In a case of first impression, Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (Mar. 27, 2014), the Tax Court held that a trust could materially participate in a trade or business based upon the activities of the trustees. This case is significant because neither the Internal Revenue Code nor the Treasury Regulations provides guidance on material participation by trusts. In addition, this case provides direction on the application of the section 1411 net investment tax to certain trusts.
Facts of Frank Aragona Trust
The trust at issue (the “Trust”) was a complex residuary trust owning rental real-estate properties and was also involved in other real estate business activities such as holding and developing real estate. The Trust had six trustees, including one independent trustee and three trustees which worked full-time for a limited liability company (an “LLC”) wholly-owned by the Trust. The LLC managed most of the Trust’s rental real estate properties.
The Trust incurred losses from its real estate activities in 2005 and 2006, which it treated as non-passive losses on its tax returns for those years. The IRS disallowed these losses stating they were passive activity losses because a trust could not qualify as a real estate professional and the Trust did not materially participate in real estate activities.
Pertinent Law - Section 469
Generally, section 469 of the Internal Revenue Code (the “Code”) prohibits passive losses from offsetting non-passive income. Rental activity is per se passive; however, an exception to the per se rule exists under section 469(c)(7) if a taxpayer is considered a “real estate professional.” There are two tests, both of which must be satisfied to be a real estate professional: (i) more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the year must be performed in real property trades or businesses in which the taxpayer materially participates, and (ii) the taxpayer must perform more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. Under section 469(h), material participation in an activity exists if the taxpayer is involved on a “regular, continuous and substantial basis.”
1. A Trust Can Qualify as a Real Estate Professional
The IRS argued that a trust could not qualify for the real estate professional exemption because a trust could not perform personal services. Personal services are defined under Treasury Regulation section 1.469-6(b)(4) as “any work performed by an individual in connection with a trade or business.” According to the IRS, because a trust is not an individual, it cannot perform such services. The IRS further looked to legislative history to support its view, specifically a report of the House Ways and Means Committee, H.R. Rept. No. 103-11 (1993), which provided that section 469(c)(7) applies to individuals and closely-held C corporations.
The Tax Court ruled for the taxpayer and held that a trust is capable of performing personal services and therefore can satisfy the section 469(c)(7) exception. The court reasoned that if Congress wanted to exclude trusts from the 469(c)(7) exception, it could have done so explicitly by limiting the exception to “any natural person.” Further, the court rejected the IRS’ legislative history argument stating that the report does not say that the exception applies to only individuals and closely held C corporations; thus, it follows that not only individuals and closely held C corporations can qualify for the exception.
2. Trusts Can Materially Participate in a Trade or Business
The Tax Court also addressed the IRS’ alternative argument, that even if some trusts can qualify for the section 469(c)(7) exception, this Trust does not qualify because it did not materially participate in real property trades or businesses. The IRS contended that only the activities of the trustees can be considered and the activities of the trust’s employees (some also trustees) must be disregarded. The Tax Court rejected this argument, and stated that becoming an employee does not relieve a trustee of its duty to its beneficiaries, so the trustee-employees’ hours must be counted towards material participation in the real estate activities.
Importance of Frank Aragona Trust in Tax Planning
Not only does Frank Aragona Trust hold that a trust can materially participate in an activity as well as meet the exception for a real estate professional, this case also provides guidance on the application of the 3.8% net investment tax under section 1411. Such tax is generally imposed on passive income, including rental income. Frank Aragona Trust allows trusts to treat rental activity income as “active” income, and avoid the 3.8% tax on such income.