February 27, 2021
IRS attorneys are working to limit the reach of an important pro-taxpayer Tax Court decision applying the passive loss rules to trusts. These rules limit the ability of taxpayers to deduct business losses if they do not “materially participate” in a loss-generating business. If a “passive” business generates income, it is treated as investment income subject to the 3.8% net investment income tax (NIIT) imposed by Code Section 1411.
Taxpayers can prove material participation by establishing time spent in an activity under 7 tests set forth in Temporary Treasury Regulation section 1.469-5T. For example, spending 500 hours spent on an activity in a year does the trick.
Trusts are subject to the passive loss rules. When these rules were first enacted in 1986, it wasn’t clear how a trust could participate in a business. The Tax Court’s decision in Frank Aragona Trust v. Commissioner, (142 T.C. 165, 2014) provided the clearest guidance so far on the application of the Sec. 469 passive loss rules to trusts.
Judge Morrison explains the Aragona Trust facts in the Tax Court opinion:
One of the six trustees was an independent trustee. The other five trustees were Frank Aragona's five children, including Paul V. Aragona, the executive trustee. Although the trustees formally delegated their powers to the executive trustee (in order to facilitate daily business operations), the trustees acted as a management board for the trust and made all major decisions regarding the trust's property. . . Each of the six trustees was paid a fee directly by the trust (referred to here as a "trustee fee" or collectively as "trustee fees") in part for the trustee's attending board meetings. Three of the children--Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran--worked full time for Holiday Enterprises, LLC, a Michigan limited liability company that is wholly owned by the trust. Holiday Enterprises, LLC, is a disregarded entity for federal income tax purposes. Holiday Enterprises, LLC, managed most of the trust's rental real-estate properties. It employed several people in addition to Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran, including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks. In addition to receiving a trustee fee, Paul V. Aragona, Frank S. Aragona, and Annette Aragona Moran each received wages from Holiday Enterprises, LLC.
The trust conducted some of its rental real-estate activities directly, some through wholly owned entities, and the rest through entities in which it owned majority interests and in which Paul V. and Frank S. Aragona owned minority interests. It conducted its real-estate holding and real-estate development operations through entities in which it owned majority or minority interests and in which Paul V. and Frank S. Aragona owned minority interests.
Based on these facts the Tax Court determined that if the trustees are individuals, and they work on 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” under Treasury Regulation Section 1.469-9(b)(4).
Notably the Tax Court rejected IRS arguments trying to allocate or limit the hours spent by trustees as employees versus time spent as trustees directly in the business.
The Tax Court stated (emphasis added):
[t]he 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.
The Court found it paramount that the interests were aligned when the trustees/fiduciaries act directly for the trust and as employees of the property owned by the trust. It also found it significant that any one of three trustees participated in the trust’s real estate operations full-time; the trusts operations were substantial; the trust had no other types of operations; and the trustees handled no other businesses on behalf of the trust. The Court continued:
Trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust. Therefore, their activities as employees of Holiday Enterprises, LLC, should be considered in determining whether the trust materially participated in its real-estate operations.
The Tax Court also rejected the IRS argument that because some of the Trustees held minority interests in the same business entities as the trust that their efforts were attributable to their personal portions of the business. The Court rejected this reasoning that trustee’s combined interests were never greater than the trust’s ownership interest, never a combined 50% interest, that their interests were compatible with the trust’s goals and they were involved in the day to day management of the trusts business. Notably the Court did not give any more or less weight to any of these factors or conclude any of them were directly determinative.
The ability to attribute trustee participation in activities to their trusts creates tax planning opportunities. Selecting trustees who work in a business can enable a trust to deduct business losses and avoid the 3.8% NIIT. The NIIT issue is especially important for trusts. While single individuals don’t face the NIIT until they have adjusted gross income of at least $200,000, it applies to trusts with AGI over $12,950 in 2020.
Tomorrow we will look at how the IRS appears to be trying to push back on the opportunities that Aragona Trust has opened up for taxpayers.
 . Cf. In re Estate of Butterfield, 341 N.W.2d at 457 ("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.").
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