Income Tax Alert: Tax Court Rules That Trust Qualifies For Passive Activity Exception

On March 27, 2014, the U.S. Tax Court issued its decision for the case of Frank Aragona Trust et al. v. Commissioner, 142 T.C. No. 9, No. 15392-11 (2014). The Court held that the Frank Aragona Trust (“the Trust”) qualified for the Internal Revenue Code (“IRC”) Sec. 469(c)(7) passive activity exception. The Tax Court found that a trust is capable of performing personal services through its individual trustees and that the Trust materially participated in real property trades or business. It concluded that the Trust’s rental activities were consequently not passive.

In light of the recent imposition of the 3.8 % Net Investment Income Tax (NIIT), this ruling is especially important because any income derived from trade or activities in which a trust or estate materially participates would not be subject the NIIT.

Background.

The Frank Aragona Trust is a residuary trust that owns rental real estate properties and engages in other real estate activities. The trustees of the Trust consist of five siblings and one unrelated individual, who serves as an independent trustee. Together, the trustees act as a management board for the Trust, and three of the sibling-trustees work as full time employees for an LLC wholly owned by the Trust that manages the Trust’s rental properties.

The IRS determined that the Trust’s rental activities were passive activities, which resulted in a finding of deficiency due to the resulting increase in passive activity losses of the Trust. The Trust challenged this determination in the Tax Court.

Summary of Tax Court’s Opinion.

Tax Court Judge Richard T. Morrison’s opinion addressed whether or not the Trust qualified for the Sec. 469(c)(7) exception, which provides an exception for the per se passive activity determination of a taxpayer’s rental real estate activities.

IRC Sec. 469(c) provides that for the purposes of defining passive activities, any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity. However, if a taxpayer meets the two requirements of IRC Sec. 469(c)(7)(B), such rental activities will not be considered passive. The first requirement of IRC Sec. 469(c)(7)(B) provides that more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. The second requirement provides that the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

  1. First Holding.

The first contention of the IRS was that a trust could not qualify for the IRC Sec. 469(c)(7) exception because a trust cannot perform “personal services.” Income Tax Reg. 1-469-9(b)(4) defines “personal services” to mean “work performed by an individual in connection with a trade or business.” The IRS argued that a trust is not an individual, so it cannot perform personal services, and therefore doesn’t qualify for the exception.

However, in its analysis, the Court stated that if a trust’s trustees are individuals that work on a trade or business as a part of their trustee duties, then their work could be considered “work performed by an individual in connection with a trade or business.” Thus, the Court rejected the IRS’s argument and concluded that a trust is capable of performing personal services, allowing it to qualify for the IRC Sec. 469(c)(7) exception.

  1. Second Holding.

Second, the IRS argued that even if some trusts could qualify for the IRC Sec. 469(c)(7) exception, the Trust did not qualify because it did not materially participate in real property trades or businesses. IRC Sec. 469(c)(7) exception requirements can only be met if a taxpayer materially participates in a real property trade or business.

IRC Sec. 469(h) provides the definition for what it means to materially participate in activity, stating that a taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous and substantial. While the Treasury Department has promulgated regulations for determining whether taxpayers who are individuals materially participate in an activity, no regulations have yet been promulgated for taxpayers that are trusts.

Consistent with its position in IRS Technical Advice Memorandum (TAM) 201317010, the IRS argued that when determining whether a trust materially participates in an activity, only the activities of the trustees as fiduciaries can be considered and not the activities of any employee of the trust.

The Tax Court however rejected this reasoning, and instead held that the activities of the trustees of the Trust, including their activities as employees of the wholly owned LLC, should be considered in determining whether the trust materially participated in its real estate operations. This decision is consistent with the Mattie K. Carter Trust case (Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003)), in which a Texas district court held that a trust’s material participation should be determined by considering the activities of the trust’s fiduciaries, employees and agents. After reviewing the activities of the six trustees, the Court found that the Trust materially participated in its real estate operations.

  1. Conclusion.

Consequently, the Court held that the Trust met the IRC Sec. 469(c)(7) exception for the years at issue and held that the trust’s rental real estate activities were not passive.

Significant Takeaways.

Two of the important legal takeaways from this case are the Tax Court’s rejection of the IRS arguments made in TAM 201317010 and that its decision did not challenge the Mattie K. Carter Trust case. Instead, its decision confirmed that a trust can materially participate in real estate activities, but more importantly that activities of a trustee who is also an employee of a trust can be used to assess whether or not a trust materially participates in an activity.

For estate planning purposes, this case also has important implications for the application IRC Sec. 1411 and the NIIT to trusts. IRC Sec. 1411(c) provides that the tax only applies to net investment income derived from trades or businesses that are considered passive under IRC Sec. 469. As previously discussed, if the trust materially participates under the requirements of IRC Sec. 469(c)(7) in the trade or business, the activity isn’t considered passive, and consequently, the NIIT would not apply. The Court’s decision makes it easier for trusts to materially participate, which in turn would allow more trusts to avoid the 3.8% net investment income tax. Such considerations should be taken into account when planning for a trust that will hold rental real estate properties.

For a more detailed discussion on material participation by trusts and estates, see Lewis Saret’s CCH article “Material Participation of Trusts & Estates Part 1.”

 

Written by Allaya Lloyd.

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