Tax Court: Trusts Can Meet Material Participation Requirements, Avoid Passive Activity Rules

In a highly anticipated recent ruling, the US Tax Court shot down an Internal Revenue Service argument that trusts are by definition incapable of materially participating in the business assets they own and ineligible to utilize the net operating loss rules when those assets lose money. The court decided that trusts could avoid the “passive activity” tag, and its negative tax consequences, if their trustees were individuals who met the material participation rules of the tax code. The ruling represented an important win for the trustees of one family trust, and potentially many more in the future, as it means that the trusts can take greater advantage of their money-losing assets when they file their income tax returns.

As part of his estate plan, Frank Aragona created a trust in which he was the grantor and the original trustee. His five children and one independent professional were the trust’s successor trustees. Aragona funded some rental real estate properties, as well as some other real estate assets, into the trust. After Aragona’s death, the successor trustees managed the properties. When the trust filed its federal income tax returns in 2005 and 2006, the trust asserted that the rental real estate properties had lost money and claimed deductions for net operating losses which it carried back in accordance with net operating loss rules. The IRS assessed a deficiency against the trust, concluding that trusts cannot materially participate in business activities like rental real estate, meaning that the losses were passive activity losses and not eligible for treatment under the net operating loss rules, as the trust claimed.

The trust appealed to the the Tax Court, arguing that its rental real estate activity was not passive because it met the standard for a real estate professional. The IRS countered that the Section 469(c)(7) exception to the passive activity rule regarding rental real estate requires “personal services performed … by the taxpayer” and that this exception could apply only to individuals, not trusts. The court sided with the trust and said that it was possible for trusts to materially participate in the businesses they owned. The court stated that, because trusts were simply legal arrangements in which trustees managed assets for the benefit of beneficiaries, they could materially participate in the their business holdings if the trustees are individuals and those individual trustees meet the criteria imposed by Section 469(c)(7). The court pointed out that, if Congress had wanted to limit Section 469(c)(7)’s exception to individuals, it could have inserted the language “any natural person” instead of “taxpayer” to create such an outcome, but it did not do so.

Estate planning and tax planning often go hand in hand, as the choices one makes in one’s estate plan can have substantial impact on one’s tax liability and the liability of one’s successors. To get knowledgeable and clear advice about the income tax ramifications of your estate plan options, contact the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. They can discuss with you each of your options and the effect each one will have on your taxes, and weigh the pros and cons of each approach. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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Photo credit: Brian Turner at Wikimedia Commons.