The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Michael S. Jackson, CPA, and Jared S. Szychter,
Grant Thornton LLP, Philadelphia, PA
In a long awaited ruling, the Tax Court held in Frank
Aragona Trust v. Commissioner1, that a trust can
qualify for the §469(c)(7) exception (i.e. the "real estate
professional" exception) and materially participate in activities
based on the efforts of the trustees, thereby allowing losses from
real estate activities to be treated as nonpassive and deductible
in determining the trust's taxable income.
The decision in this case has implications for all tax paying
trusts that own businesses. It affects both the application of §469
on their passive losses and whether income from these activities is
subject to the new 3.8% net investment income tax under §1411.
In reaching its conclusion as to the application of the
§469(c)(7) exception to the per se passive rules for
rental activities, the Tax Court had to determine two key
1. Could services performed by individual trustees of a trust be
considered "personal services" performed by the trust, and
2. Could a trust materially participate in real-property trades
By ruling in favor of the trust, the Tax Court has provided
important guidance for determining when a trust materially
participates in a given activity. Taxpayers are now faced with
interpreting the court's decision to determine its application to
other trust arrangements.
Facts of the Case
The Frank Aragona Trust (the "trust") was a complex residuary
trust that owned rental real estate properties and was involved in
other real estate business activities such as holding and
developing real estate. There were six trustees of the trust, three
of whom were employed full-time by Holiday Enterprises, LLC
("Holiday"), a limited liability company that was wholly owned by
the trust and treated as a disregarded entity for federal tax
purposes, which managed most of the trust's real estate. Holiday
also employed other individuals to carry out certain business
activities of the management company, such as accounting, leasing
agents and maintenance workers.
Some of the real estate activities were conducted directly by
the trust while other activities were held in entities in which the
trust owned majority interests. Two of the trustees also held
minority interests in some of these entities.
The trust incurred losses in 2005 and 2006 from the real estate
properties and deducted these losses on its returns as nonpassive
activities. The losses resulted in net operating losses which were
carried back to earlier tax years of the trust. In the notice of
deficiency, the IRS determined that the trust's rental real estate
activities were passive activities under §469; therefore, the
losses were suspended and did not generate net operating
losses. In addition to an increase in taxes for the years at
issue, the IRS also assessed an accuracy-related penalty under
§6662(a), which it later conceded.
Opinion of Tax Court
The trust relied on qualifying as a "real estate professional"
under §469(c)(7) for its position. If applicable, the rental real
estate losses would not be per se passive under
§469(c)(2). Instead, the losses would be treated as nonpassive if
the trust materially participated in the rental real estate
activities. To qualify for the real estate professional
exception the trust would be required to pass two tests:
1. A taxpayer qualifies as a real estate professional if more
than one-half of the personal services performed in a taxable year
are performed in real property trades or business in which the
taxpayer materially participates, and
2. The taxpayer performs more than 750 hours of services during
the taxable year in real property trades or business in which the
taxpayer materially participates.2
The IRS argued that, because "personal services" are defined by
regulation as "work performed by an individual in
connection with a trade or business," a trust cannot perform
personal services.3 Therefore, the
IRS argued the trust did not qualify for the §469(c)(7) exception
because it did not meet the first test. The court rejected
In explaining its holding, the court wrote:A trust is an
arrangement whereby trustees manage assets for the trust's
beneficiaries. … If 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.' … We conclude that a trust is capable of
performing personal services and therefore can satisfy the section
Indeed, if Congress had wanted to exclude trusts from the
section 469(c)(7) exception, it could have done so explicitly by
limiting the exception to `any natural person'. In section 469(i),
the Internal Revenue Code does exactly that. … That Congress did
not use the phrase `natural person' but instead used the word
"taxpayer" in section 469(c)(7) suggests that Congress did not
intend to exclude trusts from the section 469(c)(7)
In support of its position, the IRS pointed to the legislative
history of §469(c)(7). The House Ways and Means Committee Report
only mentions individuals and closely held C corporations in
discussing the §469(c)(7) exception.4 Noting this, the
court said:The report does not say that the exception applies
only to individuals and closely held C corporations.
Therefore, the report does not compel the conclusion that only
individuals and closely held C corporations can qualify for the
section 469(c)(7) exception.
Once the court determined a trust can qualify for
the §469(c)(7) exception, they turned to whether the trust
did qualify based on the facts presented.
The IRS argued that the trust did not qualify for the exception
because it did not materially participate in real property trades
or businesses. The definition of what it means to materially
participate is found in §469(h). A taxpayer is treated as
materially participating in an activity only if the taxpayer is
involved in the operations of the activity on a basis which is
regular, continuous and substantial. While individuals and closely
held C corporations are provided more bright-line tests to
determine material participation, trusts are left with no guidance,
as Regs. §1.469-5T(g) has been "reserved" since the regulations
were enacted in 1992.
The IRS has a long-standing position, as promulgated in various
rulings and memoranda, that material participation for a trust is
determined only by reference to the activities of the trustees, and
only in their capacity as trustee.5 In support of
this position, the IRS cited the Senate Finance Committee Report on
the Tax Reform Act of 1986 stating that a trust "is treated as
materially participating in an activity … if an executor or
fiduciary, in his capacity as such, is so participating."6 Therefore, in the IRS
view, if the trustee serves in any other capacity, such as an
employee, that time does not count towards determining the trust's
participation. In addition, the IRS did not consider the efforts of
non-trustee agents or employees of a trust as being attributed to
the trust or trustee for purposes of measuring material
In absence of regulatory guidance, the Tax Court had to
determine whether the trust materially participated in the
activities. The court held that based on the IRS interpretation of
the Senate report, none of the activities of the trust's
non-trustee employees would count towards material participation.
Additionally, because three of the trustees were also employees of
the LLC managing the real estate, their participation would also
not be counted under the IRS's argument because it is impossible to
disaggregate the activities they performed as employees from the
activities they performed as trustees. The court highlighted the
fact that Michigan statutory law requires trustees to act as a
prudent person would in dealing with the property of another (i.e.
a beneficiary) while administering a trust.8 As a
result, the court held that the activities of the trustees as
employees of Holiday should be considered in determining whether
the trust materially participated in its real estate
The court found that the trustees' participation in the trust
activities were regular, continuous and substantial, thereby
meeting the material participation requirements. The court found no
need to decide whether the activities of the trust's non-trustee
employees should be considered in determining material
The IRS also argued that because two of the employee-trustees
also held minority interests in the same real estate operations,
that their efforts are attributable to their personal portions of
the businesses, not the trust's portion. The court was not swayed
by this argument after considering that:
1. The trustees' combined ownership interest in each entity was
not a majority interest and for no entity did their combined
ownership interest exceed 50%.
2. The trustees' combined ownership interest in each entity was
never greater than the trust's ownership interest.
3. The trustees' interests as owners were generally compatible
with the trust's goals.
4. Both trustees were involved in managing the day-to-day
operations of the trust's various real estate businesses.
Many trusts were waiting for this decision to determine how to
apply the passive activity rules for both §469 and §1411, and now
have a very limited window to digest the case before 2013 tax
returns are due or extended.
The key findings of the Tax Court's decision can be summarized
1. A trust can qualify for the real estate professional
exception under §469(c)(7).
a. It should be noted that since the basis of the IRS's argument
was that trusts are categorically barred from §469(c)(7) and that
the trust did not materially participate in the real property trade
or business, the court found no need to rule on how many hours of
personal services were performed by the trust in real property
trades or businesses.
2. A trustee's participation in a trust-owned businesses,
regardless of the trustee's capacity, should be considered in
determining trust material participation. In making this
ruling, the court held that:
a. Under Michigan law, a trustee is required to act prudently
with respect to the trust assets at all times (it should be noted
that most states follow the same or similar requirements).
b. The activities of the trustees, including their activities as
employees, should be considered in determining whether the trust
3. The court did not conclude whether the material participation
tests are satisfied if merely one of the trustees qualifies or if,
in the case of multiple co-trustees, some other threshold must be
4. The court did not address whether the participation of
non-trustee employees should be incorporated into the material
participation determination for a trust.
5. Despite the fact that certain trustees also held minority
interests in the same entities as the trust, the court did not find
that the trustees' efforts to manage the personal portions of the
business affected the trust portion. However, it is unclear
whether the court would rule in the same way if the trustee owned a
majority interest in an asset also owned by the trust.
As with any court decision, an extreme amount of care and
consideration should be given to the differences in facts in the
decided case from other taxpayer situations. Nonetheless, the Tax
Court's decision establishes an important precedent that the IRS
must address. It is possible that in light of the Tax Court's
decision in Aragona Trust, the IRS will re-evaluate its
litigation position, but it is still too early to tell what the IRS
Chief Counsel's Office will decide.
While practitioners and taxpayers await IRS comments about this
case, there will continue to be hope for the issuance of
regulations under Regs. §1.469-5T(g) to provide better, more
reliable guidance in this area.
For more information, in the Tax Management Portfolios, see
Shaviro, 549 T.M., Passive Loss Rules, and Acker, 852
T.M., Income Taxation of Trusts and Estates, and in
Tax Practice Series, see ¶2980, Passive Loss Rules, and ¶6120,
Estate and Trust Income Taxation - General Rules.
7 Work performed by non-trustee agents and
employees (and the trustee) of the trust were considered in
determining material participation in Mattie K. Carter Trust v.
United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003).
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