One of the most vexing tax issues remaining unresolved since the 1986 enactment of the passive loss (PAL) rules is whether business or rental income earned by a trust can be active income and whether business or rental losses sustained by a trust can be active losses. The enactment of the 3.8 percent net investment income tax (NII Tax) increases the significance of the uncertainty surrounding this issue. The taxpayer’s total victory in the March 27, 2014, tax court decision, Frank Aragona Trust v. Commissioner, provides a partial answer to this question just in time for the 2013 tax filing season. Because the Internal Revenue Service (IRS) may yet appeal this case, it does not definitely resolve these issues.
Income or losses for PAL purposes are generally active when the taxpayer “materially participates” in the business or real estate activity. Congress enacted the PAL rules to prevent a taxpayer from taking business or rental activity tax losses against portfolio, salary and other income, unless the taxpayer materially participated in the business or rental activity generating the loss. These rules are significant for purposes of the NII Tax because income from a business or real estate activity if active is exempt from the NII Tax and if passive is subject to the NII Tax.
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