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Trusts Can "Materially Participate" in Businesses
Estate planning attorneys and financial planners now have much-needed guidance about "material participation" and "personal services" as they relate to trusts. The Tax Court recently ruled that a trust materially participated in its rental real estate business and therefore could deduct the losses it incurred in conducting those activities as losses from non-passive activities. The court rejected the IRS's argument that "personal services" performed in real estate activities must be performed by an individual, not a trust. This ruling is especially important considering the introduction of the "Medicare Tax" which imposes a 3.8% surtax on net investment income (the definition of net investment income includes income derived from a trade or business that is a passive activity to the investor).
The landmark case, Frank Aragona Trust et al, v. Commissioner ("Aragona"), involved a residuary trust that was created under the revocable trust of the decedent, Frank Aragona. The trust owned interests in various rental properties and real estate activities. There were six trustees, five of which were the decedent's children. Because of liability concerns, the trustees decided to transfer assets of the real estate business owned by the trust to a limited liability company named Holiday Enterprises, LLC ("the LLC"). The LLC was disregarded for income tax purposes because it was wholly owned by the trust. Three of the trustees worked as full-time employees of the LLC (along with other non-trustee employees). Two of the trustees also held minority interests in other entities which were majority owned by the trust.
During 2005 and 2006, the trust incurred substantial real estate losses and deducted those losses on its returns as non-passive activities. The losses resulted in net operating losses which were carried back to earlier tax years of the trust. After an audit, the IRS disallowed those losses.
In general, rental real estate is a "per se" passive activity under the IRS Code. This rule does not apply to a taxpayer, however, if they meet two requirements: (1) more than one-half of the taxpayer's personal services performed during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) such taxpayer performs more than 750 hours of service during the tax year in such real property trades or businesses in which the taxpayer materially participates. This exemption is generally known as the "real estate professional exemption."
The IRS supported its disallowance of the Aragona trust losses on two alternate grounds. First, the IRS argued that the trust was ineligible for the real estate professional exemption because it is impossible for a trust to perform "personal services." The Tax Court rejected this argument, finding that a trust is indeed capable of performing personal services within the meaning of code. The court found that if a trustee was an individual who worked in the trade or business as part of his trustee duties, that work could be considered work performed by an individual in a trade or business.
Alternatively, the IRS argued, if a trust could perform personal services, the Aragona trust did not materially participate in the real estate business. Material participation requires a taxpayer's regular, continuous and substantial activity. The trustees' activity as it related to their fiduciary capacity, according to the IRS, did not rise to this level. Again, the Tax Court disagreed. Based on Michigan law (where the trust was located), "trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust." Recall that the LLC was wholly owned by the trust. Therefore, the activities of trustees as employees could be considered in determining whether the trust materially participated in real estate operations.
What it means
Taxpayers (and their attorneys and financial planners) will find the Aragona decision to be helpful in planning for trusts that are active in the real estate business. This ruling may also make it easier to avoid the 3.8% tax on net investment income by showing that trusts are materially participating in a trade or business. There are questions that remain, such as how the holding relates to non-trustee employees. Nonetheless, the case provides important clarification and serves as a taxpayer victory.
Terri R. Stallard is a Member of McBrayer, McGinnis, Leslie & Kirkland, PLLC and practices from the Lexington and Louisville offices. Ms. Stallard concentrates her practice in the areas of estate planning, trust and estate administration, and charitable planning. She is licensed to practice law in Kentucky, Georgia, and Tennessee, and in the U.S. Tax Court. She can be reached at firstname.lastname@example.org or (859) 231-8780, ext. 1258.
This article is intended as a summary of federal and state law and does not constitute legal advice.
 Frank Aragona Trust et al, v. Commissioner, 142 T.C. No. 9, No. 15392-11 (2014).