On March 27, 2014, the Tax Court released its much-anticipated decision in the Frank Aragona Trust case. At issue in the case was how material participation of a trust is determined under the passive activity loss rules and whether a trust can qualify for the exception to the passive activity loss rules for taxpayers who are engaged in a real estate business on a substantially full-time basis.
In general, losses from a business activity conducted by an individual as a proprietor or through an entity or trust are treated as passive losses unless the taxpayer “materially participates” in the activity. Passive losses can be deducted only against other passive activity income. The principal way that a taxpayer can materially participate is by spending more than 500 hours during the year on the activity.
In the case of rental activities, including real estate, the activity is always passive, even if the taxpayer does materially participate. There is an exception to this rule, however, in IRC Section 469(c)(7) for people who work substantially full-time in a real estate business. If the taxpayer materially participates and also spends more than half of his working time and more than 750 hours in real estate trades or businesses, then his real estate rental activity is not a passive activity.
The concept of passive activity has recently taken on expanded importance beyond just limiting the deduction of losses. If a taxpayer does not materially participate in a business activity in which he has an ownership interest, then his income from that activity is also subject to the new 3.8 percent Medicare tax imposed on net investment income.
The IRS has consistently taken a very narrow view of how a trust can materially participate in a business activity. Its position has been that only participation by actual trustees may be considered and then only to the extent they participate in their capacity as a trustee. If they are also employed by a business owned by the trust, the IRS has said that their participation as an employee of the business cannot be counted. The IRS took an even narrower view of the full-time real estate exception and said that a trust simply cannot qualify for that exception.
These positions of the IRS came before the Tax Court in the Frank Aragona Trust case. The court took a very long time to reach its decision after the trial was completed and the parties’ briefs had been filed. People who follow the passive activity area have been eagerly awaiting the result, which was a significant taxpayer victory.
The court first determined that there is nothing in IRC Section 469(c)(7) or its legislative history that would lead to a conclusion that the exception was not intended to apply to trusts. Having dispensed with that issue, the court turned to how the level of participation by the trust was determined. The court determined that all activities of the trustees, whether in their trustee capacity or in their capacity as an employee of the business owned by the trust, should be counted. In this case, three of the trustees worked full-time in the trust’s real estate business, so all of the participation requirements were easily satisfied.
The court did not have to decide, and so left for another day, the question of whether the activities of employees of the trust or its business who are not also trustees can be counted. Again, the IRS does not think so. Thus far, one District Court in Texas, in the Mattie Cartercase, has held that the activities of any employees can be counted. That issue may eventually reach the Tax Court as well. The government may also appeal the Aragona case to the Court of Appeals.