Tax Court Determines that a Trust Can Materially Participate

by Arthur A. DiPadova

On March 27, the Tax Court issued a decision in Frank Aragona Trust, et al. v Commissioner, 142 TC 9 (2014).  The case is very significant in that it held that a trust, through the activities of its trustees, could materially participate in an activity for purposes of the passive loss rules under Code Section 469.  The passive loss rules were enacted to limit the ability of taxpayers to deduct losses from certain activities (and in particular from real estate and rental activities) against other forms of income.  Because the thrust of Section 469 had to do with the ability to use losses, the issue did not arise that frequently in the context of trusts.

An unanswered question since 1986 has been whether a trust could materially participate and if so, how.  Notwithstanding the fact that no official guidance nor any Regulations have ever been issued in the matter, the Service has indicated many times its position that trusts could not participate, could not satisfy material participation, and that the activities of a trustee would not be counted for purposes of applying the rules under Section 469.  In Aragona, the Tax Court flatly rejected that position and concluded that work performed by a trustee in connection with a trade or business of the trust would count.  Not only did it determine that a trust could demonstrate material participation through the activities of the trustee, the court also determined that a trust, through its trustees, could also be treated as a “real estate professional” for purposes of Section 469(c)(7).  Generally real estate rental activities are per se passive, however, Section 469(c)(7) allows persons engaged in real estate trades or businesses, and who can demonstrate material participation, to treat their rental activities as active.  This was extended by the Court to trusts.

Prior to Aragona, there was only one other case dealing with the issue (Mattie K. Carter Trust v U.S., 256 F.sup. 2d, 536(N.D. Tex. 2003)) and that case had peculiar facts.  The decision is especially important now as a result of the new 3.8% tax on Net Investment Income under Section 1411.  For trusts with taxable income in excess of $12,000, the Section 1411 tax applies to rents (other than rental income incurred in the ordinary course of a trade or business) and passive activities.  There has been much discussion about whether and what a trust could do to attempt to avoid the Section 1411 tax on its real estate activities and much of that was guesswork because of the lack of guidance.  Now there is something solid for taxpayers to consider as a base.  However, the Aragona case does not automatically mean that the trust will materially participate or that a trust with rental activities will be treated as a real estate professional.  Much will depend on the facts, what the trustees do and are required to do, and meeting all of the other requirements of these particular provisions.  Also, there still remain unanswered questions.  For example, what about a trust that owns stock in a corporation that operates a business.  If the person who is the trustee of the trust also happens to be the president of the corporation, does his services count as activities on behalf of the trust or in his capacity as an officer of the corporation?  While there will be many lingering questions, this case remains a significant favorable development for taxpayers.

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