Losses Trust Deducted Were Not From Passive Activity

IRC section 469(a)(1) defines a passive activity as one involving the conduct of any trade or business in which the taxpayer does not materially participate. In section 469(a)(2), the statute describes a taxpayer as any

Individual, estate or trust. Closely held C corporation. Personal service corporation.

In general, the IRS will treat a taxpayer as materially participating in an activity only if that taxpayer is involved in the operations on a regular, continuous and substantial basis.

The Mattie K. Carter Trust was established in 1956 under the will of Mattie K. Carter. Benjamin Fortson, the trustee since 1984, manages its assets, including the Carter Ranch, which the trust has operated since 1956. The ranch covers some 15,000 acres and includes cattle-ranching as well as oil and gas interests. At the times in question the Carter Trust employed a full-time ranch manager and other employees who performed essentially all the ranch’s activities. Fortson also devoted a substantial amount of time and attention to ranch activities.

The Carter Trust claimed deductions for losses it incurred in connection with the ranch operations for 1994 and 1995 of $856,518 and $796,687, respectively. In April 1999 the IRS issued a deficiency notice disallowing the deductions because of section 469’s passive activity rules. The Carter Trust paid the disputed tax in full plus interest and made a timely refund claim, which the IRS denied. The trust then sued for a refund in district court.

The court considered the question of whether the Carter Trust materially participated in the cattle-ranch operations or was otherwise “passively” involved. The IRS argued a trust’s “material participation” in a trade or business, within the meaning of section 469(h), should be determined by evaluating only the trustee’s activities. The IRS proposed to disallow the losses in full for both tax years because the trustee, Fortson, failed to meet the IRC’s material participation requirements. The IRS classified the losses as “passive activity losses.”

The Carter Trust said it—not the trustee—was the taxpayer, and material participation should be determined by assessing the trust’s activities through its fiduciaries, employees and agents. The trust also said that as a legal entity, it could participate only through the actions of those individuals. Their collective efforts on the cattle-ranching operations during 1994 and 1995 were regular, continuous and substantial.

Result. For the taxpayer. The court found the IRS’s contention that the trust’s participation in the ranch operations should be measured by referring to the trustee’s activities had no support within the plain meaning of the statute. The court said this position was arbitrary and subverted common sense and, in the absence of case law or regulations, the IRS should not create ambiguity where there was none.

The court held it undisputed that the Carter Trust, not its trustee, was the taxpayer. The trust’s participation in the ranch operations entailed an assessment of the activities of those who labored on the ranch, or otherwise conducted ranch business on the trust’s behalf. Their collective activities during the times in question were regular, continuous and substantial enough to constitute material participation.

The court concluded the losses the Carter Trust had sustained were not passive within the meaning of section 469. The IRS had improperly disallowed the ranching losses as passive activity losses, and the trust was entitled to a refund of the overpaid taxes with interest.

Mattie K. Carter Trust v. United States, 256 F Supp 2d 536 (Tex. 2003).

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.