Tax Court Holds That a Trust Can Qualify for Rental Real Estate Exception.
(Parker's Tax Library April 11, 2014)

While the Code Sec. 469 passive activity rules apply to trusts, there has been a dearth of guidance on how a trust can establish material participation for purposes of these rules. That is important because passive activity losses are limited where the taxpayer does not materially participate in an activity. Until recently, only one court opinion had addressed that issue. In Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003), a district court in Texas held that in determining whether a trust met the material participation rules, the activities of the trust's fiduciaries, employees, and agents should be taken into account. The court rejected the IRS's position that the determination should be made solely with reference to the activities of the trustee.

Recently, in Frank Aragona Trust v. Comm'r, 142 T.C. No. 9 (2014), the IRS took an even harder line, arguing that trusts are categorically barred from qualifying for the Code Sec. 469(c)(7) exception to the general rule that real estate rental activities are per se passive. For the Code Sec. 469(c)(7) exception to apply, there must be personal services performed by the taxpayer and, according to the IRS, a trust cannot perform personal services. However, the Tax Court rejected the IRS's position, holding that a trust can qualify for the Code Sec. 469(c)(7) exception. According to the Tax Court, a trust is capable of performing personal services within the meaning of Code Sec. 469(c)(7) because services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.

Facts

The Frank Aragona Trust owns rental real estate properties and is involved in other real estate business activities, such as holding and developing real estate. In 1979, Frank Aragona formed the trust with himself as grantor and trustee and with his five children as beneficiaries. Frank died in 1981. He was succeeded as trustee by six trustees. One of the six trustees was an independent trustee. The other five trustees were Frank's five children, one of whom served as the executive trustee. Although the trustees formally delegated their powers to the executive trustee 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. During 2005 and 2006, the board met every few months to discuss the trust's business. Each of the six trustees was paid a fee directly by the trust in part for the trustee's attending board meetings.

Three of the Aragona children worked full time for Holiday Enterprises, LLC (Holiday), a Michigan limited liability company wholly owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust's rental real estate properties. It employed several people in addition to three of the Aragona children, including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks. In addition to receiving a trustee fee, the three Aragona children who worked for Holiday received wages from Holiday.

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 Aragona children 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 two of the Aragona children owned minority interests.

During the 2005 and 2006 tax years, the trust incurred losses from its rental real estate properties. On its returns, the trust treated its rental real estate activities, in which it engaged both directly and through its ownership interests in a number of entities, as nonpassive activities. Thus, the losses from these activities contributed to net operating losses, which the trust carried back to its 2003 and 2004 tax years.

The IRS issued a deficiency notice in which it determined that the trust's rental real estate activities were passive activities, which increased the passive-activity losses for 2005 and 2006. The increase in the passive-activity losses resulted in a decrease in the allowable deductions from gross income for each of those years, which decreased the net-operating-loss carrybacks to the 2003 and 2004 years.

Passive Activity Losses and Rental Real Estate

Under Code Sec. 469(a)(1), a taxpayer's passive-activity loss is disallowed for the year if the taxpayer is described in Code Sec. 469(a)(2) - that is, if the taxpayer is an individual, estate, trust, closely held C corporation, or personal service corporation. Code Sec. 469(d)(1) defines a passive-activity loss as the excess of the aggregate losses from all the taxpayer's passive activities for the year over the aggregate income from all the taxpayer's passive activities for that year. Code Sec. 469(c)(1) in turn defines a passive activity as any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Under Code Sec. 469(c)(2), any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity. Thus, any rental activity is generally passive per se.

However, Code Sec. 469(c)(7) provides an exception - the per-se passive activity rule does not apply to the rental real estate activity of any taxpayer who meets both of the following two tests:

(1) more than one-half of the "personal services" performed in trades or businesses by the taxpayer during the tax year is performed in real property trades or businesses in which the taxpayer materially participates; and

(2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.

In the case of a closely held C corporation, the exception applies for a tax year if more than 50 percent of the corporation's gross receipts for that tax year are derived from real property trades or businesses in which the corporation materially participates.

These requirements can be met only by a taxpayer who materially participates in a real property trade or business. This is because the one-half-of-personal-services test, the 750-hour test, and the special rule for closely held C corporations all presuppose that the taxpayer materially participates in real property trades or businesses. The term "real property trade or business" is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Under Reg. Sec. 1.469-9(b)(4), personal services mean any work performed by an individual in connection with a trade or business. This is an interpretation of the term "personal services" used in the first test of Code Sec. 469(c)(7)(B).

Code Sec. 469(h) provides that for the purposes of Code Sec. 469, a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis that is regular, continuous, and substantial. The test in Code Sec. 469(h) has two functions. First, it is used to determine whether a particular activity is a passive activity. Second, it is used to determine whether a taxpayer materially participates in real property trades or businesses.

IRS's Arguments

The IRS argued that, for the Code Sec. 469(c)(7) exception to apply, there must be personal services performed by the taxpayer and because the regulations define personal services as work performed by an individual in connection with a trade or business, a trust cannot perform personal services. Therefore, a trust cannot qualify for the Code Sec. 469(c)(7) exception.

The IRS's fallback position was that even if a trust can qualify for the Code Sec. 469(c)(7) exception, the Frank Aragona Trust did not qualify because it did not materially participate in real property trades or businesses. The IRS argued that in determining whether a trust is materially participating in an activity, only the activities of the trustees can be considered, and the activities of that trust's employees must be disregarded. In support of this position, the IRS cited a Senate report that stated that a trust is treated as materially participating in an activity if an executor or fiduciary, in his capacity as such, materially participates, and that the activities of employees are not attributed to the taxpayer. Thus, the IRS argued that the court should ignore the activities of the trust's non-trustee employees, as well as the activities of the three trustees who were employees of Holiday. The IRS reasoned that the activities of those three trustees should be considered the activities of employees and not fiduciaries because the trustees performed their activities as employees of Holiday, and it would be impossible to separate the activities they performed as employees of Holiday and the activities they performed as trustees. Disregarding all of these individuals would leave only the relatively insignificant activities of the three trustees who were not employees (one of whom was a dentist, one of whom was disabled and unable to work, and an outside attorney who served as the independent trustee).

A Trust Can Qualify for the Exception

The Tax Court first rejected the IRS's argument that a trust cannot qualify for the Code Sec. 469(c)(7) exception. A trust is an arrangement under which trustees manage assets for the trust's beneficiaries. According to the court, 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. The court also found nothing in the legislative history of the Code Sec. 469(c)(7) exception that would compel the conclusion that only individuals and closely held C corporations can qualify for the exception. Thus, the court concluded that a trust is capable of performing personal services and therefore can qualify for the Code Sec. 469(c)(7) exception.

The Trust Did Qualify for the Exception

The court also rejected the IRS's fallback position, holding that the Frank Aragona Trust materially participated in a real property trade or business. The court found that even if the activities of the trust's non-trustee employees had to be disregarded, the activities of the three trustees who were employees of Holiday -- including their activities as employees of Holiday --should be considered in determining whether the trust materially participated in a real property trade or business. The trustees were required by Michigan 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. Trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust. Therefore, the trustees' activities as employees of Holiday Enterprises should be considered in determining whether the trust materially participated in its real property operations.

The court noted that under Code Sec. 469(h), a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Considering the activities of all six trustees in their roles as trustees and as employees of Holiday, the court held that the trust materially participated in its real property operations. Three of the trustees participated in the trust's real estate operations full time. The trust's real estate operations were substantial, and the trust had practically no other types of operations. The trustees handled practically no other businesses on behalf of the trust.

The court also rejected the IRS's argument that because two of the trustees had minority ownership interests in all of the entities through which the trust operated real estate holding and real estate development projects, and because they had minority interests in some of the entities through which the trust operated its rental real estate business, some of these two trustees' efforts in managing the jointly held entities are attributable to their personal portions of the businesses, not the trust's portion. Despite two of the trustees' holding ownership interests, the court was convinced that the trust materially participated in the trust's real estate operations. First, the two trustees' combined ownership interest in each entity was not a majority interest. Second, their combined ownership interest in each entity was never greater than the trust's ownership interest. Third, their interests as owners were generally compatible with the trust's goals -- they and the trust wanted the jointly held enterprises to succeed. Fourth, they were were involved in managing the day-to-day operations of the trust's various real estate businesses.

Having held that the trust materially participated in a real property trade or business, the court said the next steps in ascertaining whether the trust was entitled to the benefits of the Code Sec. 469(c)(7) exception involved (1) determining whether more than one-half of the personal services performed in trades or businesses by the taxpayer during the year were performed in real property trades or businesses, and (2) determining whether the taxpayer performed more than 750 hours of services during the year in the real property trades or businesses. However, the IRS had limited its arguments to the two arguments discussed above, namely (1) that trusts were categorically barred from qualifying under the Code Sec. 469(c)(7) exception, and (2) that this particular trust did not materially participate in real property trades or businesses. Thus, in the context of the arguments raised in the case, the court held that the trust met the requirements for the Code Sec. 469(c)(7) exception for the years at issue.

Once the court determined that the trust qualified for the Code Sec. 469(c)(7) exception, and that therefore the trust's rental real estate activities were not per se passive activities, the next step would have been to determine whether the trust materially participated in its rental real estate activities. If the trust materially participated in its rental real estate activities, then its rental real estate activities would not be passive activities. If the trust did not materially participate in its rental real estate activities, then its rental real estate activities would be passive activities. Again, however, the IRS had argued only that the trust did not qualify for the Code Sec. 469(c)(7) exception it did not argue that, in the event the court determined that the trust did qualify for the exception, the trust did not materially participate in its rental real estate activities. Thus, the court concluded that, in the context of the arguments presented in the case, the trust's rental real estate activities were not passive activities. (Staff Editor Parker Tax Publishing)

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