In a long-awaited ruling, the U.S. Tax Court in Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014), has ruled that a trust can materially participate in trade or business activities based on the efforts of its trustees, regardless of whether the trustees are acting in their fiduciary capacity.
The decision is especially important in light of the Section 1411 net investment income tax, which imposes a 3.8% tax on the interest, dividends, capital gains, rents, royalties, annuities and other passive income earned by individuals, trusts and estates. All of a trust’s trade or business that is considered passive under Section 469 will be included in net investment income under Section 1411.
In Frank Aragona Trust, the taxpayer was a complex residuary trust that owned rental real estate property and was involved in real estate development. The trust had six trustees, three of whom were employed full time by a limited liability company that was wholly owned by the trust and that was treated as a disregarded entity for federal tax purposes. That entity managed most of the trust’s real estate holdings and employed other individuals to carry out certain business activities.
The trust incurred losses in 2005 and 2006 from its real estate activities and deducted the losses as arising from nonpassive activities. The IRS issued a notice of deficiency, asserting the trust’s real estate activities were passive under Section 469(c)(2) because the trust could not qualify as real estate professional and did not materially participate in the activities.
Section 469, generally
Under Section 469, a taxpayer’s passive activity losses in excess of passive income are disallowed unless the taxpayer “materially participates” in a trade or business activity. Rental activities are per se passive under Section 469(c)(2), but under Section 469(c)(7), the rental real estate activities of taxpayers who qualify as “real estate professionals” are not subject to this per se passive rule. To qualify as a real estate professional, a taxpayer must pass two tests under Section 469(c)(7)(B):
One half of the “personal services” performed in trades or businesses by the taxpayer must be performed in real property trades or businesses in which the taxpayer materially participates.
The taxpayer must perform more than 750 hours of real property trade or business “services” during that year.
For individual taxpayers, these tests are straightforward under the regulations. However, it has been unclear how to apply these tests to an estate or trust, and whether a trust can provide “personal services,” as an individual taxpayer can. The question of whether a trust can materially participate in a trade or a business has caused significant controversy.
The IRS has long argued in private letter rulings, technical advice memoranda and similar guidance that a trust may not materially participate in a trade or business activity by itself. Rather, a trust may materially participate by virtue of its trustees and only in their capacity as fiduciaries, and not in any other capacity (such as employees or owners). In support of this position, the IRS has relied on the legislative history of Section 469. The Senate Finance Committee’s report on the Tax Reform Act of 1986, which created Section 469, said that a trust is treated as materially participating in an activity “if an executor or fiduciary, in his capacity as such, is so participating.”
On the question of whether a trust can qualify as a real estate professional under Section 469(c)(7), the IRS cited the Ways and Means Committee’s report, H.R. Rept. No. 103-11 (1993), which said that the exception applies to individuals and closely held C corporations. The IRS argued that the report’s failure to say the exception applies to trusts proves that trusts cannot qualify for the exception.
Tax Court’s analysis
In Frank Aragona Trust, the IRS argued that a trust could not satisfy the performing “personal services” prong of the real estate professional test under Section 469(c)(7)(B), because the regulations define “personal services” as work performed by an individual. The Tax Court rejected this argument. The court said that if Congress wanted to exclude trusts from the real estate professional exception under Section 469(c)(7), it could have explicitly done so in the statute.
The court also rejected the IRS’s argument that the 1993 Ways and Means Committee report precluded trusts from qualifying under the real estate professional exception. The legislative history “does not compel the conclusion that only individuals and closely held C corporations can qualify for the section 469(c)(7) exception,” [emphasis in the original].
Finally, the Tax Court rejected the IRS’s argument that only the activities of the trustees – and not the activities of the trusts’ employees – can be considered in determining material participation by the trust. The court stopped short of determining whether the activities of nontrustee employees should be considered in determining the material participation of the trust, but said the efforts of the trustees, including their efforts as employees of the underlying business, should be considered.
At the very least, the Tax Court’s decision in Frank Aragona Trust goes a long way to settle the question of when a trust can materially participate in an activity for purposes of the Section 469 passive activity rules. It also addresses the question of whether a trust may qualify under the Section 469(c)(7) exception to the passive activity loss rules as a real estate professional.
The decision creates an opportunity for taxpayers to argue that a trustee’s activities, regardless of whether they are conducted in the role of fiduciary, should count toward determining material participation. This is especially important considering the new net investment income tax of Section 1411. For trusts and estates, the 3.8% tax is imposed on undistributed net investment income to the extent adjusted gross income exceeds the trust’s highest tax bracket. In 2014, the tax would start at $12,150.
The Tax Court’s decision, however, does not address whether the activities of a nontrustee employee of the trust count toward establishing material participation by the trust. It is worth noting however, that a U.S. district court in 2003 ruled that the actions of a trust’s agents and employees should be considered in measuring a trust’s participation in an activity. See Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Texas 2003).
Since at least 2003, the IRS has taken an aggressive position in determining whether a trust can materially participate. The Tax Court’s decision in Frank Aragona Trust may cause the IRS to adjust its litigating position, but it is not clear how the IRS will address the trust material participation issue going forward – especially for nontrustee employees. Additional guidance on the issue would help taxpayers, but again, it is unclear if and when additional guidance will be issued.
In response to the Frank Aragona Trust decision, trusts should consider extending their filing date, to determine whether they materially participate in business activities. These issues can be very complex. Fiduciaries should consult with experienced tax professionals before making a determination.
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