The Tax Court held that a trustee's activities in a trade or business of a trust was work performed by an individual, and, therefore, it was possible for a trust to qualify for the Sec. 469(c)(7) exception to the treatment of rental real estate activities as per se passive activities.
The Frank Aragona Trust is a Michigan-based trust that owns rental real estate properties and is involved in other real estate activities including holding and developing real estate. Frank Aragona formed the trust in 1979, naming himself as trustee and his five children as beneficiaries who shared equally in the trust's income. When Aragona died in 1981, his children became the trustees along with a sixth independent trustee. The trustees delegated their powers to an executive trustee to facilitate the trust's business operations, but all the trustees continued to act as a management board for the trust, met regularly to discuss the trust's business, and were paid trustee fees.
Three of the children worked full time for Holiday Enterprises LLC, which was owned by the trust and treated as a disregarded entity. This LLC managed most of the trust's rental real estate properties. Overall, the trust conducted some of its rental real estate activities directly, some through wholly owned entities, and the rest through entities in which it owned majority interests and in which two of the children owned minority interests.
During the 2005 and 2006 tax years, the trust incurred losses from its rental real estate properties. On its returns, the trust treated its rental real estate activities, in which it engaged both directly and through its ownership interests in a number of entities, as nonpassive activities. Treated as such, the losses from these activities contributed to net operating losses (NOLs), which the trust carried back to its 2003 and 2004 tax years. The trust also reported gains from its other nonrental real estate activities.
In a notice of deficiency, the IRS determined that the trust's rental real estate activities were passive activities, a determination that increased the passive-activity losses for 2005 and 2006. The increase in the passive-activity losses resulted in a decrease in the allowable deductions from gross income for each of those years, which decreased the trust's NOL carrybacks to the 2003 and 2004 years.
A passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not participate (Sec. 469(c)(1)). In addition, any rental activity is considered a passive activity, even if the taxpayer materially participates (Sec.469(c)(2)). However, under Sec. 469(c)(7), a rental real estate activity will not be considered per se passive if:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and
- The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
Under Regs. Sec. 1.469-9(b)(4), personal services are defined to mean any work performed by an individual in connection with a trade or business.
Sec. 469(h) provides that for purposes of Sec. 469, a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a regular, continuous, and substantial basis.
The IRS's Arguments
The IRS offered two arguments for why the trust's activities were passive activities. The first was based on the requirement that the taxpayer perform "personal services" for the Sec. 469(c)(7) exception to passive loss treatment to apply. The IRS noted that the regulations' definition of personal services refers to "work performed by an individual." Thus, a trust could not qualify for the exception.
The IRS also pointed to the legislative history of Sec. 469(c)(7) in support of this argument. A House Ways and Means Committee report about the bill that enacted Sec. 469(c)(7) described the provision as applying to individuals and corporations and described how each could qualify for the exception. The report did not describe how any other type of taxpayer could meet the exception's requirements. The conference committee report likewise only described how individuals and corporations could meet the exception's requirements. Therefore, according to the IRS, these reports indicate that Congress did not intend for other entities to qualify for the exception.
In the alternative, the IRS argued that the Sec. 469(c)(7) exception did not apply because while the trust's real estate operations qualified as real property trades or businesses, it did not materially participate in those operations. The IRS asserted that in determining material participation of the trust, only the activities of the trustees, and not the activities of nontrustee employees of the trust, could be considered. The IRS also claimed that the activities that the trustees who were employees of the trust (through Holiday Enterprises) performed as employees could not be taken into account. Finally, the IRS argued that some of the activities of two of the trustees could not be included in the determination because they owned minority interests in some of the trust entities.
The Tax Court's Holding
The Tax Court held that a trust can perform personal services through a trustee and consequently qualify for the Sec. 469(c)(7) exception to passive loss treatment for rental real estate activities. It further found that the Frank Aragona Trust did materially participate in real property trades or businesses and therefore qualified for the exception.
The Tax Court observed that a trust is an arrangement in which trustees manage assets for the trust's beneficiaries. The court found that if the trustees of a trust are individuals and they work on a trade or business as part of their trustee duties, their work is work performed by an individual. The court posited that if Congress had meant to exclude trusts from the Sec. 469(c)(7) exception, it would have limited the exception to "any natural person," similar to the way it limited the special $25,000 offset for rental real estate activities in Sec. 469(i).
With respect to the IRS's legislative history argument, the Tax Court found that the IRS drew an incorrect conclusion from the committee reports. The court noted that while the reports said the exception applies to individuals and closely held C corporations, it did not say it applied only to those two types of taxpayers.
Having determined that the trust could qualify for the Sec. 469(c)(7) exception, the Tax Court then analyzed the IRS's argument that the trust did not qualify because it did not materially participate in real property trades or businesses. The court explained that Sec. 469(h) provides that a taxpayer is treated as materially participating in an activity if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis, but that the IRS has not issued regulations specifically describing how a trust can meet this standard, so it was forced to make this decision without any regulatory guidance.
The court first considered whether all of the activities of the trustees who were employees of the LLC, including their activities as employees of the LLC, should be taken into account. The court found that under Michigan law, all of the trustees were required to administer the trust solely in the interests of the trust beneficiaries. Further, under Michigan law, the trustees are not relieved of this requirement by conducting the activities through a corporation wholly owned by the trust. Therefore, the activities of the trustees as employees of the LLC should be considered in the material participation determination.
The court noted that the employee trustees participated in the trust's substantial real estate operations full time and that they handled practically no other business on behalf of the trust. Thus, including all the activities of the employee trustees in the determination, the court concluded that the participation by the trustees in the trust's activities rose to the level of material participation, even if some of the activities of the two trustees who owned minority interests in trust entities were disregarded. Because it found the trust met the material participation standard based on the trustees' activities, the court did not decide whether the activities of the trust's nontrustee employees should be disregarded in the material participation determination.
In a footnote in its opinion, the Tax Court dropped a hint to the IRS, observing that, "A number of commentators have argued that there is a need for a regulation that resolves questions regarding material participation of trusts and generally coordinates the passive-activity-loss rules of sec. 469 with the rules on taxation of trusts in subch. J." Hopefully, the IRS will take this hint and provide such a regulation sooner rather than later.
Frank Aragona Trust, 142 T.C. No. 9 (2014)