In 2014, a significant Tax Court opinion provided some long-awaited guidance as to the application to trusts of the tax rules limiting losses incurred in passive activities. In Frank Aragona Trust v. Commissioner,1 the Tax Court held that a trust can qualify as a real estate professional under the "passive activity rules"2 based on the participation of the individual trustees and their involvement in the underlying activity. Clarification of this issue has been sought for many years in connection with the passive activity rules, but has now assumed considerably increased importance and interest since the enactment of the additional 3.8 percent Medicare tax,3 which became effective in 2013.
As discussed below, the passive activity rules only affect taxpayers whose business activity generates a loss; if the activity is characterized as "passive," use of the loss is limited. However, with the introduction of the new 3.8 percent Medicare tax, individuals and trusts, both of whom are subject to the tax, also may need to determine whether all their business interests are "passive" or "active."
The 3.8 percent Medicare tax is in addition to the regular income tax, and for trusts is imposed on the lesser of (1) undistributed "net investment income" (NII), or (2) the excess of adjusted gross income over the dollar amount at which begins the highest trust income tax bracket for the year ($12,300 for 2015). As a result, any trust with adjusted gross income in excess of $12,300 in 2015 must determine its NII. It is in this calculation that the passive activity rules come into play; if an activity is passive under the "passive activity" rules, the income generated will be NII and subject to tax. On the other hand, if the trust is active within the business, the 3.8 percent tax will not apply. The real estate professional rules, which are the subject of Aragona, allow a trust to materially participate in rental real estate activities, and so be considered active.
Background on the Rules
The 1986 passive loss rules came about to curb the expansive use of tax shelters and allow only taxpayers with substantial and bona fide involvement in certain activities the ability to deduct losses for the activity. The rules allow a loss produced in a passive activity in any year to be used only against other passive activity income of the same taxpayer. Any loss disallowed for the year is carried forward to the next year and is subject to the same limitations. Generally, any remaining suspended passive losses can be utilized against non-passive income when the activity is disposed of in a taxable transaction.
Whether an activity is deemed passive or active for any year is determined on a taxpayer-by taxpayer basis, so that a partnership's (or LLC's) income may be passive with regard to one partner but active with regard to another partner in the same entity. An activity is passive if a taxpayer does not materially participate in that particular trade or business. However, regardless of the level of the taxpayer's involvement, rental real estate activity is by statute, per se passive, unless the exception for certain qualified real estate professionals applies. The exception is nuanced, and close attention must be given to what is defined as an activity, what constitutes a trade or business, and what constitutes material participation.
Simply put, a taxpayer materially participates when involvement is regular, continuous, and substantial. However, the tax regulations provide quantitative tests to determine if this standard is met, and establishing material participation under one of these rules is paramount. The most commonly used test states that a taxpayer that devotes at least 500 hours during the year to the activity will be deemed to materially participate. This 500-hour test is the primary test for limited partners, but there are several other tests available to non-limited partners. Significantly, however, LLP and LLC members are not treated as limited partners for this purpose.
As noted above, a rental real estate activity is statutorily per se passive. However, there is an exception for certain qualified real estate professionals. Qualifying taxpayers must perform at least 750 hours of personal service in real property trades or businesses (including rental real estate) in which they materially participate, and this must constitute more than half of all hours of personal services performed by the taxpayer in all trades or businesses during the year.
Assuming this first hurdle is met, a taxpayer must then demonstrate material participation in rental real estate activities in order to be treated as non-passive. An election can be made to aggregate all rental real estate activities to facilitate meeting this material participation requirement. Since the hours test is most commonly used, it is important to keep very detailed, contemporaneous records.
Historically, there has been a lack of clear statutory and legislative guidance on the application of the material participation standards to trusts and estates. Regulations clarifying the rules for trusts and estates have still not been issued, nearly 30 years after the original enactment of the law. There has been a scarcity of other authority relating to the application of the passive activity rules to trusts, and these did not directly address the question as to whether a trust could qualify as a real estate professional.
'Aragona': A Turning Point
On March 27, 2014, the Tax Court ruled that the Frank Aragona Trust qualified for the "real estate professional exception" and the trust materially participated in the real estate rental business. The trust is a residuary trust governed by the laws of the state of Michigan. It owned rental real estate and was involved in other real estate holdings and development. After Frank Aragona passed away, his five children (also trust beneficiaries) and an independent trustee were appointed as trustees. One of Frank's children served as the executive trustee while others worked as full-time employees for an LLC which was wholly owned by the trust.
The trust conducted its real estate activities through the LLC and other entities in which it held a majority interest. It claimed that it should be treated as a real estate professional so that the losses would be currently deductible. The IRS sought to disallow the losses as passive losses and recover refunds that the trust had received. The main issues before the Tax Court were whether the trust could qualify for the exception as a "real estate professional" and whether the trust materially participated in real property trade or businesses via the activities of the trustees and employees.
The IRS first argued that real estate professional rules did not apply to trusts at all, and that the legislative history supported their position. The IRS asserted that the definition of personal services for this purpose is "work performed by an individual in connection with a trade or business," and so could only be performed by an individual and not a trust. The court ultimately rejected this position by noting that a trust is an arrangement whereby the trustee manages assets for the trust's beneficiaries and is therefore capable of performing personal services. The court suggested that if Congress wanted to exclude trusts from the exception, it could have done so by limiting the exception to any natural person.
The IRS also took the position that, if a trust could qualify at all, only the activities of a trustee taken in a fiduciary capacity count toward material participation. The trust argued that under Michigan trust law, a trustee always has a fiduciary obligation to the beneficiaries of the trust, even when performing as an employee. Again, the court ruled in favor of the trust by holding that the time the trustee spent as trustee and employee should be used in determining material participation.
A Victory with Holes
While Aragona is clearly a taxpayer victory, in that it established that trusts may qualify as real estate professionals, there are still many questions left unanswered. The court partially cleared the ambiguity over the treatment of trustees who perform activities on behalf of the trust in a fiduciary capacity as well as being employees of the underlying business entity. Interestingly, however, the court did not address the proper allocation of hours in computing the 500-hour test for determining material participation because the IRS never included that as part of their arguments. Also, the court did not address the treatment of non-trustee employees and corporate trustees.
At this point, it is not clear how the IRS will respond to the Tax Court opinion. While it may not appeal, these unresolved issues leave room for the IRS to propose regulations that could limit the application of the real estate professional rules to trusts. In any event, the decision has opened a door for trustees to take advantage of the real estate professional exception for both the passive activity rules and the 3.8 percent Medicare tax, but it is clear that planning needs to be done. It is important to keep in mind that the determination of whether a taxpayer materially participates in a real estate rental activity is made on an activity-by-activity basis unless the taxpayer makes an affirmative aggregation election. In addition, careful attention must be given to language within trust instruments that may limit certain powers of trustees participating in trust-owned businesses.
Trusts that have income from trades or businesses, including rental real estate, should seek out expert advice to capitalize on the potential tax advantages, whether the trust's business generates losses subject to the passive activity limitations, or generates income which could be subject to the new Medicare tax.
1. Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014)
2. See Internal Revenue Code Section 469
3. See Internal Revenue Code Section 1411
Reprinted with permission from the February 20, 2015 issue of The New York Law Journal. © 2015 ALM Media Properties, Inc. Further duplication without permission is prohibited. All rights reserved.