Frank Aragona Trust v. Commissioner: Guidance at Last on The Material Participation Standard for Trusts? By Dana M. Foley 1

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1 Frank Aragona Trust v. Commissioner: Guidance at Last on The Material Participation Standard for Trusts? By Dana M. Foley 1 Nearly a year after the enactment of the 3.8% Medicare Tax, taxpayers and fiduciaries alike are still in search of authoritative guidance to aid in their understanding of how the material participation requirements under Section 469 apply in the context of an estate or trust for purposes of qualifying for an exception to this new tax. While the Treasury Department and the Internal Revenue Service ( IRS or Service ) released final regulations under Section 1411 on November 26, 2013, these regulations only provide guidance on the general application of the Medicare Tax and the computation of net investment income. The preamble to the final regulations notes, that while commentators have raised valid concerns by pointing out that case law and IRS guidance surrounding the application of the material participation requirements in the context of an estate or trust conflict, the Treasury Department and the IRS believe that further guidance on the issue would be addressed more appropriately in the section 469 regulations. The preamble goes on to state that because the issues inherent in drafting administrable rules under section 469 regarding the material participation of estates and trusts are very complex... addressing material participation of trusts and estates at this time would significantly delay the finalization of these regulations. Therefore, the issue of material participation of estates and trusts is still currently under study by the Treasury Department and the IRS and may be addressed in a separate guidance project issued under section 469 at a later date. Despite the continued lack of regulatory guidance, however, a case currently pending before the United States Tax Court, Frank Aragona Trust v. Commissioner, U.S. Tax Court Docket , could offer some much needed clarity regarding the application of the material participation standard in the context of a trust. The Tax Court s decision in this case will prove to be quite significant, as it is the first time the Tax Court has ruled on the application of the material participation standard to a trust, and it will be the only judicial opinion since the enactment of the Medicare Tax to be handed down on the issue. I. The 3.8% Medicare Tax and the Passive Loss Exemption Effective January 1, 2013, Section 1411 imposes a 3.8% Medicare Tax on net investment income of certain high-income individuals, estates and trusts. Net investment income is comprised of: (1) specified income (a taxpayer s gross income from interest, dividends, annuities, royalties, rents and other passive income), (2) certain business income (gross income from a trade or business), and (3) covered gains (gains derived from the disposition of property), less properly allocable expenses. As applied in the context of an estate or trust, Section 1411(a)(2) imposes a tax of 3.8% on the lesser of: (1) the undistributed net investment income for such taxable

2 year, or (2) the excess (if any) of (a) the adjusted gross income for such taxable year, over (b) the dollar amount at which the highest tax bracket in Section 1(e) begins for the tax year in question ($11,950 for 2013). With the Medicare Tax imposed at a much lower threshold income level for estates and trusts than for individuals, nearly every fiduciary should be concerned with minimizing the application of this tax. One way in which a fiduciary may minimize the application of the 3.8% Medicare Tax is to demonstrate that the trust or estate materially participates in the activity generating trade or business income. Certain types of income are specifically excluded from the definition of net investment income, including non-passive trade or business income. This important exception requires: (1) there be an activity that involves a trade or business within the meaning of Section 162, and (2) the taxpayer materially participates in the activity as defined in Section 469. II. Material Participation of Trusts: Legislative History, Prior Case Law, and Past Private Rulings Section 1411 looks to Section 469 to determine whether there is passive activity. Section 469(h)(1) provides that a taxpayer shall be 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. Section 469(a)(2)(A) explicitly identifies estates and trusts as taxpayers to whom the passive activity rules apply. While individuals may use one of seven quantitative tests outlined in the regulations to establish material participation and avoid passive activity treatment, there is not a clear set of rules regarding material participation by estates and trusts. Although the Treasury Department reserved regulations addressing the application of the material participation rules in the context of an estate or trust nearly twenty-five (25) years ago, those regulations have never been issued. a. Legislative History Given the lack of statutory and regulatory guidance on the application of the material participation standard in the context of an estate or trust, the IRS relies almost exclusively on the legislative history surrounding Section 469, and takes the position that estates and trusts are not treated as individuals for purposes of establishing material participation. Relying on the Senate Report accompanying the Tax Reform Act of 1986, which included Section 469, the IRS maintains that the material participation requirements in the context of an estate or trust can only be met if the fiduciary is involved directly in the operations of the business on a regular, continuous, and substantial basis. The Senate Report relied upon by the Service treats an estate or trust as materially participating in an activity if an executor or fiduciary, in his capacity as such, is so participating (emphasis added). Therefore, the IRS has recently advanced a fiduciary capacity argument in which the Service argues that material participation by an estate 2

3 or trust should be determined solely by reference to the activities of the fiduciary acting only in a fiduciary capacity. b. Case Law: Mattie K. Carter Trust v. United States Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003) is the only court decision to date addressing the issue of how a trust materially participates for purposes of Section 469. In Carter, the trust owned a 15,000-acre cattle ranch. The trustee spent significant time reviewing financial records and making financial decisions on behalf of the trust and the ranch. The day-to-day operations of the ranch, however, were carried on by a non-trustee ranch manager and farm hands employed on either a full-time or part-time basis to run the ranch operations under the trustee s supervision. Relying almost exclusively on the legislative history contained in the Senate Report, the IRS took the position that only the actions of the trustee, individually, and not the activities of the ranch manager or farm employees, should count for purposes of determining material participation by the trust. Looking only to the trustee s activities, the IRS submitted that the work performed by the trustee, individually, did not amount to regular, continuous, and substantial participation by the trust. The taxpayer, on the other hand, argued that, like a closely held C corporation, a trust could only participate in an activity through its fiduciaries, agents and employees and that the activities of all persons acting on behalf of the trust or participating in the trust-owned business should therefore be included for purposes of meeting the material participation standard. The taxpayer maintained that in assessing all of the activities performed by the trustee, ranch manager and farm employees, the trust materially participated in the operations of the cattle ranch. The District Court ultimately found for the taxpayer, holding that material participation should be determined by reference to all persons who conducted business on behalf of the trust, regardless of whether those activities were conducted by employees or fiduciaries. The Court dismissed the Service s reliance on the snippet of legislative history the IRS supplied, observing that measuring a trust s participation solely by reference to the trustee finds no support within the plain meaning of the statute, and concluding that the court only resorts to legislative history where the statutory language is unclear, which, is not the case here. c. Private Rulings Although acknowledging the existence of the Carter decision, the IRS rejected the District Court s rationale in Technical Advice Memorandum , in which the Service found that merely appointing a person involved in the business as a special trustee would not suffice for purposes of establishing material participation by a trust. Under the facts of that TAM, the special trustee was involved in some of the day-to-day operations of the business, such as reviewing the operating budget and negotiating sales, however, the decision-making authority remained solely in the hands of another 3

4 trustee. The IRS held firm to its position that only a fiduciary s actions may be assessed in determining material participation in the context of a trust. Because the special trustee did not hold discretionary authority to act on behalf of the trust, the Service concluded that the special trustee was not a fiduciary, and therefore the special trustee s activities could not count for purposes of meeting the material participation requirements. Private Letter Ruling reiterated the Service s position that a trust materially participates in a business activity only if the trustee is directly involved in the operations of the trust s business activities on a regular, continuous and substantial basis. Interestingly, the IRS did not even refer to or acknowledge the Carter decision in this letter ruling. Technical Advice Memorandum is the latest installment from the Service on the application of the material participation standard to a trust. Under the facts of this recent TAM, A, one of the beneficiaries of two almost identical trusts, was appointed as special trustee of the trusts. As special trustee, A only held the power to vote and sell sock of Company X (an S corporation) and Company Y (a qualified subchapter S subsidiary of Company X) owned by the two trusts. While A did not participate in the day-to-day operations of either company, A served as president of Company Y and owned the remaining outstanding stock in Company X. The taxpayer submitted that A s roles as special trustee, president of Company Y, and individual shareholder of Company X were all interrelated, and that it was impossible to differentiate among A s time spent in these various capacities, since A s obligations in each role were carried out simultaneously. Therefore, the taxpayer asserted that all of A s activities should be considered and credited in determining whether the trusts materially participated. The IRS, however, focused on two issues: (1) A s power as special trustee was limited, and (2) A s activities as president were not conducted in A s fiduciary role as a trustee of the trust. In examining only the special trustee s time spent in a fiduciary role, here, voting and selling the stock, the Service concluded that the special trustee s activities did not rise to the level of regular, continuous, and substantial participation by the trust. III. Pending Tax Court Case: Frank Aragona Trust v. Commissioner Frank Aragona Trust v. Commissioner was tried before the Honorable Richard T. Morrison of the United States Tax Court in May The case concerns whether a trust can qualify for the real estate professional exemption under Section 469(c)(7), which would allow the trust to deduct losses from any rental real estate activity in which the trust materially participates. While the case is still currently pending and does not directly concern the application of the Medicare Tax, the Court s decision will nevertheless address the material participation standard in the context of a trust, which will provide some guidance to taxpayers and fiduciaries, who are eager for authority on how to meet the requisite material participation requirements under Section

5 a. Facts and Issues The petitioner, Frank Aragona Trust (the Trust or Taxpayer ), is a residuary trust created under the revocable trust of the decedent, Frank Aragona, and governed by the laws of the State of Michigan. The Trust owned interests in various rental real estate ventures, however, because of liability concerns, the trustees, with the consent of the probate court, transferred assets of the real estate business owned by the Trust to HE LLC (the LLC ). The LLC was disregarded for income tax purposes, as it was wholly owned by the Trust. The LLC commenced managing the rental properties and employed leasing agents, maintenance workers, accountants, and various other nontrustee employees. The decedent s five children and an independent trustee were appointed as trustees of the Trust. During the years in question, three of the decedent s children worked nearly full-time in managing the real estate investments and were heavily involved in the day-to-day operations of the business, while the two remaining children and the independent trustee had no involvement in the Trust activities, other than attending periodic trust meetings to discuss the Trust s business. The three trustees who were heavily involved in the daily operations of the real estate business were all employed by the LLC and collected an annual salary from and participated in the 401(k) plan of the LLC. Two of the three trustees who were heavily involved in the daily operations of the business, also individually owned an interest in several of the rental properties in which the Trust held an ownership interest. Taking the position that the Trust participated in the real estate business activity on a regular, substantial and continuous basis, losses from the rental real estate activity were claimed on Schedule E of Form 1041 for the tax years at issue, and certain losses were carried back to adjust prior tax years. In this case, the IRS seeks to disallow these losses as passive losses under Section 469 and, accordingly, recover refunds the Trust received in carrying losses back to prior tax years. The principal issues before the Tax Court are: (1) whether the Trust could qualify for treatment under Section 469(c)(7) as a real estate professional, and (2) whether the Trust materially participated in its real estate trade or business through the activities of its trustees and/or employees. a. Whether the Trust Could Qualify as a Real Estate Professional In general, real estate rental activity is treated as a passive activity under Section 469(c)(2), regardless of the extent to which a taxpayer materially participates in that activity. If a taxpayer, however, is a qualifying taxpayer under Section 469(c)(7)(B) (also commonly referred to as a real estate professional ), the taxpayer may avoid automatic passive activity characterization, and, accordingly, may use losses or credits generated by the activity to offset non-passive income. To determine if the taxpayer is a real estate professional, the taxpayer must meet two requirements under Section 469(c)(7)(B): (1) more than one-half of the taxpayer s personal services performed 5

6 during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates, and (2) such taxpayer must perform more than 750 hours of services during the tax year in such real property trades or businesses in which the taxpayer materially participates. In its briefs, the IRS argues that a trust cannot qualify for treatment as a real estate professional because a trust is not capable of performing personal services under Section 469(c)(7)(B). The Service cites Treas. Reg. Section (b)(4), which defines personal services to mean any work performed by an individual in connection with a trade or business (emphasis added). In examining the plain language of the statute, the IRS argues that the use of the word individual indicates that only a human being can perform personal services. The IRS asserts that the legislative history surrounding Section 469(c)(7) supports this limited reading because it only outlines tests used to determine whether an individual taxpayer or a closely held C corporation meet the eligibility requirements. The Service argues that if Congress intended for Section 469(c)(7)(B) to apply to a trust, it would have provided a carve out as it did for closely held C corporations. The Taxpayer argues that, pursuant to Section 469(c)(7)(A) the real estate professional exemption applies to any taxpayer for a taxable year meeting the conditions specified in Section 469(c)(7)(B). The Taxpayer quotes Section 469(a)(2)(A), which identifies any individual, trust or estate as a taxpayer described in Section 469. The Taxpayer also examines the etymology of the word personal, asserting that the term personal derives from person, and pursuant to Section 7701(a)(14), the definition of person includes a trust. Therefore, the Taxpayer takes the position that Congress contemplated that a trust is capable of performing personal services for purposes of Section 469(c)(7). The Taxpayer next dismisses the IRS s narrow reading of the legislative history, arguing that the reference to individuals and closely held C corporations should be viewed as merely illustrative, rather than exclusionary. The Taxpayer points out that Treas. Reg (c)(2) expressly acknowledges that a corporation can perform personal services, and asserts that there is no reason to interpret personal services to apply in the context of a corporation but not a trust, where both entities can only act through the actions of their agents and/or fiduciaries. b. Whether the Trust Materially Participated in its Real Estate Trade or Business Through the Activities of its Trustees and/or Employees In order to qualify for treatment as a real estate professional under Section 469(c)(7), a taxpayer must also meet the material participation requirement. In support of its position that the Trust in this case does not meet the material participation standard, the IRS cites to no new authority in its briefs, and relies principally on the fiduciary capacity argument. While the Service does not dispute that three of the trustees may have worked the requisite number of hours in the Trust s real property trades or businesses and rental real estate activities, the Service asserts that the hours worked do not count towards the Trust s material participation because the services performed by those three trustees were primarily performed as employees of the LLC or 6

7 as co-investors, and not in their fiduciary capacity as trustees. The IRS cites to the fact that these three trustees received wages from the LLC and participated in the LLC s 401(k) plan, and that two of three trustees were minority investors in some of the real estate partnerships, to support its argument that the trustees actions were not performed in a fiduciary capacity. The IRS submits that since the Trust chose to treat the three trustees as employees of the LLC, the Trust should be held to the form it chose, and cannot seek to re-characterize the trustees actions for purposes of meeting the material participation requirements. In arguing that the Trust did not met the material participation requirements, the IRS takes direct issue with the District Court s opinion in Carter. The IRS asserts that the District Court s holding was flawed because the District Court looked solely at the definition of taxpayer while ignoring that Section 469(h)(1) requires the taxpayer (and not the employees of the taxpayer) to be involved in the operations of the business on a regular, continuous, and substantial basis. The IRS maintains that it is appropriate to look only to the work performed by the fiduciary of a trust acting in his or her capacity as such, and asserts that if advisors or general employees could be classified as fiduciaries by merely providing them with a fiduciary label, the material participation requirements of Section 469 as applied to trusts would be rendered meaningless. The Taxpayer, on the other hand, argues in its briefs that there is no statutory basis or other authority mandating that a trust meet the material participation requirements solely through the actions of its trustees. In support of its position, the Taxpayer cites to Carter, in which the court allowed the activities of employees to count in determining whether the trust in that case materially participated. The Taxpayer further points out that the Service s own Blue Book states that [n]o special rule is provided for determining material participation by a trust. The Taxpayer therefore asserts that, in the absence of a special rule or specific statutory mandate requiring that only the actions of the trustees in their fiduciary capacity should count toward the material participation requirements, the activities of non-trustee employees should also be considered in determining whether the Trust materially participated. The Taxpayer further argues that even if the activities of over a dozen of the nontrustee employees who worked full-time to manage and run the Trust s real estate business were disregarded, the activities performed by at least three of the trustees meet the necessary quantum of work. In countering the IRS s argument that the trustees were wearing the wrong hat in performing their services, the Taxpayer points to state law and general trust law for the proposition that a trustee of a trust necessarily performs all work in accordance with the trustee s fiduciary duties, regardless of the type of work performed. The Taxpayer cites to Michigan case law, which the Taxpayer argues makes clear that a trustee of a trust who also works for a subsidiary entity owned by the trust must act for the subsidiary at all times in a manner consistent with the trustee s fiduciary duties to the trust. Therefore, if the trustee is acting as manager of an LLC owned by a trust, for example, any actions taken by the trustee as manager of the LLC cannot be 7

8 inconsistent with the trustee s fiduciary duty as trustee of the trust. In asserting this non-tax, state law argument, the Taxpayer is essentially arguing that it is impossible for the trustees of a trust to remove their fiduciary hat, even while carrying out multiple roles relating to the activities of the trust or of a trust-owned entity. The Taxpayer asserts that none of the three trustees who were employed by the LLC viewed themselves as merely performing duties as employees, but rather, they always viewed themselves as carrying out their fiduciary duties as trustees of the Trust. The Taxpayer maintains that this understanding comports with Michigan statutory and case law. IV. Commentary and Conclusion While the IRS continues to advance the fiduciary capacity argument, the Taxpayer s non-tax argument based on state law pokes a new hole in the logic behind the IRS s theory. While Service does not counter the Taxpayer s state law argument, which suggests that a trustee is never able to take an action as manager of a trustowned LLC inconsistent with the trustee s fiduciary duties under Michigan law, the Taxpayer raises an interesting argument that squares not only with state law, but with fundamental principles of basic trust law. The notion that a trustee ceases to act in his or her capacity as a fiduciary of a trust when he or she is employed by a business owned by the trust is contrary to black letter trust law. Perhaps the most fundamental duty owed by a trustee is the duty of loyalty, which prohibits the trustee from dealing with trust property for the benefit of the trustee or any third party, and from placing himself or herself in a position inconsistent with the interests of the trust. Even when a trustee serves in multiple roles, the trustee cannot simply disregard his or her fiduciary obligations to the beneficiaries when acting in another capacity, as that would be inconsistent with the interests of the trust and the fiduciary s undivided loyalty. Moreover, courts have found that this duty of loyalty extends to employees and agents of the trustee. Therefore, every action taken either by the trustee or by an employee or agent of the trustee, no matter in what capacity, must be consistent with the overarching duty of loyalty as a guide star. The IRS s position that only the activities of a trustee and only those actions of a trustee taken in a fiduciary capacity count toward a trust s material participation is therefore at odds with fundamental trust law. The duty of loyalty is a ubiquitous and unwavering obligation. It is therefore impossible to draw a distinction between when a fiduciary is acting solely in his or her capacity as trustee and in his or her capacity as director of a trust-owned business, for example, because a trustee is unable to disregard his or her duty of loyalty to the trust beneficiaries even when acting in multiple capacities. Where the Service seems to envision a trustee exchanging his or her hat as trustee for a different hat when acting as an officer of a company, the reality under black letter trust law is that a trustee must wear two hats when taking on an additional role in a trust-operated business. Given that the IRS s current fiduciary capacity argument appears at odds with basic principles of fundamental trust law, it is of even greater importance that taxpayers 8

9 and fiduciaries receive clear guidance on the application of the material participation requirements in the context of an estate or trust. The American Bar Association Tax Section submitted comments to the proposed regulations under Section 1411 on April 5, 2013, which propose regulations that would recognize material participation by an estate or trust under any of three tests, one of which is that [t]he fiduciary participates in the activity on a regular, continuous, and substantial basis, either directly or through employees or contractors whose services are directly related to the conduct of the activity. In addition to recommending that the actions of agents and third parties count for purposes of meeting the material participation requirements, the Tax Section also recommends that material participation of a trust could be based on the direct participation of the fiduciary for any time spent whether the fiduciary is working on the activity as a fiduciary or in another role, for instance as an officer or an individual investor. If adopted, whether as part of the Section 1411 regulations or as new regulations under Section 469 as the IRS suggested in the preamble to the final Section 1411 regulations, the Tax Section s comments would more accurately reflect the reality of a trustee s unwavering fiduciary duties under basic principles of fundamental trust law in applying the material participation requirements to a trust. Despite approaching the one-year anniversary of the enactment of the 3.8% Medicare Tax, taxpayers still face great uncertainty in the application of the material participation requirements in the context of a trust. The Tax Court s decision in Frank Aragona Trust v. Commissioner will hopefully provide some much needed guidance for taxpayers in these uncharted waters, however, whether the Tax Court follows suit with the District Court s opinion in Carter, or recognizes the recommendations advanced by the ABA Tax Section still remains to be seen. 1 Dana M. Foley is an Associate at Arnold & Porter LLP in Washington, D.C. and is a Fellow of the Real Property Trust & Estates Section of the American Bar Association. Dana focuses her practice on sophisticated estate, gift and generation-skipping transfer tax planning for high net worth individuals. Dana can be reached at dana.foley@aporter.com. 9