On March 27, 2014, the United States Tax Court ruled in Frank Aragona Trust v. Commissioner,1 instructing on the question  of material participation of trusts. In a case of first impression,  the Tax Court held that a trust qualified for the “real estate  professional” exception under the passive loss rules by  materially participating in a trust-owned real estate business.  As a result, the trust could deduct losses incurred in conducting  the real estate business as losses from non-passive activities. The Tax Court’s decision in Aragona Trust  is  a  victory  for  taxpayers under the passive loss rules, however, the court’s  ruling is of even greater significance in light of the new 3.8%  Medicare surtax on net investment income (the “NII Tax”) under  the Affordable Care Act of 2010. With scant time remaining until  the September 15th deadline to file partnership tax returns on  extension for 2013, taxpayer s and advisor s are now tasked with  interpreting the court’s decision to determine its application to  other trust arrangements.

  1. Background: The NII Tax and  Material Participation

Effective January 1, 2013, Internal Revenue Code Section  1411 imposes a 3.8% tax on net investment income of certain  high-income individuals, estates, and trusts. Net investment  income is generally comprised of interest, dividends, annuities,  royalties, rents, income der ived from a trade or business, gains  derived from the disposition of property, and other non-passive  income, less properly allocable expenses. The NII Tax is  imposed on estates and trusts with undistributed net investment  income and adjusted gross income at a very low threshold.2 With many trusts owning interests in businesses that produce. trade or business income each year, the application of the NII  Tax requires that taxpayers and fiduciaries engage in proper  planning in light of this new surtax.

The NII Tax does not apply where the taxpayer “materially  participates” in the activity producing the net investment income.  Section 1411 looks to the passive loss rules to determine what  constitutes material participation. Under the passive loss rules, a taxpayer is treated as materially participating in an activity  if the taxpayer is involved in the operations of the activity on a  “regular, continuous, and substantial basis.”

While individuals may use one of seven clearly defined  quantitative tests outlined in the Treasury Regulations (for  example, the widely known 500-hour test) to establish material  participation, no legislative or regulatory guidance is currently  available in the context of a trust. There is but one statement  regarding trusts in the legislative history surrounding the  passive loss rules, which states that a trust “is treated as  materially participating in an activity… if an executor or fiduciary,  in his capacity as such, is so participating.” 3 Determining which  activities qualify for purposes of material participation has been  a source of contention between the Internal Revenue Service  (IRS) and taxpayers for over a decade.

Relying on the legislative history, the IRS asserts that only the  activities of the trustee acting in a fiduciary capacity should  count in establishing material participation by a trust. This  “fiduciary capacity” argument was first tested by the IRS in  Mattie K. Carter Trust v. U.S.,4 in which a federal district court  rejected the IRS’s narrow position on the issue. In Carter Trust,  the trust operated a ranch, the day-to-day operations of which  were overseen by a non-trustee ranch manager and conducted  by ranch employees. The trustee of the trust reviewed financial  materials and made financial decisions on behalf of the trust,  but did not participate in the daily operations of the ranch.  The taxpayer in that case sought to include the activities of  the trustee as well as the activities of the non-trustee ranch  manager and all ranch employees in determining whether the  trust materially participated in the ranch business. By contrast,  the IRS argued that only the limited financial activities of the  trustee should be taken into account. The court rejected the  IRS’s argument, stating that it had studied the “snippet of  legislative history [the] IRS supplied” and found the contention  that only the trustee’s activities should be considered “is  arbitrary, subverts common sense, and attempts to create ambiguity where there is none.” As a result, the activities  of all those acting on behalf of the trust were included in  the determination that the trust materially participated in the ranch business.

Following the IRS’s loss in Carter Trust, the IRS issued two  Technical Advice Memoranda and a Private Letter Ruling 5  in  which the IRS rejected the district court’s opinion in Carter Trust and further expounded upon its fiduciary capacity argument  in light of various planning techniques. In Technical Advice  Memorandum 200733023, the IRS concluded that merely  labeling an employee of a trust-owned business as “Special  Trustee” would not count for purposes of establishing material  participation by the trust unless the Special Trustee retained  final decision-making authority with respect to the trustowned business. Further, in Technical Advice Memorandum  201317010, the IRS held that where an individual serves in a  dual role as both trustee and officer or trustee and shareholder,  work performed in the individual’s non-fiduciary role as officer  or shareholder must be separated out and should not be  considered in establishing material participation by a trust.

  1. The Decision: Aragona Trust

The Frank Aragona Trust (the “Trust”) owned rental real estate  properties and invested in developed real estate. For liability  reasons, some of the Trust’s real estate activities were operated  through a wholly-owned limited liability company (the “LLC”).  Following the settlor’s death, the settlor’s five children and a  non-family member were appointed as co-trustees of the trust.  Three of the children-trustees were employed full time by the  LLC. The Trust incurred losses in 2005 and 2006, which the  Trust sought to carry back to prior years. The issues before the  court were: (1) whether the Trust could qualify for treatment as  a “real estate professional” and (2) whether the Trust materially  participated in its real estate businesses through the activities  of its trustees and/or employees.

With respect to the real estate professional exception, the IRS  argued that a trust could never meet this exception to passive  loss treatment because, as a threshold matter, a trust does not  meet the definition of “individual” under the Regulations and  therefore is incapable of performing “personal services,” which  are required to meet the exception. The court rejected the IRS’s  argument, reasoning that “[i]f the trustees are individuals, and  they work on a trade or business as part of their trustee duties, their work can be considered ‘work performed by an individual  in connection with a trade or business.’” Therefore, the Tax  Court concluded that a trust can satisfy the requirements of  the real estate professional exception.

As to the issue of material participation in the context of a trust,  the Tax Court further held that the Trust materially participated  in its real estate business. In so holding, the court disregarded  the IRS’s fiduciary capacity argument and found that the  activities of the trustees, including the activities of three of the  trustees acting as employees of the LLC, should be considered  in the determination of material participation. The Tax Court  reasoned that all the activities of the three trustee-employees  should count toward the Trust’s material participation because  state law required the trustees to administer the trust solely in  the interests of the beneficiaries, and the trustees were not  relieved of this duty of loyalty merely by conducting the real  estate activities through a wholly-owned LLC.

  1. Analysis and Key Guidance

The Tax Court’s decision in Aragona Trust  is the second  published opinion to reject the IRS’s fiduciary capacity  argument with respect to material participation by a trust.  While the IRS may seek to appeal the Tax Court’s decision,  the Aragona Trust  case provides taxpayers and fiduciaries  with a more clearly defined framework for establishing material  participation in the context of a trust. The key guidance  gleaned from the Tax Court’s decision in Aragona Trust can  be summarized as follows:

  • Reliance on State Law. The Tax Court turned to state law  in finding the activities of the trustees as employees of  the trust-owned LLC should be considered in determining  whether the trust materially participated in the real estate  business. Under the law of every state, trustees owe a duty  of loyalty to trust beneficiaries. Therefore, the Tax Court’s  decision in Aragona Trust highlights the impor tance of state  trust law as support for establishing material participation  when a fiduciary holds dual roles.
  • Structural Arrangement. Aragona Trust  involved an LLC  wholly owned by the Trust. In analyzing this arrangement,  the court held that the actions of the trustees employed  by the LLC should be considered in determining if the  Trust materially participated in the real estate business.  The Tax Court reasoned that the duty of loyalty imposed  by state law was not diminished merely because the  business activities of the Trust were conducted through a wholly-owned LLC. The Tax Court did not indicate that  its holding was limited to the LLC arrangement used by  the Trust in Aragona Trust, and the cour t’s rationale would  seem equally as applicable in an array of other structural  arrangements given the nature of a trustee’s duty of loyalty.  Until further guidance is available on this issue, however,  it is advisable to follow the LLC arrangement in Aragona Trust as a model in structuring the business activities of  a trust.
  • Material Participation Among Co-Trustees. Many questions  with respect to satisfying the material participation  requirements have arisen when multiple trustees act  on behalf of a trust. There is currently no guidance as  to whether all, a majority, or only one co-trustee must  participate in a trust’s business activities to meet the  material participation requirements. While the Tax Court  does not explicitly address this question, the Tax Court  nevertheless found the Trust in Aragona Trust materially  participated when only three of the six co-trustees (i.e., not  a majority) were participating. Therefore, taxpayers may  point to Aragona Trust as support where not all co-trustees  are active in a trust’s business.
  • Activities of Non-Trustee Employees. With respect to  activities of non-trustee employees of a trust, the Tax  Court in Aragona Trust did not go as far as the district  court in Carter Trust. While in Carter Trust, the district  court found that the actions of all individuals acting on behalf of a trust, including agents and employees, could  be considered for purposes of material participation the Tax Court noted in Footnote 15 of the Aragona Trust  decision that under the issues raised by the parties, it  was not necessary for the Tax Court to decide whether  the activities of non-trustee agents or employees should  be disregarded. Nevertheless, contrary to the IRS’s strict  fiduciary capacity approach to material participation of  trusts, the Tax Court explicitly found that all of the activities  of the three trustee-employees, including their activities as  employees of the trust-owned LLC, should be considered  in determining whether the Trust materially participated  in the real estate business. Therefore, while there is still  limited precedent on whether the activities of non-trustee  employees and agents should count toward the material  participation of a trust, the Tax Court’s decision in Aragona  Trust suppor ts the proposition that all activities per for med  by a trustee should be considered for purposes of meeting  the material participation requirements.

As with any court decision, extreme care and consideration  must be given to distinguishing factors between the facts in  a given case and another taxpayer’s situation. Nonetheless,  the Tax Court’s decision in  Aragona Trust establishes additional precedent that challenges the IRS’s position and  lends support to positions many taxpayers and advisors will  undoubtedly wish to take on those 2013 partnership returns  currently on extension.