Tax Court decision cuts 3.8 percent NII tax for many trusts

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


On March 27, 2014, the Tax Court in Frank Aragona Trust v Commissioner, 142 T.C. No. 9 (2014), held that a trust materially participated in its rental real estate business and, therefore, could deduct the losses it incurred in those activities as non-passive losses.

The Frank Aragona Trust was formed by Frank Aragona (a Michigan resident) during his lifetime. After his death, the trustees were his five children plus an independent trustee. Three of the children were also employees of an LLC which was wholly owned by the trust. Two of those three children were part owners of other LLCs in which the trust was a majority owner. The trust incurred substantial losses, but the IRS disallowed those losses due to its conclusion that the trust could not meet the material participation test of IRC Section 469.

IRC Section 469 prohibits the offsetting of losses from passive activities against non-passive income. However, there is an exception (IRC Sec. 469(c)(7)(B)) if the taxpayer meets both of the following tests:
    1. More than one-half of the personal services performed in the trade or business by the taxpayer are performed in businesses in which the taxpayer materially participates on a regular, continuous and substantial basis; and

    2. The taxpayer performs more than 750 hours of services for the trade or business.
In the case of the Frank Aragona Trust, the IRS made two arguments. First, the exception did not apply to trusts because “personal services” are defined under the Treasury Regulations Sec. 1.469-9(b)(4) as work performed by an “individual” (not a trust) in a trade or business. Alternatively, the IRS argued that even if trusts in general can come within the exception, the Frank Aragona Trust did not (because it failed to materially participate).

The Tax Court disagreed with the IRS’s first argument because the IRC Section 469(c)(7)(B) exception uses the word, “taxpayer," as opposed to “natural person” (a term used in another part of the Treasury Regulations under IRC 469). Thus, the Tax Court concluded that Congress did not intend to exclude trusts from the IRC Sec. 469(c)(7)(B) exception.
With respect to the IRS’s alternative argument, the Tax Court noted that there was no regulatory guidance for determining how a trust might materially participate. The IRS reserved Temp. Regs. Sec. 1.469-5T(g) for that purpose in 1988, but has yet to issue any guidance. Therefore, the Tax Court had to make its own determination. The IRS’s position was that the trustees’ services as employees of the businesses had to be disregarded. In other words, according to the IRS, a trustee can only materially participate if he/she is doing so in his/her fiduciary capacity. In response, the Tax Court held that under Michigan law, the trustees had a fiduciary duty to conduct the business for the beneficiaries’ benefit, and their activities as employees could be considered in determining the Trust’s material participation. The Tax Court also found that the trustees’ activities met the material participation test and, therefore, the losses were deductible.

Equally as important as allowing losses to be deducted, the Frank Aragona Trust v Commissioner ruling allows trusts to avoid the 3.8 percent Net Investment Income Tax under IRC Sec. 1411 when it comes to profits generated by trust-held businesses organized as pass-through entities. For trusts and estates, the NII Tax is 3.8 percent of the lesser of 1.) the undistributed net investment income for the tax year, or 2.) the excess of a.) the undistributed adjusted gross income for the tax year, over b.) $12,150 (for 2014). NII does not include, however, income from active, trade or business activity, or the disposition of property held in an active trade or business. Unfortunately, the Final Regulations under IRC Sec. 1411 did not address how a trust or estate can materially participate in the conduct of a trade or business (deferring instead to future guidance under the IRC Sec. 469 regulations).

Because of the lack of regulatory guidance, the Tax Court’s opinion in Frank Aragona Trust v Commissioner is quite significant. It’s the only judicial opinion since the enactment of the NII Tax to be handed down on the issue. It’s important to note, however, that the Tax Court’s decision by its terms only covers situations in which the trustee is materially participating in the trade or business activity. Unfortunately, the Tax Court did not go as far as a Texas U.S. District Court did in Mattie K. Carter, 256 F Supp 2d 536 (Tex. 2003), which counted participation of trust employees in determining whether the trust materially participated in the trade or business. The Tax Court said, “We need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.” Thus, while the Tax Court did not say that non-trustee employees can give trusts material participation, it did not rule it out either. Future litigation will have to settle that issue. Nevertheless, the Frank Aragona Trust decision is a big taxpayer win. It is also likely to be appealed by the IRS.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS
BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT
INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL
AND TAX ADVISERS AS TO THEIR SPECIFIC SITUATION.