decide that nonlending transactions are
subject to self-charged treatment. Conversely, petitioners argue
that section 469 is self-executing, they are entitled to claim
self-charged treatment, and this Court is permitted to approve
such treatment. We agree with petitioners.
In general, where regulations have been necessary to
implement a statutory scheme providing favorable taxpayer rules,
this Court has found that the statute’s effectiveness is not
conditioned upon the issuance of regulations. See Estate of
Maddox v. Commissioner, 93 T.C. 228, 233-234 (1989); First
Chicago Corp. v. Commissioner, 88 T.C. 663, 676-677 (1987), affd.
842 F.2d 180 (7th Cir. 1988); Occidental Petroleum Corp. v.
Commissioner, 82 T.C. 819, 829 (1984). As in the above-cited
cases, we are placed in the difficult position of “doing the
Secretary’s work” where there is a failure to issue regulations
that are congressionally intended. First Chicago Corp. v.
Commissioner, supra at 677. If Congress intended relief from the
passive activity rules for self-charged transactions, we must
decide whether petitioners’ claim is within that intent. In
other situations, we have held that the U.S. Department of the - 15 -
Treasury’s failure to provide the needed guidance should not
deprive taxpayers of the benefit or relief Congress intended.
However, if, as contended by respondent, the Secretary was given
dominion over whether taxpayers were entitled to offset self-
charged items, then a court may not substitute or exercise its
judgment in deciding what rules or regulations should have been
promulgated. To answer these questions, we turn to the statute
and legislative history.
The relevant statutory provision is section 469(l), which
provides as follows:
SEC. 469(l) Regulations.--The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations--
* * * * * * *
(2) which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income),
In determining whether section 469(l)(2) is self-executing, it is
instructive to look at how section 469(l)(1) has been interpreted
by this Court. The language of section 469(l)(1) has been
generally described as self-executing. In Schwalbach v.
Commissioner, 111 T.C. 215, 226 (1998), “we [found] nothing in
the statutory text, or in its legislative history, that
conditions the effectiveness of section 469 on the issuance of - 16 -
regulations.” See also Trans City Life Ins. Co. v. Commissioner,
106 T.C. 274, 299-300 (1996); Estate of Neumann v. Commissioner,
106 T.C. 216 (1996); H Enters. Intl., Inc. v. Commissioner, 105
T.C. 71, 81-85 (1995). We can find no reason that would justify
or reconcile treating section 469(l)(1), which was at issue in
the Schwalbach case, as self-executing and treating section
469(l)(2) as not being self-executing.
We have held language similar to that in section 469(l)(2)
to be self-executing. For example, in International Multifoods
Corp. v. Commissioner, 108 T.C. 579, 584 (1997), the taxpayer
sourced a loss in accordance with the statutory rule of section
865(a). Despite a statutory provision that “The Secretary shall
prescribe such regulations as may be necessary or appropriate to
carry out the purpose of this section, including regulations * *
* relating to the treatment of losses from sales of personal
property,” no loss sourcing regulations were issued. The
Commissioner argued that nothing in the statute required the
promulgation of any “particular rule” with respect to the
allocation of losses on the disposition of personal property. In
rejecting that argument, we found that Congress had intended to
change the rules regarding the sourcing of losses and held that
the Commissioner could not hide behind the failure to promulgate
regulations. Under those circumstances, we stated:
When Congress directs that regulations be promulgated to carry out a statutory purpose, the fact - 17 -
that regulations are not forthcoming cannot be a basis for thwarting the legislative objective. It is well established that the absence of regulations is not an acceptable basis for refusing to apply the substantive provisions of a section of the Internal Revenue Code. * * *
Id. at 587. This Court reasoned that Congress had articulated
the “overall purpose” behind the statute in the legislative
history, and the taxpayer’s action was appropriate even in the
absence of regulations because the statute was self-executing.
Moreover, where the regulations merely provide “how” a
statutory provision applies, this Court has found the statutes to
be self-executing. In Estate of Neumann v. Commissioner, supra
at 218-219, the language in the statute’s command provision (that
is “The Secretary shall prescribe such regulations as may be
necessary or appropriate to carry out the purposes of this
chapter”) was contrasted with the language from certain other
statutes that provide that a statutory provision would apply
“only to the extent provided in regulations prescribed by the
Secretary.” See also Occidental Petroleum Corp. v. Commissioner,
supra; First Chicago Corp. v. Commissioner, supra. In Estate of
Neumann v. Commissioner, supra at 221, we concluded that
issuance of regulations is to be considered a precondition to the imposition of a tax where the applicable provision directing the issuance of such regulations reflects a “whether” characterization * * * and not where the provision simply reflects a “how” characterization. * * * - 18 -
The command provision of section 469(l) contemplates regulations
that reflect a “how” characterization and does not contain the
type of “only to the extent” language that is found in statutes
that are not self-executing.
Respondent’s argument is essentially that the statute is not
self-executing since the Secretary was charged with writing
regulations. Respondent’s position that congressionally intended
benefits can be withheld simply by the refusal of the Secretary
to issue regulations is peculiarly Draconian. Respondent, in a
brief devoid of case references, articulated no reason for
denying the taxpayers in this case the tax treatment sought. In
that regard, allowing netting in this case fulfills the “economic
significance” concerns expressed in the legislative history. The
failure to issue regulations covering nonlending transactions
should not be a reason to preclude taxpayer from congressionally
intended and appropriate relief. As stated in Estate of Maddox
v. Commissioner, 93 T.C. 228, 234 (1989),
we must do the best we can with the statutory provision * * * now before us in the absence of pertinent regulations, since, in our view, the Secretary cannot deprive a taxpayer of rights which the Congress plainly intended to confer simply by failing to promulgate the required regulations. * * *
Section 469(l)(2) mandates the issuance of regulations
providing “that certain items of gross income will not be taken
into account in determining income or loss from any activity (and
the treatment of expenses allocable to such income)”. Although - 19 -
self-charged items are not specifically mentioned in the statute,
we have little difficulty placing self-charged items within the
ambit of section 469(l)(1) and (2). Through the legislative
commentary, the Secretary was directed to issue regulations for
self-charged lending transactions. The Secretary, by following
that direction and issuing section 1.469-7, Proposed Income Tax
Regs., 56 Fed. Reg. 14034 (Apr. 5, 1991), acknowledges that the
mandate of section 469(l)(2) includes self-charged items. Under
those circumstances, it is more difficult to accept respondent’s
position that the Secretary’s failure to issue regulations is a
bar to a taxpayer’s claiming that nonlending self-charged
transactions may also be offset. Respondent’s position would
ring more true, but not necessarily more correct, if no
regulations at all regarding self-charged items had been issued.
Having decided that the absence of regulations here is not
an acceptable basis for respondent’s determination, we turn to
the provision in question to determine whether petitioners are
entitled to self-charged treatment for the management fee income
and deductions. Petitioner received nonpassive income, through
SMC, for SMC’s providing real estate management services for the
partnerships (in which petitioner had an ownership interest,
either directly or indirectly). In connection with these real
estate management services, petitioner was also entitled to a
deduction for his distributive share of the management fees - 20 -
expense of the partnerships for the services provided by SMC.
The essence of these transactions is that petitioner, through
entities in which he held an interest, earned and paid the same
management fees; i.e., moved management fees from his “passive
pocket” to his “nonpassive pocket”. Under those circumstances,
the partnerships’ management fee deductions should be offset8
against the management fee payments (income) received by SMC.
There was no net accretion of wealth with respect to the
management services provided from SMC to the partnerships. Under
respondent’s determination, petitioners would be required to
recognize income even though respondent does not dispute that, in
effect, petitioner has simply paid a management services fee to
himself. Respondent has identified no difference between the
circumstances in this case and those set forth in the proposed
regulation and the legislative history permitting an offset where
a taxpayer’s self-charged transaction involves interest (a
lending transaction).
Respondent’s position denying the offset to petitioners is
not only contrary to the legislative history and intent of
Congress, but it does not appear to be based on any established
tax policy or any reason other than the failure to promulgate a
regulation. Again, we note that respondent has not articulated
8 Any offset must, of course, be limited to petitioners’ ownership percentages. - 21 -
any reason why petitioners should be prohibited from
recharacterizing the management fees deduction as nonpassive in
order to accurately reflect the economic significance of the
transaction. Indeed, respondent does not dispute that
disallowing self-charged treatment for the management fees would
result in the very mismatching that Congress sought to alleviate
by directing the Secretary to issue regulations for self-charged
transactions. Nor has respondent identified a distinction
between lending and nonlending transactions in the context of
this case that would lead us to conclude that the two
transactions should be treated differently under the self-charged
regime.
We have considered all other arguments advanced by the
parties, and to the extent we have not addressed these arguments,
consider them irrelevant, moot, or without merit.9
To reflect the foregoing,
Decision will be entered for
petitioners.
9 Because of our conclusion that petitioners are entitled to self-charged treatment with respect to the management fees, we find it unnecessary to address their alternative argument that the partnerships properly reported two activities to petitioner (or to the upper tier partnerships or S corporations).