This article was published in the Real Estate and Tax sections of Law360 under the title "Tax Court Fails to Address Important Trust Income Issues" on July 9, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360.
The issue of whether a trust has passive or non-passive income from its investment in a pass-through entity has taken on increased importance in light of the tax imposed on net investment income under Code Section 1411 of the Internal Revenue Code of 1986, as amended (the “Code”). The increased scrutiny of the distinction between passive and non-passive income arises because income derived from a passive activity is subject to the net investment income tax, whereas income from an active trade or business is not subject to the new tax.
In the case of Frank Aragona Trust, et al. v. Commissioner, 142 T.C. No. 9, (3/27/14), the United States Tax Court determined that a trust engaged in rental real estate activities, both directly and indirectly through other entities, qualified for the Code Section 469(c)(7) “real estate professional” exception to the passive loss rules for rental real estate activities. The court found against the IRS’s position that the Trust was barred from qualifying for the real estate professional exception because a Trust could not perform personal services and could not materially participate. The court held that a Trust is capable of performing personal services by and through its individual trustees. It further held that the trustees’ activities as employees of a limited liability company (LLC) wholly owned by the Trust enabled the Trust to materially participate.
The Trust was a residuary trust with six trustees, five of whom were the deceased grantor’s children and one was an independent trustee. One of the children, Paul Aragona, was designated as the executive trustee to facilitate the Trust’s daily business operations. The trustees acted as a management board for the Trust by making all major decisions. The board met every few months to discuss the Trust’s business. Each of the trustees received a trustee fee. Three of the trustees, including Paul Aragona, worked full-time for Holiday Enterprise, LLC (Holiday), which was wholly owned by the Trust. Holiday managed most of the Trust’s rental real estate properties, and paid wages to the three trustee employees. The Trust also owned interests in a number of entities engaged in owning and holding real estate for investment and development. The Trust conducted its real estate rental activities through direct real estate ownership, through wholly owned entities, and through entities in which it owned majority interests. Two of the trustees owned minority interests in the entities in which the trust owned majority interests. The Trust also conducted real estate holding and real estate development operations through entities in which it owned majority or minority interests and in which two of the trustees owned minority interests.
The Trust classified the losses from the rental real estate activities in 2005 and 2006 as losses from non-passive activities. The Trust carried back the losses to 2003 and 2004. The Trust claimed that it met the Code Section 469(c)(7) exception to the general rule that rental real estate activities are passive. This exception applies to remove a real estate activity from passive activity loss characterization if (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participated, and (ii) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participated.
The IRS claimed that the rental real estate losses were passive activity losses that could not be deducted and carried back as an NOL. The IRS’s position was that a trust is incapable of satisfying the Code Section 469(c)(7)(B)(i) exception because it requires the performance of “personal services by the taxpayer.” The IRS supported its position by citing the regulations, which provide that personal services mean work performed by an individual in connection with a trade or business. Consequently, in the IRS’s view, only an individual can perform personal services; because a trust is not an individual, a trust cannot not perform personal services and, thus, cannot use the exception.
The court rejected the IRS’s argument, noting that a trust is an arrangement in which trustees manage assets for the trust’s beneficiaries. The court found that if individual trustees work in a trade or business as part of their trustee duties, their work can be considered work performed by an individual in connection with the trade or business of the trust. On that basis, a trust is capable of performing personal services through its trustees and therefore can satisfy the exception. After examining the legislative history to Code Section 469(c)(7), the court concluded that if Congress had wanted to exclude trusts from this exception it could have done so explicitly by limiting the exception to a natural person, but that the use of the term “taxpayer” in this section suggests that Congress did not intend to exclude trusts from the exception.
Having lost on the question about whether a trust can satisfy the personal services exception, the IRS’s fallback position was the Trust did not qualify for the exception because it did not materially participate in real property trades or businesses. The IRS argued that in determining whether a trust materially participates in an activity, only the activities of trustees can be considered and the activities of the Trust’s non-trustee employees must be disregarded. The IRS further argued that the trustees who were employees of Holiday could not include, in the determination of whether the Trust satisfied the passive activity rules, any of the hours performed by them as employees. This position was based on the legislative history, which provides that a trust is treated as materially participating if an executor or fiduciary, in its capacity as such, is so participating. The legislative history further provides that the activities of employees are not attributed to the taxpayer. On the basis of these legal principles, the IRS contended that the activities of the three trustees who were employees of Holiday should be ignored, because such activities should be considered the activities of employees and not fiduciaries. The IRS reasoned that the trustees performed their activities as employees of Holiday, and that it was impossible to disaggregate the activities they performed as Holiday employees from the activities that they performed as trustees.
The court found that the activities of the trustee/employees should be considered in determining whether the Trust materially participated in its real estate operations. The court based this conclusion on Michigan law, under which trustees are obligated to administer a trust solely in the interest of the beneficiary (which is the general rule and not limited to Michigan). As a consequence, the trustees’ activities as Holiday employees were considered by the court in determining whether the Trust materially participated. However, the court did not delineate how to parse the trustee/employee’s time spent on the Trust’s business. It merely noted that the Trust’s real estate operations were substantial and that the three trustees/employees worked full-time in the real estate businesses. The court observed that the Trust had practically no other types of operations and the trustees handled practically no other business on behalf of the Trust.
The IRS made a further argument based on the fact that two of the trustees/employees had minority interests in all of the entities in which the Trust operated its real estate holdings and real estate development projects, and they had had minority interests in some of the entities through which the Trust operated its rental real estate business. On account of these ownership interests, the IRS contended that some of their efforts in managing the joint entities should be attributed to their personal portions of the business and not the Trust’s portions. The court rejected that contention as well, by pointing out that trustees/employees’ combined ownership interest did not exceed 50 percent, was not greater than the Trust’s ownership interest, and that their interests as owners were generally compatible with the Trust’s goals. Even considering their personal ownership, the court held that the two trustees/employees’ activities were sufficient for the Trust to materially participate in the real property trades or businesses.
Having determined that a trust can provide personal services and that the Trust materially participated, the next inquiry would have been whether the personal services provided by the Trust were sufficient to meet the remainder of the Code Section 469(c)(7) test – namely, were more than one-half of the personal services performed in real property trades or businesses, and did the Trust perform more than 750 hours of services during the year in the real-property trades or businesses? However, the IRS had limited its arguments to the two specific issues of whether a trust is categorically barred from qualifying under the exception and whether the Trust materially participated. Because both of these issues were resolved in favor of the Trust, the court found that the Trust satisfied the Code Section 469(c)(7) exception for the years at issue.
The court at no time gave any significance to the fact that Holiday was wholly owned by the Trust. Therefore, the court left open the issue of whether the activities of trustees would count if the trustees had been employees of an entity in which the Trust owned less than all of the interests. If a lesser ownership level would permit attribution of the trustees’ activities, what level of ownership would count? Only more than 85 percent? Anything more than a majority? Less than a majority? The court also did not address how to measure the extent of trustees’ activities necessary to cause a trust to materially participate. Are the activities of each of the trustees aggregated? Are they aggregated using an hours test? Must the aggregate time reach 500 hours or can a trust satisfy the facts and circumstances test with less aggregate time? Does it matter if the trustees are employees of several different entities in which a trust has an ownership interest? Would it matter if a trust owned a minority interest and the trustee owned a majority interest? If a trustee has an ownership interest, can the trustee’s time count both for satisfying the trustee’s material participation for the trustee’s personal tax return and for satisfying the material participation test for the trust?
Furthermore, the court did not decide whether the activities of non-trustee employees should be counted in determining that the trust materially participated. Allowing the activities of those persons to count would greatly expand the class of persons whose activities could be used to enhance the ability of a trust to be found to have materially participated.
Pepper Perspective: Aragona is a significant taxpayer victory in its conclusion that a trust can satisfy the real estate professional exception, and that the activities of trustees who are employees of an entity owned by a trust can satisfy the material participation standard. However, the conclusion about material participation was based on the particular facts of Aragona, and many trusts will have facts that are not as favorable as the Aragona facts. The failure of Aragona to explain whether the trustees’ activities are aggregated, need to reach 500 hours in the aggregate, and would count if the trust owned less than 100 percent of the interests in the entity in which the trustees were employed are tantalizing questions that will need to be resolved in subsequent cases.
W. Roderick Gagné and Lisa B. Petkun
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