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Made in Michigan: Case produces fruitful holding for business owners
As the material participation debate continues to ripen, taxpayers and tax professionals are provided with the sweet taste of clarity surrounding the question of whether a trust may materially participate in a trade or business.
To the present day, overcoming the “material participation” hurdle of the passive activity loss rules has been a prevailing concern of taxpayers looking to deduct business losses. Preserving the ability to deduct business losses and in light of Internal Revenue Code 1411’s 3.8 percent Medicare surtax, ensuring that this standard is met is of great importance.
The surtax is imposed on Net Investment Income, which includes income earned from passive trade or business activities. Unless a taxpayer “materially participates” in the activity, that trade or business is considered a passive activity. While the activities of an individual taxpayer will certainly count toward the regular, continuous and substantial requirement of 469, it is less clear whether the activities of trustees, including those as employees, should be considered.
The Tax Court in Frank Aragona Trust v. Commissioner has provided further guidance to taxpayers with trusts holding business interests. While the opinion provides valuable insight, its reach is limited.
Remaining unanswered since 1986 was the question of whether a trust can materially participate in a trade or business. In what appeared to be a case of first impression in the 2003 case of Mattie K. Carter Trust v. United States., a federal district court in Texas held that material participation may be determined by taking into account the activities of the trustee, in addition to those of the trust’s non-trustee employees and agents. Following the Carter decision in two Technical Advice Memoranda and one Private Letter Ruling, the Service opined that only a trustee’s time, when spent acting in a trustee/fiduciary capacity, would count toward satisfying the regular, continuous and substantial involvement requirement.
Despite a continued lack of regulatory guidance from the Service on material participation for trusts, the Tax Court provided meaningful instruction in Frank Aragona Trust. This case represents a significant favorable development to taxpayers that have trusts holding business interests.
In Frank Aragona Trust, the Tax Court held that the activities of trustees, in both fiduciary and employment capacities, could count in determining whether the material participation threshold is met. A Michigan trust held rental real estate which operations were managed by a limited liability company that employed three of six trustees, in addition to other employees. During 2005 and 2006, the trust incurred losses from its real estate activities that were reported on its federal tax return as “non-passive” losses.
Rental real estate is considered “per se” passive, unless the activity meets the established exception provided under the Code. The exception applies if more than one-half of the services performed are in real property trades or businesses in which the taxpayer materially participates and performs more than 750 hours in during the taxable year.
It was the Service’s position that the trust did not qualify for the exception to consider the income as “non-passive” for two reasons. First, the Service argued that personal services may only be provided by individuals and not a trust. Second, the Service emphasized that even if a trust could provide personal services under the applicable definition, the trust did not materially participate in the activity because the trustees, in their fiduciary capacity, did not meet the material participation requirement. The Service concluded that the trustees employed by the LLC should be disregarded in determining whether the material participation requirement has been met.
In an unexpected opinion by the Tax Court, the Service’s arguments were rejected. The Tax Court finding that a trust was capable of performing personal services, reasoned “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.”
Basing its opinion on Michigan’s applicable state law, the Tax Court held that the activities of trustees, as employees, should be considered in determining whether a trust has materially participated in a trade or business activity.
The Tax Court’s decision in Frank Aragona Trust is a significant victory for taxpayers who have trusts with trustees engaged in employment roles and a departure from the restrictive view taken by the Service in its previous rulings. The Service maintained a very limited interpretation of the “material participation” requirement and stressed that only individuals could perform personal services, and that even if trusts could perform such services, only the activities of a trustee, and not an employee, could be considered.
While Frank Aragona Trust specifically involved rental real estate activities, its holding likely has broad application to other trade or business activities, to the benefit of all taxpayers. While the Tax Court provided much needed insight to the question of what constitutes material participation by a trust, many ambiguities remain. For example, the Tax Court failed to address the issue of whether non-trustee employees may be considered.
While a noteworthy triumph, taxpayers and fiduciaries should ensure that they fully understand and receive clear guidance on the Code’s application to the Tax Court’s decision in Frank Arogona Trust. Future developments in discussion and law will determine how, and to what extent, the Tax Court’s holding is received by the Service.
Jamie Downes is an associate in Private Client Services at BDO in Grand Rapids.