During the last week of March 2014, the Tax Court, in the Frank Aragona Trust Case, held that a trust can qualify as a real estate professional under the passive activity loss rules based on the participation of trustees acting as employees of the rental activities. In its analysis, the Court addressed the issue of how a trust can determine material participation in a business. This decision becomes applicable to a broad range of businesses and not limited to real estate rentals.
There are two major consequences to a trust if a business interest is considered to be a passive activity:
1. Tax losses generated by the business interest can only be applied against income generated from other passive activity interests and cannot be used to offset investment income (e.g., interest, dividends, capital gains) and other non-passive business interests. This causes many trusts to be unable to currently use losses and increases income taxes. The limitation on the use of tax losses is particularly harmful to trusts due to the compressed income tax brackets. The maximum 39.6% tax rate applies to taxable income in excess of $11,950 for 2013.
2. For 2013 and later, the new 3.8% net investment income tax applies to passive activity business interests held by a trust. Unlike individuals, where the tax applies if modified adjusted gross income exceeds $200,000 (single filers) or $250,000 (joint filers), the new tax applies to trusts with modified adjusted gross income in excess of only $11,500. Additionally, the 3.8% tax will be imposed on gains generated from a sale of the business interest in the future.
If “material participation” can be demonstrated in the business activity, then income or loss generated from such activity will not be considered passive. However, rental activities are generally treated as passive regardless of the level of participation, unless a specific exception applies. An exception exists for real estate professionals. A taxpayer is considered to be a real estate professional if:
a. More than one-half of “personal services” performed in trades or businesses during the year relate to certain real property trades or businesses; and
b. Personal Service hours exceed 750 hours.
If these requirements are satisfied, the rental activity is not deemed to automatically be passive. However, the taxpayer must still demonstrate “material participation” in the activity. In its regulations, the Service has provided several methods to determine material participation in an activity, several of which involve counting the hours worked in the business.
The facts of the new Tax Court case are:
• Frank Aragona (the grantor) formed a trust as grantor and trustee with his five children as beneficiaries. The five children were to share equally in the income of the trust. When Frank died in 1981, he was succeeded as trustee by five 5 children (as non-independent trustees) and his attorney (as the independent trustee). Three of the children (Paul, Frank and Annette) worked full-time as paid employees for a limited liability company which was wholly-owned by the trust (Holiday Enterprises LLC). The LLC also employed other persons, including a controller, leasing agents, maintenance workers, accounts payable clerks and accounts receivable clerks. All six trustees formally delegated their powers to Paul (the Executive Trustee) to facilitate the daily business operations. However, the trustees acted as a management board, met every few months, and made all major decisions regarding the trust’s business. The trust conducted some of its rental real estate activities through wholly-owned entities and some through entities in which it held a majority interest. Two of the working trustees (Frank and Paul) also owned minority direct interests in the flow-through entities.
• The trust treated losses from the real estate rental activities as deductible and not subject to the passive activity loss rules. The trust claimed that it should be treated as a real estate professional and that the trust materially participated in its real estate rental activities.
• The IRS determined on audit that the real estate losses should be subject to the passive activity loss limitation rules and were not deducible against non-passive activity income.
The IRS’ position is that a trust can never satisfy the requirements for real estate professional status since it must demonstrate that more than one-half of its “personal services” performed in the tax year were in real property related trades or businesses. The Service argued that “personal services” refer to the acts of individuals and cannot apply to an entity, like a trust.
The court rejected this position. It reasoned that if Congress wanted to exclude trusts from real estate professional status, it could have done so by explicit statutory language. Additionally, it stated that if the trustees are individuals, then personal services can be performed.
Even if a trust satisfies the requirements of being a real estate professional, this merely means that its rental activities are not considered to be per se passive activities. The trust must still demonstrate that it materially participates in the same manner as any non-rental activity. The IRS position has historically been that a trust can materially participate in a business activity only if the trustee of the trust sufficiently participates in the business,in his or her capacity as a trustee . This means that any time spent in the activity in some other capacity (e.g., employee of the business entity) must be ignored.
The Trust argued that it should be able to count the hours worked by certain trustees as employees of the business. It also argued that it should be able to count the hours of non-trustee employees and agents in demonstrating material participation.
The Court stated that the trustees were bound under Michigan law to administer the trust solely for the interests of the trust beneficiaries and they were not relieved of this duty even when acting in another capacity. Therefore, the time of the trustees spent as employees of the businesses owned by the trust should be used in determining material participation. From all the facts of the case, it was clear that the trustees materially participated in the business activities.
This case offers a number of planning opportunities for trusts to maximize the benefits of business losses and to avoid the new net investment income tax.