Did Aragona Answer All Questions? An Analysis of Outstanding Issues for Trusts Owning Rental Real Estate

By Katie Groblewski and RoseMary Reed

“Frank Aragona Trust v. C.I.R. is the first and only Tax Court case to address whether the income earned by an irrevocable trust holding rental real estate is non-passive.  While the case was a victory for the trust taxpayer, the Tax Court did not fully analyze all aspects of the passive activity rules, leaving questions unanswered for families preparing succession plans for rental real estate businesses.  It is imperative for advisors and their clients to review the complex matrix of passive activity rules and the application of state law fiduciary duties to derive a managerial structure that will suit both tax objectives and business management realities.  Avoiding application of the passive activity rules to a trust-owned rental real estate business may still be quite a challenge.”

Now, Katie Groblewski and RoseMary Reed provide members with their analysis of Aragona.  Members will find their commentary particularly helpful as it includes a number of “practice tips” that planners should consider when assisting clients with management of rental real estate in a trust.

EXECUTIVE SUMMARY:

Frank Aragona Trust v. C.I.R., 142 T.C. 165 is the first and only Tax Court case to address whether the income earned by an irrevocable trust holding rental real estate is non-passive.  While the case was a victory for the trust taxpayer, the Tax Court did not fully analyze all aspects of the passive activity rules, leaving questions unanswered for families preparing succession plans for rental real estate businesses.  It is imperative for advisors and their clients to review the complex matrix of passive activity rules and the application of state law fiduciary duties to derive a managerial structure that will suit both tax objectives and business management realities.  Avoiding application of the passive activity rules to a trust-owned rental real estate business may still be quite a challenge.

FACTS:

The Service has repeatedly argued against permitting an irrevocable, non-grantor trust to have a trust-owned business that qualifies as “non-passive”.  However, since 2003, there have been a series of cases and IRS rulings that have addressed various aspects of passive activity rules in the trust context, with some success for trust-taxpayers.  Frank Aragona Trust v. C.I.R., 142 T.C. 165, is the first Tax Court case to address whether the income earned by an irrevocable trust holding rental real estate is non-passive.

However, the application of Aragona to trust management may still be problematic because the Tax Court: (1) relied upon the interpretation of state law-specific fiduciary duties to find in favor of the taxpayer, (2) did not specifically address the exception related to performance of services by a trustee who is a non-owner employee and (3) did not address at all whether non-trustee employee or agent (i.e., third party) activities could count towards the “real estate operator exception” test.  In short, many questions remain when determining how to structure a trust’s management of rental real estate so as to have such activity be non-passive.

COMMENT:

It has long been the case that a loss produced from passive activity can only be used to offset passive activity income.  Therefore, taxpayers often prefer for business activities to be characterized as non-passive or “active” to avoid the passive activity loss rules.  With the introduction of the 3.8 percent Medicare surtax, there is a heightened interest in whether income that a trust derives from its business holdings is passive or non-passive.   If such income is passive under the passive activity rules, the passive income will be included in the trust’s net investment income and subject to the surtax.  On the other hand, if such income is considered non-passive, then it is excluded from net investment income and the surtax will not apply.

Frank Aragona Trust v. C.I.R., 142 T.C. 165 (2014), is the first Tax Court case to address whether the income earned by an irrevocable trust holding rental real estate is non-passive. This commentary provides an overview of the issues related to whether and how the trustee of a trust can “actively manage” real estate rentals, post-Aragona, thereby avoiding the passive loss rules.  This commentary also provides some practical pointers to consider when drafting trust documents or assisting clients with structuring the management of trust-owned rental real estate.

“Passive Activities,” Generally

The passive loss rules work to limit the amount and type of business deductions that an affected taxpayer may take on its income tax return.  Under IRC §469(a), passive activity losses for a trust are limited to the aggregate income from the trust’s passive activities. [i]  It is generally more desirable to be treated as engaging in non-passive activities for income tax purposes because passive activity losses may not be used to offset “active business” or “portfolio” income (e.g., interest, dividends).[ii]  In addition, a trust with net investment income (NII) above a certain threshold will be subject to the 3.8% “Medicare” surtax.  NII includes income from a passive activity within the meaning of IRC §469.[iii]

Passive activity is defined as any activity (a) which involves the conduct of any trade or business, in which (b) the taxpayer does not materially participate.[iv]  The taxpayer bears the burden of showing that an activity is non-passive vis-à-vis material participation.[v]  A taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.[vi]  There are generally seven tests that may be applied to a taxpayer’s activities to determine whether the taxpayer is materially participating in the activity per the Treasury Regulations (“Regulations”).[vii]  (These tests will be referred to herein as the “Regulatory Tests”).  The Regulatory Tests consist largely of tests related to the number of hours spent working in the particular trade or business activity.[viii]  A specific test related to the material participation in a trade or business activity by a trust has not been created under the Regulations.[ix]

Rental Real Estate Activities are Generally “Passive”

Real estate rental activities are statutorily per se passive activities, regardless of whether the taxpayer materially participates in the activities.[x]  However, IRC §469(c)(7) provides an exception to the per se passive nature of rental activities.  This exception is commonly known as the “real estate operator exception” and must be evaluated each tax year to determine whether the taxpayer qualifies for the exception.

To qualify for the “real estate operator exception,” the taxpayer must meet a three-part test:

  1. He or she must have materially participated in a rental real estate business (i.e., a “real property trade or business”) under the Regulatory Tests. If this element is met then,
  2. More than half of the total personal services provided by the taxpayer must have been performed in such business; and
  3. The taxpayer must have performed more than 750 hours of services in such business.[xi]

Each component of this test contains terms of art that require further examination.  The phrase “real property trades or businesses” is defined to include “any interest in a real estate business that gives rise to deductions under IRC §212,” which is a fairly broad classification.[xii]  Material participation in a “real property trade or business,” is determined under the Regulatory Tests.[xiii]  “Personal services” do not include work performed as an investor or work performed as an employee unless the employee is at least a 5% owner of the employer.[xiv]  The manner of ownership of the employer by the employee and the legal capacity in which an employee provides services is a relevant, technical inquiry, without much informative guidance.[xv]

The primary difficulty regarding trusts in this context is accounting for the activities of the trustee and any employees and agents that are collectively managing the trust (or in some cases distinct underlying assets) in order to satisfy the elements of the “real estate operator exception” test.  Case law offers some clarity, as discussed below.

Pre-Aragona “Passive Activity” Cases

Until Aragona, no cases addressed how rental real estate management by a trust could be a non-passive activity.  There have only been a handful of cases and rulings addressing various types of businesses owned by trusts.  Since 2003, the IRS has consistently taken the position that to determine whether a trust “materially participates” in a trade or business, one must look only to the activities of the trustee and ensure that the trustee’s activities are occurring in its capacity as a fiduciary, rather than as an employee or an entity officer.  The Service has historically asserted (and continues to assert) that the policy behind the passive and non-passive activity distinction itself and the various Regulatory Tests require that the IRS be narrow and strict in its interpretation of the rules.

The first case addressing trusts and the passive activity rules was Mattie K. Carter Trust v. U.S., 256 F. Supp. 2d 536 (N.D. Texas 2003).  Mattie K. Carter involved a ranching business operated directly by a trust and not through an intervening corporate entity.  The issue before the court was whose activities on behalf of the trust should count for determining whether the trust materially participated in the ranch business.  The Service argued that only the trustee’s activities, performed as a fiduciary, should be counted.  The taxpayer argued that since the trust (and not the trustee) was the taxpayer under IRC §469(a)(2)(A), the taxpayer’s participation in the business should be measured by the activities of all of those acting in furtherance of the trust’s business (i.e., its fiduciaries, employees and agents).  The court agreed with the taxpayer’s arguments, finding that it was only “common sense” that material participation of the trust in its ranching business be measured by all those acting on behalf of the trust.[xvi]

However, when the issue came up again in 2007, the Service refused to follow the Mattie K. Carter court’s rationale.  In TAM 200733023, the testamentary trust at issue owned a majority interest in an LLC and the LLC, in turn, conducted its own underlying business activities.  The trust document permitted the trustee to appoint a “special trustee” with respect to the trust property.  The trustee contracted with various “special trustees” to manage the trust’s interest in the LLC.  The trust asserted that the activities of the special trustees in managing the trust’s business assets (e.g., reviewing financials for the LLC and selling the trust’s interest in the LLC), should be included when determining whether the trust materially participated in the business.

Without distinguishing the case from Mattie K. Carter, the Service concluded that only the services of a “fiduciary trustee” should be considered for the material participation Regulatory Tests.  The Service reasoned that the “special trustees” were not “fiduciary trustees” because they were “…appointed solely to perform certain contractual acts intended to satisfy the material participation standard of IRC §469(h).” Essentially, the IRS asserted that the “special trustees” were more like agents with specific authority (which, incidentally did not include the ability to bind the trust contractually), instead of trustees with corresponding fiduciary obligations.

The Service then released TAM 201317010, which not only continued to ignore the ruling in Mattie K. Carter, but specifically rebutted its findings.  In this TAM, the trust had a “special trustee” who was also the president of an S-corporation that was owned in part by the trust.  The special trustee also personally owned stock in the S-corporation.  The special trustee’s fiduciary authority was limited by the trust instrument to voting the corporate stock and making decisions about the sale of the corporate stock.  In addition, the special trustee was actively involved in the day-to-day operations of the S-corporation as its President.

The taxpayer-trust argued that the activities of the special trustee as a trustee, as President of the S-corporation, and as an individual shareholder were indistinguishable and that all activities of the person should count towards the trust’s material participation.  To counter the taxpayer’s arguments and to specifically rebuff the holding in Mattie K. Carter, the Service articulated two rationales: (1) the policy behind the passive loss rules does not permit attribution of employee activities towards the Regulatory Tests and (2) there are specific types of fiduciary duties that must exist in order to count a fiduciary’s activities towards satisfying the Regulatory Tests.

Regarding the policy behind the Regulatory Tests, the Service stated,

As a general matter, the owner of a business may not look to the activities of the owner’s employees to satisfy the material participation requirement . . .   Indeed, because an owner’s trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity.  A trust should be treated no differently.

The Service essentially argued that by casting such a wide net and including the activities of all parties that work to operate a business, the Regulatory Tests become irrelevant.

The Service also asserted that like the hypothetical “business owner,” only the trustee, acting in a fiduciary capacity, may cause a trust to materially participate in a trade or business.  The Service argued that a “fiduciary” is defined under IRC §7701(a)(6)[xvii] and also cited a Ninth Circuit case to assert that a fiduciary “must be vested with some degree of discretionary power to act on behalf of a trust.”[xviii]  By defining the scope of “fiduciary” duties in this way, the Service could extrapolate that in this case, only the special trustee’s specifically enumerated fiduciary duties to vote or sell the stock of the S-corporation should count towards the trust’s attempt to establish material participation.  It was then determined that contextually, those particular activities did not rise to the level of being “regular, continuous, and substantial” under the Regulatory Tests.  Accordingly, the trust’s business activities were considered passive.

Holding in Aragona

Mattie K. Carter and the TAMs discussed above involved trusts with interests in businesses other than rental real estate businesses.  Aragona was the first Tax Court case that expressly addressed the management of rental real estate by a trust and the application of the “real estate operator exception” under IRC §469(c)(7) to trusts.  The holding in Aragona in favor of the taxpayer-trust is significant because it refutes the Service’s position that a trust can never qualify for the “real estate operator exception” under IRC §469(c)(7).  This case also affirms that activities of trustees can be considered for purposes of material participation even if the trustee also performs such activities as an employee or as a minority shareholder of an entity through which the trust conducts its activities.   However, for planning purposes, there are still questions that remain unanswered under Aragona.

In Aragona, the trust owned rental real estate and was involved in other real estate holding and development activities.  There were six trustees of the trust who were also trust beneficiaries.  The trust wholly-owned Holiday Enterprises, LLC, a disregarded entity for tax purposes, which managed most (but not all) of the trust’s rental real estate properties.  The trust also conducted some of its real estate activities directly, while the rest were conducted through other closely-held entities in which the trust owned a majority interest.  One of the six trustees was responsible for the day-to-day operations of the trust (the “executive trustee”).  The executive trustee and two of the other trustees also worked as full-time employees of Holiday Enterprises, LLC.  Holiday Enterprises, LLC had several other non-trustee employees, including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks.[xix]

The primary issue in the case was whether a trust could qualify for the “real estate operator exception” so that the trust’s rental real estate activities could qualify as non-passive activities.  The Service argued the trust could not qualify for the exception because a required element of the three-part test was providing “personal services,” which could only be done by an individual (or a C-corporation in certain enumerated circumstances).[xx]  The court, however, found that “a trust is an arrangement in which trustees manage assets for the trust’s beneficiaries [, and i]f the trustees are individuals, and they work on a trade or business as part of their trustee duties, their work can be considered work performed by an individual in connection with a trade or business.”[xxi]  Accordingly, the court concluded that it was possible for a trust to satisfy the “real estate operator exception” set forth in IRC §469(c)(7).[xxii]   This reasoning from the Tax Court is similar to the “common sense” approach taken by the court in Mattie K. Carter.

Another issue reviewed in Aragona was what types of activities of the trust, undertaken by people acting in various roles, would count towards satisfying the three-part test for the “real estate operator exception.”  The court began by reviewing the trust’s material participation in a “real property trade or business.”  The Service argued that (1) only the activities of the trustees could be considered, and (2) the activities of the three trustees who were employed by Holiday Enterprises, LLC should be disregarded because they performed those services as employees of the LLC, not as trustees.  The Service repeated its arguments from Mattie K. Carter and the 2007 and 2013 TAMs.  The court, however, held that the activities of the trustees, in their capacities as trustees and as employees of Holiday Enterprises, LLC must be considered.[xxiii]  Note that the court never addressed whether the activities of the 20 non-trustee employees of the LLC should be considered because the activities of the trustees (in both capacities) easily met the material participation standard under the Regulatory Tests.[xxiv]

It is also important to note that the court considered the scope of a trustee’s fiduciary duties under relevant state law when deciding whether the trustees’ actions as employees would be counted.  The court acknowledged that Michigan law provided trustees were required “to administer the trust solely in the interests of the trust beneficiaries, because trustees have a duty to act as a prudent person would in dealing with the property of another, i.e., a beneficiary.”[xxv]  Additionally, under Michigan law, “[t]rustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust.”[xxvi]  Because the trustees were still bound by their fiduciary duties to the trust beneficiaries when acting as employees of the LLC, those activities were considered for purposes of the material participation test.  Therefore, a review of the relevant state law interpretation of fiduciary duties of a trustee is an important step in claiming a structure of operations analogous to Aragona.  This facet of the holding also shows that perhaps the court didn’t stray too far from the Service’s position of requiring fiduciary duties to exist before counting the individual’s services in the material participation context.

Finally, it is also important to note that the court did not review the additional two elements of the three-part test (i.e., the personal services test and the 750-hour test).  These two elements raise other issues, including whether the activities of the trustee-employees should have been counted where IRC §469(c)(7)(D)(ii) precludes counting services performed as an employee unless the employee owns 5% or more of the employer.  A trustee is not the “owner” of a trust or the trust’s wholly-owned entity.  In Aragona, two of the trustee-employees did individually own minority interests in some of the entities through which the trust managed its real estate, but there was no discussion of the percentages that they owned or of the management activities associated with the part-owned entities in the court’s ruling.[xxvii]  Instead, the court held that the Service had simply failed to argue the merits related to the two elements of the “real estate operator exception” test and thus waived the issue in favor of the taxpayer.[xxviii]  This result, while favorable to the trust in Aragona, does not provide clarity for other trusts that use entity and entity-employee structures to manage trust real estate.

Outstanding Issues with Trust Management

There are three central issues related to trust management of rental real estate that remain unclear after Aragona, including:

  1. The ability to count a trustee’s activities when the trustee is acting as an employee or as a minority shareholder likely depends upon the interpretation and scope of a trustee’s fiduciary duties under relevant state law.
  2. It is possible that problems could arise under the IRC §469(c)(7)(D)(ii) exception related to performance of services by a trustee who is a non-owner employee. Technically, one is traditionally an employee as an individual, and if the employer is an entity that is wholly-owned by the trust (and not at all by the individual employee), then the Service could assert that the employee’s activities don’t count towards “personal services” under the “real estate operator exception” test.[xxix]
  3. The question of whether the activities of non-trustee employees of a trust’s wholly-owned entity can be considered in determining material participation under the Regulatory Tests remains unanswered. Mattie K. Carter remains the sole authority holding that activities of non-trustee employees of a trust (but not of a trust-owned entity) can be considered for purposes of material participation under the Regulatory Tests.  No case has analyzed the “real estate operator exception” test with respect to the non-trustee employees.  But, given that it would be even less likely that non-trustee employees would be owners of their employer entity, their services could be disregarded for parts two and three of the “real estate operator exception” test.

Practice Tips and Planning Ideas

Given the holding of Aragona, if non-passive activity is desired for income tax purposes, what should planners consider when assisting clients with management of rental real estate in a trust?

Choice of Trustee.  Given that the only certain guidance from Aragona is that the activities of the trustee in managing the trust’s real estate holdings will be considered for purposes of satisfying all three parts of the “real estate operator exception” test, selecting a trustee who will regularly, continuously and substantially participate in the management of the rental real estate is critical.  This may weigh against choosing a family member who would otherwise be reasonably qualified to serve as trustee.  It could also influence trust provisions regarding replacement of trustees to a trustee who can satisfy the “real estate operator exception” test (i.e., a trustee who is willing to work full time (or nearly so) on just trust real estate management).

Entity and Management Structure.  There are various items that would drive an advisor to recommend managing a trust’s real estate activities via a wholly-owned LLC, and having the trustee act as an employee of such entity.  These items include, for example, employer liability protection, social security pay-in for the employee, and the possibility of providing employee benefits for the trustee-employee.  It is clear, however, that the Service would argue that only the activities of the trustee, in such capacity, would count towards material participation under the Regulatory Tests and towards personal services under the “real estate operator exception” test.  It would therefore be important to design a structure where the trustee’s activities are analogous to the trustee-employees in Aragona, as a threshold matter.

Additionally, in Aragona, the court found that Michigan law stated that a trustee could not avoid his or her fiduciary duties by performing his or her managerial actions as an employee via a wholly-trust-owned corporate entity.  It would also therefore be important to review state law to ensure that trustee-employee activities would fall under the umbrella of a trustee’s general fiduciary obligations.

Like Michigan, Washington law provides that a “trustee must exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property…[and t]he trustee owes to the beneficiaries of the trust the highest degree of good faith, diligence, fidelity, loyalty, and integrity, and the duty to deal fairly and justly with them and solely in their interests.[xxx]  In addition, Washington’s fiduciary duty of loyalty[xxxi] is based upon the Uniform Trust Code (“UTC”) §802, the comments to which clearly indicate that a trustee may not avoid its fiduciary duty by managing trust property through a corporate entity.[xxxii]  While Washington did not specifically adopt UTC §802(g) related to trustee management of corporate assets, the drafting task force indicated that it elected not to do so because it felt that the concept was already well established under Washington law and the common law.[xxxiii]

Under RCW 11.98.070(21), Washington law permits the trustee to manage a trust-owned business entity and to delegate, in the trustee’s discretion, facets of the management of that business.[xxxiv]   In addition, except in cases where the Settlor has specifically stated the trustee is a directed trustee, Washington law provides that a trustee who delegates certain trust functions is not relieved of his or her fiduciary duties merely as a result of the delegation. [xxxv]  Newly enacted Washington legislation, which is based upon section 9 of the Uniform Prudent Investor Act (“UPIA”), provides that a trustee must act with “reasonable care, skill and caution” when selecting a delegee, defining the scope of delegation, reviewing the delegee’s work and enforcing the delegation.[xxxvi]  This would necessarily include a delegation of duties relating to trust business activities by the trustee to himself or herself as a trust employee.  In Washington, and perhaps in other states whose laws are based on the UTC and UPIA, it appears that the fiduciary duties of a trustee cannot be arbitrarily shed by the trustee who is playing multiple roles in the trust administration (e.g., trustee, entity manager and/or entity employee).

Modifications of Fiduciary Standards.  The court in Aragona specifically focused upon the trustee-employees’ duty of loyalty under Michigan law when espousing such trustee-employees’ fiduciary status.  In many states, it is possible to waive or modify the fiduciary duty standards.  Indeed, in many estate plans involving family businesses, it is advisable for the Settlor to modify some or all fiduciary duties, specifically the duty of loyalty, when the Settlor’s desired fiduciaries have multiple roles in the business and estate plan.[xxxvii]  Given the Service’s focus on activities undertaken in a “fiduciary capacity” and the Tax Court’s focus on the duty of loyalty, it could be problematic if the Settlor of a trust modifies the trustee’s fiduciary duties, including specifically the duty of loyalty, in the trust agreement.  Accordingly, the drafting attorney and Settlor should proceed carefully where at least some of the trustee’s activities as an employee (e.g., salary, commissions, or sales that may benefit the trustee personally) are subject to a reduced fiduciary standard (e.g., to the duty of good faith as opposed to the duty of loyalty).  It may be appropriate for the drafting attorney to isolate the reduced fiduciary standard to discrete, enumerated circumstances instead of a blanket reduction of the standard whenever that is consistent with the Settlor’s intent.  Otherwise the trustee is at risk of being so dissimilar to the trustees in Aragona as to fall outside of its purview.

Recordkeeping.  The taxpayer bears the burden of proof in establishing that its activities were sufficient to satisfy the “real estate operator exception” test.  It is therefore critical that for all years, all parties participating in a trust’s real estate business, especially the trustee, maintain adequate records of their rental business activities including time spent, the types of work performed, and the capacity in which work is performed.  Additionally, it is important that the characterizations reflected in the timekeeping records are consistent with cash flow and tax reporting choices.  For example, it may be advantageous for various income tax reasons to have a trustee take an employee salary from the trust-owned company rather than be paid a trustee fee.  However, it may be problematic to claim that recorded time spent was undertaken as a trustee if the trustee does not take a trustee fee and instead draws a salary as an employee.  Ultimately, the financial impacts of the structure of the trust’s management must be weighed against a possible passive activity classification.

Staff Appropriately.  If the trustee’s activities alone (either as trustee or employee) would not meet the requirements of the “real estate operator exception” test, then it is unlikely that the non-trustee employees’ activities will be considered by the Service.  While Mattie K. Carter held that the actions of a trust’s employees and agents can be considered for the “material participation” test, in that case, the trust conducted its ranch business directly, not through corporate entities.  In a situation where a trust holds its real estate assets in separate corporate entities, it is unclear whether the holding from Mattie K. Carter would apply for purposes of satisfying the Regulatory Tests and the more onerous “real estate operator exception” test.

Further, in Aragona, the trust’s wholly-owned LLC actually conducted the day-to-day management of the trust’s rental real estate, where as it is common for trusts to engage an unrelated third-party property management entity to manage the property day-to-day.  Therefore, it is possible that even if the Tax Court would extend Aragona to non-trustee employees of a trust-owned entity, it is unclear if the court would go one step further and count the activities of the third-party property manager hired by the trustee.  Regardless, even more problematic in the context of a rental real estate business, is that the “real estate operator exception” test requires that personal services performed by an employee of the taxpayer not include work performed as an employee unless such employee is at least a 5% owner of the employer.[xxxviii]  Given the Service’s  position of interpreting the passive activity rules and regulations narrowly, the use of a third-part property manager may work against the taxpayer’s arguments of an otherwise actively involved trustee.

Conclusion

While the Tax Court’s holding in Aragona was positive for trust taxpayers, many unanswered questions remain.  It is clear that the analysis of the passive activity rules are complex and that the existing Regulations are not easily analogized to ownership and management of assets inside of a trust.  It is also clear that the Service has consistently argued for literal and narrow interpretations of the existing Regulations in situations where businesses are managed by trusts.

Where so much wealth is held in the form of family businesses, including rental real estate businesses, it is important for advisors and their clients to review the intricate matrix of the passive activity rules when designing succession plans.  Most critically, it is important to have honest discussions with clients and their family members about the choice of fiduciaries for the estate plan, the practical aspects of managing trust property and the potential financial impacts of the resulting managerial structure.  Planning proactively with full knowledge of all of the details will put the trust taxpayer in the best position possible to claim non-passive activities.  However, it remains necessary to balance the tax impacts against the practical structure of the trust and to design a plan that works best for the entire family in the long-term.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Katie Groblewski and RoseMary Reed

“Reproduced Courtesy of Leimberg Information Services, Inc. (LISI)”.  Estate Planning Newsletter #2341 (September 8, 2015) at http://www.leimbergservices.com  Copyright 2015

CITATIONS:

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[i] The passive activity loss for a given year is the amount, if any, by which the passive activity deductions for the taxable year exceed the passive activity gross income for the taxable year. Temp. Treas. Reg. §1-469.2T(b)(1).

[ii] IRC § 469(e).

[iii] IRC §1411(c)(2).

[iv] IRC §469(c)(1).

[v] See e.g., Michael T. Donovan  and Timothy G. Stewart, Material Participation by Trusts: Questions Remain After Frank Aragona Trust, 121 J. Tax’n 5 (July 2014).  See also Temp. Treas. Reg. §1.469-5T(f)(1).

[vi] IRC §469(h)(1).

[vii] Temp.Treas. Reg. §1.469-5T(a).

[viii] See, e.g., Temp. Treas. Reg. §1.469-5T(a)(1). An in-depth discussion of these tests is outside of the scope of this commentary.

[ix] See Temp. Treas. Reg. §1.469-5T(g).

[x] IRC § 469(c)(2) and (4).

[xi]  IRC §469(h); IRC §469(c)(7)(B). Elements 1 and 2 are often referred to as the “Personal Services Test” and element 3 is often referred to as the “750 Hours Test.”

[xii] IRC §469 (c)(7)(C); Treas. Reg. §1.469-9(b)(2).

[xiii] See, generally,  Daniel N. Shaviro, Passive Loss Rules, 549-2nd Tax Mgmt. Portfolio (BNA) at A-45.  Taxpayers who make grouping elections under the passive loss rules may have to carefully parse how to evaluate which “activities” count as “real property trade or business” and the Regulatory Tests, but since no grouping election exists for the Trust, we believe that the Trust may use the Regulatory Tests to show “material participation” in its “real property trade or business.”

[xiv] IRC §469 (c)(7)(D)(ii); Treas. Reg. §1.469-9(c)(5). The ownership attribution rules of IRC §318 apply when considering percentage of ownership.  Note that Treas. Reg. §1.469-9(c)(5) includes one inconsistent reference to ownership of the employer-entity by the “taxpayer” instead of the employee, which could nullify the issue related to this subsection in the case of a trust-owned management entity.  There is no real guidance as to the application of his Regulation.

[xv] See, generally,  Shaviro, supra at  A-46.

[xvi] 256 F. Supp. 2d 541.

[xvii] IRC  §7701(a)(6) provides,  “The term ’fiduciary‘ means a guardian, trustee, executor, administrator, receiver, conservator, or any person acting in any fiduciary capacity for any person.”

[xviii] TAM 201317010, citing to United States v. Anderson, 132 F.2d 98 (9th Cir. 1942).

[xix] Frank Aragona Trust v. C.I.R., 142 T.C. 165, at 167-168 (2014).

[xx] Id at 174.

[xxi] Id at 175.

[xxii] The court also stated that if Congress wanted to exclude trusts from IRC §469(c)(7) exception, it could have done so by limiting the exception to “any natural person” as it had done in other provisions of the passive activity loss rules under IRC §469.  Id at 176.

[xxiii] Id at 178.

[xxiv] Id at 178-179.  Here, the court analyzed whether the trust materially participated in a “real property trade or business.”  The court specifically looked to the Regulatory Tests under IRC §469(h)(1) to determine whether the activities constituted material participation.

[xxv] Id at 179.

[xxvi] Id.

[xxvii] Id at 168, 179-180.

[xxviii] Id at 180.

[xxix] Additionally, if a portion of a trust’s management entity is also individually held by a trustee-employee, it is likely that the trustee will need to prove that time spent related to such entity should be allocated to his capacity as a trustee or an employee and not as an individual owner.

[xxx] Monroe v. Winn, 16 Wash.2d 497, 508, 133 P.2d 952 (1943).

[xxxi] The duty of loyalty has been codified in Washington in RCW 11.98.078.

[xxxii] See Comment to Uniform Trust Code §802(g) “When the trust owns the entirety of the shares of a corporation, the corporate assets are in effect trust assets that the trustee determines to hold in corporate form. The trustee may not use the corporate form to escape the fiduciary duties of trust law. Thus, for example, a trustee whose duty of impartiality would require the trustee to make current distributions for the support of current beneficiaries may not evade that duty by holding assets in corporate form and pleading the discretion of corporate directors to determine dividend policy. Rather, the trustee must vote for corporate directors who will follow a dividend policy consistent with the trustee’s trust-law duty of impartiality.”

[xxxiii] Karen E. Boxx and Katie S. Groblewski, Washington Trust Laws’ Extreme Makeover: Blending with the Uniform Trust Code and Taking Reform Further with Innovations in Notice, Situs and Representation, 88 Wash. L. Rev. 813, 881 (2013).

[xxxiv] See also Restatement (Second)of Trusts, §193, com. a. (1959), which provides that “[i]t is the duty of the trustee in voting shares of stock to use proper care to promote the interests of the beneficiary,“ and that the fiduciary responsibility of a trustee in voting a control block ”is heavier than where he holds only a small fraction of the shares.“  This comment relates specifically to voting shares, but would easily be translatable to other areas of management of a trust business.

[xxxv] Washington Laws of 2015, ch.115  §§ 2 & 3 (SB 5302)(effective July 24, 2015), modifying former RCW 11.98.070(27).

[xxxvi] Washington Laws of 2015, ch.115  § 3(1) (SB 5302)(effective July 24, 2015).  See also, Comments to §9 of the Uniform Prudent Investor Act, which state that even where the trustee is relieved from liability for the delegee’s actions once delegation occurs, the trustee is responsible for properly choosing the delegee and the scope of the delegation and the beneficiaries can sue the trustee for improper delegation or alternatively, force the trustee to sue the delegee for improper actions during an otherwise proper delegation.  These provisions are not intended to waive a trustee’s fiduciary obligations when delegating.

[xxxvii] See generally, e.g., Karen E. Boxx, Too Many Tiaras: Conflicting Fiduciary Duties in the Family-Owned Business Context, 49 Hous. L. Rev. 233 (2012).

[xxxviii] See supra, fn xiv.