Yesterday we discussed planning opportunities resulting from the Tax Court’s 2014 decision in Frank Aragona Trust v. Commissioner. The Tax Court allowed the taxpayers to treat the trust as “materially participating” in business activities through participation in the activities by trustees. This opens planning opportunities to deduct business losses incurred by trusts, avoiding the Sec. 469 “passive loss” limitations. It also helps trusts to avoid the 3.8% Net Investment Income Tax, which applies to “passive” business income.
Now the IRS is attempting to push back against trusts relying on Aragona in examinations. A Taxpayer filed an amended 1041 for 2016 to claim a refund. The return was amended after determining income from shares of family business stock to be non-passive under IRC 469 and Aragona case law. IRS Exam and Attorneys disagree with the position indicating that IRS believes Aragona doesn’t apply to Trusts unless Trust fiduciaries directly conduct a trust business (can’t simply own holding company stock). Also, IRS believes not all activities of trustees as employees of the business count toward 469 tests.
The Aragona opinion rejected some positions taken by the IRS in TAM 20703023, PLR 201029014 and TAM 201317010. Specifically, the IRS found in those rulings that trusts and estates are not treated as individuals under Section 469, preventing the application of the seven material participation tests. Also, the IRS concluded that the trustee must be involved directly in the operations of the business as the trustee to consider their efforts. Since Aragona didn’t agree with either of those conclusions we have been left wondering just where the IRS stands on these issues. Without Regulations on the issue many have been left guessing just how the IRS will respond. Recent IRS Examination activity may give a clue as to the IRS position and response to Aragona.
In the Aragona case, the Tax Court found that the trustees' activities, including their activities as employees of the Management LLC owned by the Trust, were enough for the trust to meet the material participation tests in the context of real estate activities.
Without published positions from the IRS following the Aragona case practitioners are left assuming that the IRS acquiesces in its holdings. Many have advocated pushing the Court’s analysis to application of the Net Investment Income Tax especially where trusts contain family owned/run businesses and the trustees are employees running that same business. Some have opined that this means the Trust Fiduciaries can never take off the Trustee hat and all their activities are considered for material participation testing. This has been the prevailing position among many practitioners and is commonly applied.
Examiners push back.
However, recent IRS examination activity (closely scrutinized by IRS Attorneys) indicates that the IRS does not agree with this broad application. During Examination the IRS has conducted interviews and information gathering centered around two specific areas, 1) the operation of a business by the trust, and 2) direct activities conducted by trust fiduciaries and employees of the business in their roles as fiduciaries in the business.
Regarding an operating business, the IRS has explained (in its examination) that they do not believe that owning shares of a holding corporation that owns a business equates to a trust “business.” Regarding differences in trustee indirect v. direct activities, the IRS explained that they do not believe every activity as an employee of a trust owned business qualifies for the 469 tests. They also implied that working for a business owned by a holding company owned by the trust is different than the situation in Aragona.
They also indicated that they believe Aragona is a case regarding the real estate professional exception and not technically Net Investment Income Tax and that Aragona is limited to its specific facts (IRS Attorney code that they disagree with its rulings). These however are common legal sleight-of-hand statements and typically have no substance.
Cryptic, certainly, but it does tell us a few things. First, it tells us that the IRS doesn’t directly agree with the broad interpretation of Aragona covering NIIT. Second it tells us they are formulating a way to differentiate Aragona regarding trust material participation for NIIT purposes. Finally, their chosen targets are whether the trust is really operating a business and applying qualifications on the type of work done as an employee. How they will home in on these targets remains a mystery and seemingly a difficult case to make considering the broad rulings in Aragona. Still, it is clear that there is motivation in the IRS to do so.
Differentiating cases from the facts of Aragona seems like a desperate push by the IRS. Is there substance to the argument that a Trust isn’t “operating a business” if it doesn’t control that business entity directly? If it only has partial or indirect control? Does it matter if the trustee employee doesn’t run the business day to day, but is a director or executive that handles only a piece of the business activities? The IRS seems to think these are drastic differences from Aragona so it may require some further rulings to clarify. Certainly Taxpayers should not easily agree.