The taxpayer’s victory in the Aragona decision makes it easier for a trust to materially participate in a business or real estate activity, allowing the trust to avoid paying the net investment income tax on its income. The decision sets the stage for the 2013 filing season. The court contradicts a recent Technical Advice Memorandum providing that a fiduciary cannot consider work done in another capacity.

One of the most vexing tax issues remaining unresolved since the 1986 enactment of the passive loss (PAL) rules is whether business or rental income earned by a  trust can be active income and whether business or rental losses sustained by a trust can be active  losses.1 The enactment of the 3.8 percent net investment income tax (NII Tax) increases the  significance of the uncertainty surrounding this issue. The taxpayer’s total victory in the March  27, 2014, tax court decision, Frank Aragona Trust v. Commissioner,2 provides a partial answer to  this question just in time for the 2013 tax filing season. Because the Internal Revenue Service  (IRS) may yet appeal this case, it does not definitely resolve these issues.

Income or losses for PAL purposes are generally active when the taxpayer “materially participates”  in the business or real estate activity. Congress enacted the PAL rules to prevent a taxpayer from  taking business or rental activity tax losses against portfolio, salary   and   other   income,   unless   the   taxpayer   materially 

participated in the business or rental activity generating the loss. These rules are significant for purposes of the NII Tax because income from a business or real  estate activity if active is exempt from the NII Tax and if passive is subject to the NII Tax.

Although the PAL regulations are clear that an individual taxpayer’s material participation depends  on meeting one of the seven tests based on the hours worked in the business, the regulations  provide no guidance on how to determine whether a trust has materially participated in a business  or real estate activity held in the trust. The PAL regulations specifically reserve on this  question. In the more than 25 years since the PAL regulations for individual taxpayers were  finalized, until the Aragona decision, the only guidance available for determining whether a trust3  materially participates consisted of one sentence of legislative history, a single court case  (Mattie K. Carter Trust v. United States4), a regulation under a different code section and less  than  a  handful  of  private  rulings.5 The  Aragona decision6 is an important addition to the limited guidance on this subject.

Facts

During the tax years at issue in the case, the trustees of the Frank Aragona Trust were Frank  Aragona’s five children and a lawyer. One son, Paul, was named  executive trustee; the lawyer was  named independent trustee. The day-to-day management activities of the real estate businesses held  in the trust were delegated to Paul. The trust owned rental real estate properties and held and  developed real estate.

The trust held  100 percent of Holiday Enterprises, LLC (the LLC),7 which managed most of the  trust’s real estate rental activities. Three of the trustees were full-time employees of the LLC.  The LLC also employed other individuals. The rental properties generated losses in 2003, 2004 and  2006. The trust deducted these losses against its income from other trust assets.

Issues

For the trust to deduct its losses, it had to establish that:

  1. The trust was a “real estate professional” under the PAL rules. The IRS argued that it was not  possible for a trust to be a real estate professional.
  2. The trust materially participated in the rental activities. The IRS argued that the trust did  not do so because the trustees participated in the rental activities as employees of the LLC, and  not as trustees.

The court found for the Taxpayer on both issues.

Court’s Analysis

The most important aspect of the decision is the court’s ruling on the second issue.  Although the  court’s ruling on the first issue is a win for this taxpayer, certain procedural issues may limit  its value for other taxpayers.

not be considered in determining whether the trust materially participated. The court rejected that position, saying:

Even if the activities of the trust’s non-trustee employees should be disregarded, the activities  of the trustees— including their activities as employees of  Holiday Enterprises, LLC—should be  considered in determining whether the trust materially participated in its real-estate operations.  The trustees were required by  Michigan statutory law to administer the trust solely in the  interests of the trust beneficiaries, because trustees have a duty to act as a prudent person would  in dealing with the property of another, i.e., a beneficiary …

Trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities  through a corporation wholly owned by the trust. ... (“Trustees who also happen to be directors of  the corporation which is owned or controlled by the trust cannot insulate themselves from probate  scrutiny [i.e., duties imposed on trustees by Michigan courts] under the guise of calling  themselves corporate directors who are exercising their business judgment concerning matters of  corporate policy.”). Therefore their activities as employees of Holiday Enterprises, LLC, should be  considered in determining whether the trust materially participated in its real-estate operations.  [Citations and footnotes omitted.]

Had the underlying business been a  true  operating company, rather than a company engaged in  rental real estate activities, a finding that material participation occurred would have required  the conclusion that the losses were deductible. However, the PAL rules provide that rental real  estate activities are always passive, unless the taxpayer is a “real estate professional.” On this  issue, the IRS argued that a trust can never be a real estate professional. The court rejected this  argument. The IRS relied solely on this argument and failed to argue that even if a trust can be a  real estate professional; this trust did not meet the requirements of being a real estate  professional.  These include a requirement that the taxpayer spend at least 750 hours in real  estate   businesses   in   which   it    materially    participates and a requirement that time  spent in those businesses must amount to more than half of its time spent in all business  activities. It is likely that the IRS will raise these issues in future litigations. Thus, other  trust taxpayers should expect to have to prove that they meet the tests of being a real estate  professional to deduct losses due to rental real estate.

The court concluded in Aragona that if trustees are individuals and 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 a trade or business.”  This holding will provide other taxpayers with a helpful basis for analyzing this issue.

The heart of the court’s ruling on the second issue is its analysis of state fiduciary law, rather  than federal tax law. The court accepted the IRS argument that in this case only the trustee’s  activities were relevant in determining whether the trust materially  participated.8  The  IRS   argued  that  the  trustees’

Trust Income Distributed to a Beneficiary

The NII Tax is imposed on net investment income. The NII Tax regulations provide that net  investment income in a trust that is distributed to a beneficiary remains net investment income.  This statement is consistent with the general rule that income distributed from a trust retains its  character to the recipient. For example, tax-exempt interest received by the trust remains tax  exempt whether or not distributed to a beneficiary.

The NII Tax regulations, however, do not address the consequence of the distribution of trust  income to a beneficiary when the income is not net investment income. It seems reasonable to assume  that the distribution of income from an active business in which the trustee materially  participated should retain its character as active when distributed to a beneficiary. If that is  the case, income distributed from an active business in which the trustee materially participated  would remain active income in the hands of the beneficiary, even if the beneficiary does not  materially participate in the business.9

Because  special  tax  rules  usually  apply  to  trusts  owning S corporation stock, this special  character rule will be unlikely to affect the NII Tax payable on trust income from an S  corporation. A trust owning S corporation stock is usually a grantor trust, a qualified subchapter  S trust (QSST) or an electing small business trust (ESBT). Income from an ESBT is taxed to the  trust at the highest tax rate and is not taxed to its beneficiaries, even  if  distributed.   The   Aragona  case  makes  it  easier  for S corporation  business  income  in  an   ESBT   to   be    active and escape the NII Tax. A grantor trust is disregarded for tax purposes, and  a  QSST  is   treated  as  grantor  trust  as  to  its S corporation stock. The Aragona decision has no impact on  grantor trusts because the individual material participation rules apply to determine whether the income is active or passive.