UNITED STATES TAX COURT



      STEPHEN AND ANN SCHWALBACH, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 17502-97.                    Filed September 8, 1998.



     Ps rented a building to a personal service
corporation for use in a business activity in which P
materially participated. On Ps' 1994 Federal income
tax return, Ps offset the rental income with unrelated
passive losses. Relying on secs. 1.469-2(f)(6) and
1.469-4(a), Income Tax Regs., R determined that Ps
could not offset the rental income with the passive
losses because the rental income was recharacterized as
nonpassive income. Ps argue that sec. 1.469-2(f)(6),
Income Tax Regs., is invalid as applied to them because
the meaning of the word "activity" as used therein does
not include attributing a C corporation's activity to a
material participant in that activity without reference
to sec. 1.469-4(a), Income Tax Regs., which, Ps argue,
is invalid because R prescribed the rules of that
section without complying with the notice and comment
requirements of the Administrative Procedure Act (APA),
5 U.S.C. sec. 553(b) and (c) (1994).
                                 - 2 -


          Held: R complied with the notice and comment
     requirements of the APA, 

prescribed sec.
     1.469-4(a), Income Tax Regs., and neither that section
     nor sec. 1.469-2(f)(6), Income Tax Regs., is invalid
     due to a lack of compliance with those requirements.

     Jay B. Kelly, for petitioners.

     Blaine C. Holiday, for respondent.



     LARO, Judge:   Petitioners petitioned the Court to

redetermine respondent's determination of an $11,869 deficiency

in their 1994 Federal income tax and a $2,374 accuracy-related

penalty under section 6662(a).    Following concessions by

petitioners, the primary issue left to be decided is whether

sections 1.469-2(f)(6) and 1.469-4(a), Income Tax Regs., are

valid as applied to recharacterize the rental income of an

individual who rents property to a personal service corporation

for use in a business in which the individual materially

participates.   We hold they are.   We also decide whether

petitioners are liable for the accuracy-related penalty

determined by respondent.   We hold they are not.   Unless

otherwise indicated, section references are to the Internal

Revenue Code in effect for the subject year.    Rule references are

to the Tax Court Rules of Practice and Procedure.    Dollar amounts

are rounded to the nearest dollar.

                         FINDINGS OF FACT

     Some facts have been stipulated.    The stipulations of fact

and the exhibits submitted therewith are incorporated herein by
                                - 3 -


this reference.    Petitioners resided in River Falls, Wisconsin,

when they petitioned the Court.    They filed a joint 1994 Federal

income tax return which was prepared by a certified public

accountant (the C.P.A.).   Petitioners presented the C.P.A. with

all relevant information to prepare the return, and he prepared

the return based on his understanding of the tax law.   As of the

time that the C.P.A. prepared the return, he had been practicing

accountancy as a C.P.A. for approximately 20 years, and he had

performed work for petitioners, including preparing their

individual and business tax returns, for at least 16 years.

Petitioners rely on the C.P.A. for business and tax advice.

     Stephen Schwalbach (Dr. Schwalbach) practices dentistry in

River Falls.   He is employed full time by Associated Dentists of

River Falls, f.k.a. River Falls Dental Association (Associated

Dentists), a personal service corporation that he owns equally

with another dentist named Timothy Knotek.   Associated Dentists'

business is based in a building (the River Falls building) owned

by petitioners and let to Associated Dentists under a lease dated

January 1, 1992.

     Petitioners' 1994 Schedule E, Supplemental Income and Loss,

reported net income of $50,556 on the rental of the River Falls

building to Associated Dentists.   This schedule also reported

that petitioners had realized a $1,670 loss renting a commercial

building sited in Hudson, Wisconsin, and that they had realized

$877 of net income renting a residential house sited in River
                               - 4 -


Falls.   Petitioners also reported on this schedule that they had

realized a $10,148 passive loss on an investment in an S

corporation named Golfview Heights, Inc., and that they had

realized a $6,297 passive loss on an investment in a partnership

named South Main Dental Partners.   Petitioners took into account

all these items of income and loss, the effect of which was that

they reported net passthrough and rental income of $33,318

($50,556 + ($10,148) + ($6,297) + ($1,670) + $877).

     Respondent determined that the three losses aggregating

$18,115 (($10,148) + ($6,297) + ($1,670)) could offset only the

$877 gain, resulting in an adjustment (increase) in income of

$17,238.   According to the notice of deficiency:

     On Schedule E, Part I of your 1994 return, in regards
     to property B [i.e., the River Falls building], you
     reported a net profit of $50,556. This property is
     related to your corporation for which you are a
     material participant. You further offset passive
     losses of $16,445 from other companies shown on
     Schedule E, Part II against the non-passive income from
     related property B. Internal Revenue Code section 469
     changes the net income from the related rental property
     B from non-passive to passive income.[1]

     Further, on Schedule E, Part V of your 1994 return,
     your total net profit that you reported on your return
     was $33,318. However, it has been determined that your
     total net profit on Schedule E is $50,556. Your
     increase in net profit of $17,238 is based on the
     unallowable loss of $17,238 * * * as summarized below.



     1
       Actually, the regulations under sec. 469 change the net
income from the rental property from passive to nonpassive
income. Based on our reading of the entire notice of deficiency,
we conclude that respondent's mischaracterization in the notice
of deficiency is merely a typographical error.
                                 - 5 -


     Therefore, your taxable income for 1994 is increased by
     $17,238.

     Passive losses as corrected:
          Loss from Schedule E, Property A, Part I       $1,670
          Loss from Schedule E, Part II                  16,445
     Total corrected passive losses                      18,115
     Allowable passive income:
          Profit from Schedule E, Property C, Part I         877
     Unallowable loss                                     17,238

     On June 21, 1993, Dr. Schwalbach paid $16,050 for a 5/6

interest in 6,000 shares of stock in a corporation named

Impression Delivery Corp. (Impression); the total purchase price

was $19,266.   Approximately 3 weeks later, the 6,000 shares were

sold for $7,374, and 6 days after the sale, Dr. Schwalbach

purchased an interest in another 4,100 shares of Impression.

Petitioners did not recognize a loss in 1993 on the sale of the

stock because the C.P.A. considered the purchase-sale-purchase as

a "wash sale" under section 1091.    In 1994, petitioners, upon the

advice of the C.P.A., reported a short-term capital loss of

$16,050 on their 1994 Schedule D, Capital Gains and Losses, with

respect to Impression's stock.    The C.P.A. rendered his advice

after ascertaining that Impression had ceased operations and was

facing litigation over allegedly fraudulent practices.

     Respondent disallowed the $16,050 loss reported by

petitioners.   According to the notice of deficiency, "It has not

been established that the company known as Impression Delivery

Corp. was insolvent or out of business in the year 1994.

Further, it has not been established that you had an adjusted
                               - 6 -


basis in this company in order to claim this loss."    Petitioners

concede that they may not deduct this loss for 1994.

     Respondent also determined that petitioners were liable for

the accuracy-related penalty under section 6662(a), on account of

negligence.   Respondent determined that this penalty applied to

the total underpayment shown in the notice of deficiency.   The

total underpayment was attributable to the disallowed capital

loss, the increased income from the passive loss adjustment, and

two de minimis computational adjustments.

                              OPINION

     The instant dispute involves the recharacterization rule of

section 1.469-2(f)(6), Income Tax Regs., and the attribution rule

of section 1.469-4(a), Income Tax Regs.   Respondent used these

rules to recharacterize petitioners' rental income from the River

Falls building from passive income to nonpassive income.

Petitioners do not argue that respondent misapplied these rules

or that the Commissioner lacked the authority to prescribe them.

Petitioners' sole argument is that section 1.469-2(f)(6),

Income Tax Regs., is invalid as applied to them because,

petitioners allege, the Commissioner prescribed section

1.469-4(a), Income Tax Regs., which is necessary to apply the

recharacterization rule to a material participant of a C

corporation's activity, without complying with the notice and

comment requirements of the Administrative Procedure Act (APA),
                               - 7 -


5 U.S.C. sec. 553(b) and (c) (1994).   The notice and comment

requirements of the APA provide:

          (b) General notice of proposed rule making shall
     be published in the Federal Register * * *. The notice
     shall include--

               (1) a statement of the time, place, and
          nature of public rule making proceedings;

               (2) reference to the legal authority
          under which the rule is proposed; and

               (3) either the terms or substance of the
          proposed rule or a description of the
          subjects and issues involved.

     Except when notice or hearing is required by statute,
     this subsection does not apply--

               (A) to interpretative rules, general
          statements of policy, or rules of agency
          organization, procedure, or practice; or

               (B) when the agency for good cause finds
          (and incorporates the finding and a brief
          statement of reasons therefor in the rules
          issued) that notice and public procedure
          thereon are impracticable, unnecessary, or
          contrary to the public interest.

          (c) After notice required by this section, the
     agency shall give interested persons an opportunity to
     participate in the rule making through submission of
     written data, views, or arguments with or without
     opportunity for oral presentation. After consideration
     of the relevant matter presented, the agency shall
     incorporate in the rules adopted a concise general
     statement of their basis and purpose. * * * [5 U.S.C.
     sec. 553(b) and (c).]

     We disagree with petitioners' assertion that sections

1.469-2(f)(6) and 1.469-4(a), Income Tax Regs., are invalid when

applied to a material participant of an activity conducted by a

C corporation.   Section 1.469-2(f)(6), Income Tax Regs., was
                                 - 8 -


prescribed by the Commissioner under the broad regulatory

authority that Congress delegated to him through sections

469(l)(1) and 7805,2 T.D. 8417, 1992-1 C.B. 173-174, and is

effective for taxable years ending after May 10, 1992, sec.

1.469-11(a)(1), Income Tax Regs.     That section provides in

relevant part:

     §    1.469-2.   Passive activity loss.-- * * *

                 *     *    *    *       *   *   *

          (f)(6) Property rented to a nonpassive activity.
     An amount of the taxpayer's gross rental activity
     income for the taxable year from an item of property
     equal to the net rental activity income for the year



     2
         In relevant part, sec. 469(l) provides:

          (l) Regulations.--The Secretary [or his delegate,
     see sec. 7701(a)(11)(B)] shall prescribe such
     regulations as may be necessary or appropriate to carry
     out provisions of * * * section [469], including
     regulations--

                 (1) which specify what constitutes an
            activity, material participation, or active
            participation for purposes of this section,

                 (2) which provide that certain items of
            gross income will not be taken into account
            in determining income or loss from any
            activity * * *,

                  (3) requiring net income or gain from a
            limited partnership or other passive activity
            to be treated as not from a passive activity
            * * *

Sec. 7805(a) generally provides that the "Secretary * * * [or his
delegate, see sec. 7701(a)(11)(B)] shall prescribe all needful
rules and regulations for the enforcement of [the Internal
Revenue Code]".
                              - 9 -


     from that item of property is treated as not from a
     passive activity if the property--

               (i) Is rented for use in a trade or
          business activity * * * in which the
          taxpayer materially participates * * * for
          the taxable year; * * *

The fact that section 1.469-2(f)(6), Income Tax Regs, was

prescribed by the Commissioner pursuant in part to the specific

grant of authority stated in section 469(l)(1), and that section

1.469-2(f)(6), Income Tax Regs., contains substantive rules that

are legislative in character, means that the promulgation of

section 1.469-2(f)(6), Income Tax Regs., is not excepted from the

notice and comment requirements of the 

.     See Chevron,

U.S.A., Inc. v. Natural Resources Defense Council, Inc., 

, 843-844 (1984); Bankers Life & Cas. Co. v. United States,

, 978-979 (7th Cir. 1998); Water Quality Association

Employees' Benefit Corp. v. United States, 

, 1305

(7th Cir. 1986); Wing v. Commissioner, 

, 28 (1983); see

also Schaefer v. Commissioner, 

, 229-231 (1995) (sec.

1.469-2T(c)(7)(iv), Temporary Income Tax Regs., 53 Fed. Reg.

5686, 5716 (Feb. 25, 1988), is a legislative regulation because

it was issued under the specific grant of authority contained in

sec. 469(l)(2)).

     Section 1.469-2(f)(6), Income Tax Regs., was issued on

May 15, 1992, and it reads nearly verbatim as it appeared when it

was proposed on February 25, 1988.    See Notice of Proposed

Rulemaking, 53 Fed. Reg. 5733 (Feb. 25, 1988) (text of section
                              - 10 -


1.469-2T(f)(6), Temporary Income Tax Regs., 53 Fed. Reg. 5686,

5723 (Feb. 25, 1988), served as the text of the proposed

regulations).   The notice of proposed rulemaking complied with

the notice and comment requirements of the 

; inter

alia, it set forth by cross-reference the substance of the

proposed regulations, including the subjects, issues, and rules

involved, and it invited written comments.   53 Fed. Reg. 5733.

The notice of proposed rulemaking also invited requests for a

public hearing and stated that a public hearing would be held,

upon the request of any commentator, at a time and place to be

published in the Federal Register.     

Income Tax Regs., was prescribed by the

Commissioner under the broad regulatory authority that Congress

delegated to him through sections 469(l) and 7805, T.D. 8565,

1994-2 C.B. 81, 83, and is generally effective for taxable years

ending after May 10, 1992, sec. 1.469-11(a)(1), Income Tax Regs.

Section 1.469-4(a), Income Tax Regs., provides:

     § 1.469-4. Definition of activity.--(a) Scope and
     purpose. This section sets forth the rules for
     grouping a taxpayer's trade or business activities and
     rental activities for purposes of applying the passive
     activity loss and credit limitation rules of section
     469. A taxpayer's activities include those conducted
     through C corporations that are subject to section 469
     * * *. [Sec. 1.469-1T(b)(4), Temporary Income Tax
     Regs., 53 Fed. Reg. 5686, 5701 (Feb. 25, 1988),
     provides that a C corporation is subject to section 469
     if it is a personal service corporation.]

The second sentence of section 1.469-4(a), Income Tax Regs.,

which contains the attribution rule in dispute, is a change from
                                - 11 -


two previous sets of proposed regulations which the Commissioner

issued to define the word "activity".    With respect to both sets

of proposed regulations, the Commissioner issued a notice of

proposed rulemaking that set forth (either in the document or by

cross-reference to another document) the substance of the

proposed regulations, including the subjects, issues, and rules

involved, and invited written comments and requests for a public

hearing.3   54 Fed. Reg. 20606 (May 12, 1989) (first set of

proposed regulations); 57 Fed. Reg. 20802 (May 15, 1992) (second

set of proposed regulations).    The notice of proposed rulemaking

on the first set of proposed regulations stated that a public

hearing would be held, upon the request of any commentator, at a

time and place to be published in the Federal Register.    54 Fed.

Reg. 20606-20607.   The notice of proposed rulemaking on the

second set of proposed regulations referenced a separate document

that stated that the Commissioner was holding a hearing on the

proposed regulations on July 24, 1992, at 1:30 p.m., in room

7400, Internal Revenue Service Building, 1111 Constitution

Avenue, N.W., Washington, D.C.    57 Fed. Reg. 20805.   On June 15,

1992, the Commissioner announced that the hearing had been



     3
       When the Commissioner issued the notice of proposed
rulemaking on the first set of proposed regulations, he also
issued temporary regulations defining the word "activity". See
sec. 1.469-4T, Temporary Income Tax Regs., 54 Fed. Reg. 20527,
20542 (May 12, 1989). The text of the temporary regulations
served as the text of the proposed regulations. 54 Fed. Reg.
20527, 20606.
                              - 12 -


changed to September 3, 1992, at 10 a.m., in room 2615, Internal

Revenue Service Building, 1111 Constitution Avenue, N.W.,

Washington, D.C.   57 Fed. Reg. 23356 (June 3, 1992).   As is true

in the case of section 1.469-2(f)(6), Income Tax Regs., the fact

that section 1.469-4(a), Income Tax Regs, was prescribed by the

Commissioner pursuant in part to the specific grant of authority

stated in section 469(l), and that section 1.469-4(a), Income Tax

Regs., contains substantive rules that are legislative in

character, means that the promulgation of section 1.469-4(a),

Income Tax Regs., is not excepted from the notice and comment

requirements of the APA, 5 U.S.C. sec. 553(b) and (c) (1994).

See Chevron, U.S.A., Inc. v. Natural Resources Defense Council,

; Bankers Life & Cas. Co. v. United

; Water Quality Association Employees'

Benefit Corp. v. United 

; Wing v.

Commissioner, 

; see also Schaefer v. Commissioner,

(sec. 1.469-2T(c)(7)(iv), Temporary Income

Tax Regs., 53 Fed. Reg. 5716, is a legislative regulation because

it was issued under the specific grant of authority contained in

sec. 469(l)(2)).

     Section 469, the section of the Code to which sections

1.469-2(f)(6) and 1.469-4(a), Income Tax Regs., relate, was

enacted by Congress as part of the Tax Reform Act of 1986 (TRA),

Pub. L. 99-514, sec. 501(a), 100 Stat. 2085, 2233, in response to

congressional concern that certain categories of taxpayers were
                               - 13 -


engaging in activities which generated losses in order to use

those losses to escape taxation on income from unrelated

activities.   See Schaefer v. Commissioner, 

.

Section 469, which is generally effective for taxable years

beginning after December 31, 1986, TRA sec. 501(c)(1), 100 Stat.

2241, was designed by Congress to thwart a taxpayer's attempt to

reduce taxable income by losses which were attributable to

activities in which the taxpayer did not materially participate;

i.e., passive activities.   Section 469 generally prevents a

taxpayer from deducting passive activity losses from income

unrelated to a passive activity, requiring that passive losses be

used only to offset passive income.     A passive activity loss

includes all losses from passive activities, and a rental

activity is generally defined by section 469(c)(2) to be a

"passive activity".   Passive income does not include certain

types of income such as portfolio income (i.e., interest,

dividends, annuities, or royalties), gain on the disposition of

property, and earned income.   Sec. 469(e).

     The linchpin of section 469 is the determination of each

activity in which a taxpayer participates, and Congress delegated

to the Commissioner the responsibility of prescribing the meaning

of the word "activity".   See sec. 469(l)(1).    The first set of

proposed regulations set forth a voluminous and complex

mechanical test for determining a taxpayer's activities.     See

54 Fed. Reg. 20527, 20606 (May 12, 1989); see also sec. 1.469-4T,
                              - 14 -


Temporary Income Tax Regs., 54 Fed. Reg. 20543 (serves as text of

proposed regulations).   As applicable herein, section

1.469-4T(b)(2)(ii)(B), Temporary Income Tax Regs., 54 Fed. Reg.

20543, provided:

               (B) Operations conducted through
          nonpassthrough entities. For purposes of
          applying section 469 and the regulations
          thereunder, a taxpayer's activities do not
          include operations that the taxpayer conducts
          through one or more entities (other than
          passthrough entities). The following example
          illustrates the operation of this paragraph
          (b)(2)(ii)(B):

               Example. (i) A, an individual, owns
          stock of X, a closely held corporation * * *
          that is directly engaged in the conduct of a
          real estate development business. A
          participates in X's real estate development
          business, but does not own any interest in
          the business other than through ownership of
          the stock of X.

               (ii) X is subject to section 469 * * *
          and does not hold the real estate development
          business through another entity.
          Accordingly, for purposes of section 469 and
          the regulations thereunder, the operations of
          X's real estate development business are
          treated as part of X's activities.

               (iii) A is also subject to section 469 *
          * *, but A's only interest in the real estate
          development business is held through X. X is
          a C corporation and therefore is not a
          passthrough entity. Thus, for purposes of
          section 469 and the regulations thereunder,
          A's activities do not include the operations
          of X's real estate development business.
          Accordingly, A's participation in X's
          business is not participation in an activity
          of A, and is not taken into account in
          determining whether A materially participates
          * * * or significantly participates * * * in
          any activity. * * *
                               - 15 -


     Following comments and a hearing on the first set of

proposed regulations, see Announcement 89-110, 1989-36 I.R.B. 27

(Sept. 5, 1989), the Commissioner withdrew the proposed

regulations and allowed the related temporary regulations to

expire under the 3-year sunset provision of section 7805(e)(2).

See 57 Fed. Reg. 20803.   The Commissioner's actions were driven,

in part, by public criticism that the proposed regulations were

"overly long and complex, burdensome for small taxpayers, and

mechanically inflexible."    

the

withdrawal of the proposed regulations, the Commissioner, on May

15, 1992, issued a second set of proposed regulations defining

the word "activity".   57 Fed. Reg. 20802.   In contrast with the

first set, the second set contained a simple "facts-and-

circumstances approach to identify a taxpayer's activities."       

contrast with the first set of proposed regulations,

the second set did not address the treatment of activities which

were conducted through a C corporation in which the taxpayer

owned an interest.

     The Commissioner finalized the proposed regulations defining

the word "activity" in late 1994 to read in relevant part as set

forth above in section 1.469-4(a), Income Tax Regs.    T.D. 8565,

1994-2 C.B. 81, 83.    Before doing so, the Commissioner considered

the comments that were proffered on the subject.    59 Fed. Reg.

50485, 50486 (Oct. 4, 1994).   As was true with respect to the

first set of proposed regulations, but which was untrue with
                              - 16 -


respect to the second set, the final regulations addressed the

treatment of activities which were conducted through a C

corporation.   In a complete reversal from the position stated in

the first set of proposed regulations, the final regulations

provided an attribution rule under which a taxpayer's activities

include activities conducted through a C corporation subject to

section 469.   Sec. 1.469-4(a), Income Tax Regs.   In line with

this attribution rule, the preamble to the final regulations

stated:

          A commentator requested clarification on whether
     activities conducted through a C corporation may be
     grouped with activities not conducted through the C
     corporation. The final regulations clarify that in
     determining whether a taxpayer materially or
     significantly participates in an activity, a taxpayer
     may group that activity with activities conducted
     through C corporations that are subject to section 469
     (that is, personal service and closely held C
     corporations). [T.D. 8565, 1994-2 C.B. at 82.]

     As we understand the thrust of petitioners' argument, an

application of section 1.469-2(f)(6), Income Tax Regs., to the

material participant of a C corporation activity is vague

because, absent regulations, the meaning of the word "activity"

does not attribute to an individual the activities of a C

corporation.   According to petitioners, the breadth of the word

"activity" must be known in order to apply the rules of section

469 and the regulations thereunder, and the Commissioner did not

settle on a meaning for that word until he issued section

1.469-4, Income Tax Regs., in 1994.    Even then, petitioners
                                - 17 -


claim, the attribution rule set forth in section 1.469-4(a),

Income Tax Regs., is a substantial change from the rules set

forth in the proposed regulations, which, petitioners allege,

means that the Commissioner should have given notice and allowed

comment on the attribution rule pursuant to the APA, 5 U.S.C.

sec. 553(b) and (c) (1994).     Because the Commissioner did not,

petitioners conclude, the attribution rule of section 1.469-4(a),

Income Tax Regs., is invalid, which, in turn, invalidates the

recharacterization rule of section 1.469-2(f)(6), Income Tax

Regs., to the extent that it attributes the activities of a C

corporation to an individual who materially participates in that

activity.

     We disagree with petitioners' assertion that sections

1.469-2(f)(6) and 1.469-4(a), Income Tax Regs., are invalid as

applied in the instant case.     With respect to section

1.469-2(f)(6), Income Tax Regs., and section 469 in general, the

uncertainty as to the breadth of a provision does not mean that

it is inoperative until regulations are issued clarifying the

breadth of it.    See SEC v. Chenery Corp., 

, 201-203

(1947); Jacks v. Crabtree, 

, 985-986 (9th Cir. 1997);

Trans City Life Ins. Co. v. Commissioner, 

, 299-300

(1996).     In the absence of regulations, a provision may be

interpreted in light of all pertinent evidence, textual and

contextual, of its meaning.     See Commissioner v. Soliman,

, 174 (1993); Crane v. Commissioner, 

, 6-7
                              - 18 -


(1947); Old Colony R.R. Co. v. Commissioner, 

, 560

(1932).   Although Congress instructed the Commissioner to

prescribe regulations under section 469 which would specify what

constitutes an activity, see sec. 469(l)(1), this does not mean

that section 469 or the regulations thereunder require the

Commissioner to define the word "activity" in order for the

statutory and regulatory provisions to be effective.   We find

nothing in the statutory text, or in its legislative history,

that conditions the effectiveness of section 469 on the issuance

of regulations.   See Trans City Life Ins. Co. v. Commissioner,

; Estate of Neumann v. Commissioner, 

(1996); H Enters. Intl., Inc. v. Commissioner, 

,

81-85 (1995).

     As to petitioners' assertion concerning the new language

that appeared in section 1.469-4(a), Income Tax Regs., the change

in language from the proposed regulations was substantial; up

until the final regulations, the Commissioner had not publicly

taken the position that an individual's activities could include

activities conducted through a C corporation.   The mere fact,

however, that the Commissioner adopted a new position in section

1.469-4(a), Income Tax Regs., does not necessarily mean that the

Commissioner was required to give another notice and allow

another comment period on that position.   The Commissioner is not

required by the 

, to include in proposed regulations

every precise rule that ultimately appears in the final
                              - 19 -


regulations.   American Paper Inst. v. EPA, 

, 959 n.13

(4th Cir. 1981); California Citizens Band Association v. United

States, 

, 48 (9th Cir. 1967); Logansport Broadcasting

Corp. v. United States, 

, 28 (D.C. Cir. 1954).     The

consensus among the Courts of Appeals is that a final rule must

differ substantially from a proposed rule in order to require

another round of notice and comment, but even when it does differ

substantially, the final rule will not require another notice and

comment period if it is "in character with the original proposal"

and a "logical outgrowth" of the notice and comments on the

proposed rule.   National Mining Association v. Mine Safety &

Health Admin., 

, 530-531 (D.C. Cir. 1997); Alabama

Power Co. v. OSHA, 

, 745 (11th Cir. 1996); Rybachek v.

EPA, 

, 1287-1288 (9th Cir. 1990); American Med.

Association v. United States, 

, 767 (7th Cir. 1989);

Chemical Manufacturers Association v. EPA, 

, 203 (5th

Cir. 1989); United Steelworkers of Am., AFL-CIO-CLC v.

Pendergrass, 

, 113 (3d Cir. 1988); Natural Resources

Defense Council, Inc. v. EPA, 

, 1282-1285 (1st Cir.

1987); National Black Media Coalition v. FCC, 

, 1022

(2d Cir. 1986); American Paper Inst. v. 

n.13.   Whether a final rule meets such a test rests on whether

"'the purposes of notice and comment have been adequately

served.'"   Northwest Tissue Ctr. v. Shalala, 

, 528 n.7

(7th Cir. 1993) (quoting Fertilizer Inst. v. EPA, 

,
                              - 20 -


1311 (D.C. Cir. 1991)); American Water Works Association v. EPA,

, 1274 (D.C. Cir. 1994) (quoting Fertilizer Inst. v.

).   The critical inquiry is whether

commentators have had a fair opportunity to present their views

on the final plan in a way that the Commissioner might find

convincing.   American Water Works Association v. 

; Fertilizer Inst. v. 

; United Steelworkers of Am.,

AFL-CIO-CLC v. Marshall, 

, 1225 (D.C. Cir. 1980);

BASF Wyandotte Corp. v. Costle, 

, 642 (1st Cir.

1979); South Terminal Corp. v. EPA, 

, 658 (1st Cir.

1974); see also American Med. Association v. United 

; Natural Resources Defense Council v. 

; American Transfer & Storage Co. v. ICC, 

,

1303 (5th Cir. 1983); Wing v. Commissioner, 

.

Stated differently, the Commissioner's final regulations are not

subject to another notice and comment period where the proposed

regulations fairly apprise interested persons of subjects and

issues that may be addressed in the final regulations.      Wing v.

Commissioner, 

; see also Small Refiner Lead

Phase-Down Task Force v. EPA, 

, 547 (D.C. Cir. 1983);

American Iron & Steel Inst. v. EPA, 

, 293 (3d Cir.

1977).   The purposes of notice and comment are adequately served

when proposed rules generate diverse public comment, are fair to

affected parties, and give affected parties an opportunity to

develop evidence in the record.   Association of Am. R.R. v.
                              - 21 -


Department of Transp., 

, 589 (D.C. Cir. 1994); Small

Refiner Lead Phase-Down Task Force v. 

.

The purpose of notice and comment is not adequately served, on

the other hand, where interested persons could not reasonably

anticipate the final rules from the proposed rules.     Natural

Resources Defense Council, Inc. v. EPA, 

, 1429

(9th Cir. 1988); see also American Water Works Association v.

; Anne Arundel County v. EPA, 

,

418 (D.C. Cir. 1992).   Where the final rules deviate too sharply

from the proposed rules, notice is inadequate.   AFL-CIO v.

Donovan, 

, 338 (D.C. Cir. 1985); Small Refiner Lead

Phase-Down Task Force v. 

.

     Our review of the evolution of section 1.469-4(a), Income

Tax Regs., leads us to conclude that the amendments contained

therein are in character with the original scheme for section 469

and the regulations thereunder and are a logical outgrowth of the

comments which were made on the two sets of proposed regulations.

The Commissioner offered affected persons the opportunity to

develop an evidentiary record on the promulgation of section

1.469-4(a), Income Tax Regs., by inviting them to comment

publicly on the substance of each set of the proposed

regulations.   The first set of proposed regulations dealt

specifically with the attribution rule stating that a

corporation's activities will not be attributed to an individual

who conducts the activity through the corporation.    Although the
                              - 22 -


second set of proposed regulations was silent on this rule,

including whether the Commissioner was considering abandoning it,

we read nothing in the second set of proposed regulations that

would lead us to believe that the Commissioner was proposing to

retain the rule.4   Given the additional fact that the

Commissioner not only invited comments on both sets of the

proposed regulations, but held hearings as well, we do not

believe that commentators were deprived of their right to comment

on the matter included in section 1.469-4, Income Tax Regs.    The

first and second set of proposed regulations fairly apprised

interested parties of the wide range of issues that the

Commissioner had to address in the final rules defining the word

"activity", and the fact that the Commissioner invited comments

on both sets of proposed regulations allowed commentators to

express their views on the final plan in a way that the

Commissioner could find convincing.    The fact that persons who

were interested in the matter of section 1.469-4, Income Tax



     4
       Petitioners assert that agents of the Commissioner stated
publicly that the lack of an attribution rule, as it applied to C
corporations in the first set of proposed regulations, would be
retained in the final regulations. We give these assertions no
weight. Even assuming arguendo that the statements were made,
these oral statements are not binding on the Commissioner.
Martin's Auto Trimming, Inc. v. Riddell, 

, 506 (9th
Cir. 1960); Darling v. Commissioner, 

, 113 (4th Cir.
1931) (Government is not bound by agents acting beyond the scope
of their authority), affg. 

(1930); Fortugno v.
Commissioner, 

, 323-324 (1963), affd. 

(3d Cir. 1965); see also Wilkinson v. United States, 

, 

, 474, 475 (1962).
                              - 23 -


Regs., could have seen and anticipated an attribution rule

therein may also be understood from the legislative history of

section 469.   The legislative history speaks directly to an

attribution rule, stating explicitly:

     The conferees believe that clarification is desirable
     regarding the regulatory authority provided to the
     Treasury with regard to the definition of income that
     is treated as portfolio income or as otherwise not
     arising from a passive activity. The conferees intend
     that this authority be exercised to protect the
     underlying purpose of the passive loss provision, i.e.,
     preventing the sheltering of positive income sources
     through the use of tax losses derived from passive
     business activities.

          Examples where the exercise of such authority may
     (if the * * * [Commissioner] so determines) be
     appropriate include the following: * * * related party
     leases or sub-leases, with respect to property used in
     a business activity, that have the effect of reducing
     active business income and creating passive income. *
     * * [H. Conf. Rept. 99-841 (Vol. II), at II-197
     (1986), 1986-3 C.B. (Vol. 4) 147.]

     In sum, we believe that the purposes of notice and comment

were adequately served in the Commissioner's promulgation of

section 1.469-4, Income Tax Regs.   The Commissioner adopted the

attribution rule pursuant to an explicit congressional grant of

authority, and commentators had a fair opportunity to present

their views on the contents of that rule.   The rule derives

directly from the legislative history to section 469, and it is

both in character with the original proposal for section 469, and

the regulations thereunder, and a logical outgrowth of the two

rounds of notice and comment on the proposed regulations.

Whereas petitioners would force the Commissioner to comply with
                               - 24 -


the 

, upon the issuance of any taxpayer-unfriendly

rule, the APA, 

require such a Draconian result.

     We sustain respondent's determination on this issue.     In so

doing, we decline petitioners' invitation to allow them to apply

the rules of section 1.469-4T(b)(ii)(B), Temporary Income Tax

Regs., 54 Fed. Reg. 20543, in lieu of the rules stated in section

1.469-4(a), Income Tax Regs.   Simply put, the effective date and

transition rules related to the regulatory rules under section

469 do not allow them to use it.   See sec. 1.469-11, Income Tax

Regs.

     As to the accuracy-related penalty, section 6662(a) imposes

an accuracy-related penalty equal to 20 percent of the portion of

an underpayment that is attributable to, among other things,

negligence.   Petitioners will avoid this charge if the record

shows that they were not negligent; i.e., they made a reasonable

attempt to comply with the provisions of the Internal Revenue

Code, and they were not careless, reckless, or in intentional

disregard of rules or regulations.      Sec. 6662(c); Accardo v.

Commissioner, 

, 452 (7th Cir. 1991), affg. 

(1990); Drum v. Commissioner, T.C. Memo. 1994-433, affd. without

published opinion 

(9th Cir. 1995); see also Allen v.

Commissioner, 

, 353 (9th Cir. 1991) (negligence

defined as a lack of due care or a failure to do what a

reasonable and prudent person would do under similar

circumstances), affg. 

(1989).     Good faith reliance on
                              - 25 -


the advice of counsel or a qualified accountant can, in certain

circumstances, be a defense to the accuracy-related penalty for

negligence.   See, e.g., Ewing v. Commissioner, 

,

423-424 (1988), affd. without published opinion 

(9th Cir. 1991); Jackson v. Commissioner, 

, 539-540

(1986), affd. 

(10th Cir. 1989); Pessin v.

Commissioner, 

, 489 (1972); Conlorez Corp. v.

Commissioner, 

, 475 (1968).   In those cases, the

taxpayer must establish:   (1) The adviser had sufficient

expertise to justify reliance, (2) the taxpayer provided

necessary and accurate information to the adviser, and (3) the

taxpayer actually relied in good faith on the adviser’s judgment.

See Ellwest Stereo Theatres v. Commissioner, T.C. Memo. 1995-610.

     The record shows that petitioners acted reasonably with

respect to the items reported on their 1994 tax return.     They

consulted their long-time business and tax adviser, an

experienced and knowledgeable accountant, and they supplied him

with the information necessary to prepare their return.     The

C.P.A. advised petitioners on what he believed was the correct

reporting position of the items reported in the return, and

petitioners relied on and followed his advice.   Under the facts

herein, we believe that petitioners' reliance on the C.P.A. to

prepare a correct return was reasonable, and we hold for them on

this issue.
                              - 26 -


     In reaching our holdings herein, we have considered all

arguments by the parties for contrary holdings, and, to the

extent not discussed above, find those arguments to be irrelevant

or without merit.   To reflect the foregoing,


                                         Decision will be entered

                                    for respondent as to the

                                    deficiency, and for

                                    petitioners as to the

                                    accuracy-related penalty.