Under IRC § 469, losses incurred by individuals (including estates and trusts) in connection with passive activities are deductible only to the extent that the taxpayer also has income from passive activities. In general terms, a passive activity is an interest in a business with respect to which the taxpayer does not materially participate. There are a variety of tests for material participation, but the general benchmark is that the taxpayer must spend at least 500 hours per year in connection with the activity. How is this to be applied in the case of a trust?
The IRS recently provided some guidance with respect to this question in TAM 200733023. A testamentary trust acquired an interest in a limited liability company that was engaged in a business. The trustees of the trust provided certain administrative and operational services to the business. However, they also contracted with “Special Trustees” to perform other services for the business. The Special Trustees did not have any authority to legally bind the trust to any transaction or activity. The Special Trustees were heavily involved in reviewing operating budgets, analyzing a tax dispute among the partners and preparing and analyzing other financial documents. They also spent time negotiating the sale of the trust’s interest in the entity to a new member. The trust reported a loss from this limited liability company on its return and concluded that it materially participated, based upon the hours spent by the trustees and the Special Trustees. In the Technical Advice Memorandum, the IRS took the position that only the time spent by the trustees counted toward the trust’s material participation. The IRS analogized the Special Trustees to employees or agents of a business which, under IRC § 469(h)(1), do not count toward the material participation of the taxpayer himself.
The IRS position in this case is contrary to that taken by a United States District Court in Texas in the case of Mattie K. Carter Trust v. United States, where the court held that employees of the trust should be taken into account in determining whether the trust participated in connection with an activity. The IRS is essentially equating the trustee of a trust with an individual taxpayer. An individual may not count the time spent by his employees in determining whether he materially participated in a business. The IRS viewed the Special Trustees in the same light as employees in concluding that only the time spent by the actual trustees could be counted.