Trust materially participated in real estate business

In a case of first impression, the Tax Court held that a trust materially participated in its rental real estate business and therefore could deduct the losses it incurred in conducting those activities in 2005 and 2006 as losses from nonpassive activities (Frank Aragona Trust, 142 T.C. No. 9 (2014)). The court rejected an IRS argument that “personal services” performed in real estate activities must be performed by an individual, not a trust.

The Frank Aragona Trust, which owns rental real estate properties and is involved in other real estate activities, was formed by Frank Aragona in 1979 with him as trustee and his five children as beneficiaries. When Frank Aragona died in 1981, his children took over as trustees. Three of the children worked full time in the business, which was operated through an LLC owned by the trust that was a disregarded entity for tax purposes. 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 two of the brothers owned minority interests.

Sec. 469 prohibits losses from passive activities to be offset against nonpassive income, and rental real estate activities are per se passive. Sec. 469(c)(7)(B), however, provides an exception if a taxpayer can meet both of the following tests: (1) More than one-half of the personal services performed in trades or businesses by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates. Under Sec. 469(h), a taxpayer is treated as materially participating in an activity only if the taxpayer is involved on a regular, continuous, and substantial basis.

In this case, the IRS argued that the Sec. 469(c)(7)(B) exception did not apply to the trust because “personal services” are defined under Regs. Sec. 1.469-9(b)(4) as work performed by an individual in a trade or business. But the court rejected that argument, reasoning instead that a trust is formed to manage assets for beneficiaries. If the trustees are individuals, their work can be considered work performed by an individual in a trade or business.

The court also countered the IRS’s argument that the exception was aimed only at people, not at trusts, by pointing to Sec. 469(i), the exception for up to $25,000 in losses from rental real estate, which specifically provides that it applies to a “natural person.” Because the exception at issue here used the word “taxpayer,” and not “natural person,” the court concluded that Congress did not intend to exclude trusts from the Sec. 469(c)(7)(B) exception.

The IRS also argued that its position was supported by the provision’s legislative history, which stated that the exception applies to individuals and closely held C corporations. But the Tax Court disagreed. The court noted that the legislative history did not say it applied only to individuals and closely held C corporations and, therefore, was not conclusive.

Finally, the court had to address the IRS’s alternative argument—that even if trusts in general could qualify for the Sec. 469(c)(7)(B) exception, this trust did not because it did not materially participate. But the Tax Court noted that, although regulations existed to determine whether individuals and closely held C corporations were involved on a regular, continuous, and substantial basis, none had been issued for trusts (the court noted that the IRS reserved Temp. Regs. Sec. 1.469-5T(g) for that purpose in 1988, but never issued guidance). In the absence of regulatory guidance for determining how a trust may materially participate, the court noted that it had to make its own determination.

The IRS argued that the activities of the trust’s employees had to be disregarded and that an executor or other fiduciary is treated as participating only if he or she is doing so in his or her fiduciary capacity. In addition, the IRS argued that the activities of the trustees who were full-time employees of the LLC should not count toward material participation because they performed their activities as employees of the LLC and it was impossible to separate the activities they performed as the LLC’s employees from their activities as trustees.

In response, the Tax Court explained that the trustees had a fiduciary duty under Michigan law to conduct the business for the beneficiaries’ benefit. Therefore, their activities as LLC employees could be considered in determining the trust’s material participation. The court concluded that their activities met the material participation test. As a result, the losses from the real estate activities were losses from nonpassive activities and not subject to the passive activity loss limitations.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.