Aragona Trust: Passive Activity Losses, the Material Participation Exception, and the Medicare Tax

Aragona Trust: Passive Activity Losses, the Material Participation Exception, and the Medicare Tax

Generally speaking, most taxpayers, including individuals and trusts, are denied the use of their passive activity losses and credits to offset ordinary income under the passive activity loss (“PAL”) rules of Section 469 of the Internal Revenue Code (the “I.R.C.”).  These PAL rules prevent investors from utilizing losses incurred in income-generating activities in which they are not materially involved, thus any passive losses are limited to use as an offset to passive income.[1]

The I.R.C. defines a passive activity as any activity involving the “conduct of any trade or business … in which the taxpayer does not materially participate.”[2]  Rental activity is specifically mentioned as a passive activity, subject to an exception listed for material participation.  Essentially, the taxpayer qualifies for the exception if more than “one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or business in which the taxpayer materially participates, and such taxpayer performs more than 750 hours of services during the taxable year in real property trades or business in which the taxpayer materially participates.”[3]  Clearly, the definition of material participation is the key factor in determining whether a taxpayer qualifies for the material participation exception for taxpayers participating in real property businesses.

A taxpayer shall be considered to be materially participating in an activity if the taxpayer is “involved in the operations of the activity on a basis which is regular, continuous, and substantial.”[4]  While this definition is made applicable to individuals, the statute does not provide a method for determining whether a trust material participates in an activity.[5]

Fortunately for trusts engaging in the rental real estate business, the court in Frank Aragona Trust v. Commissioner recently held that a trust can qualify for the material participation exception contained in I.R.C. Section 469(c)(7).[6]  The court disagreed with the IRS than only an individual could perform “personal services”, finding that the work of an individual Trustee could be considered “work performed by an individual in connection with a trade or business.”[7]  In addition, the court found that the work of a trust’s non-trustee employees should also be considered in determining material participation.[8]  Having held that the trustees and non-trustee employees could be considered in its analysis, the court found that the Frank Aragona Trust materially participated in a rental real estate business and thus qualified for the exception contained in I.R.C. Section 469(c)(7).

Aside from the court’s holding with respect to the I.R.C. Section 469(c)(7) issue, the Aragona Trust decision also has potentially interesting implications for the taxation of net investment income.  There is a 3.8% Medicare tax is applied to trusts under I.R.C. Section 1411(a)(2) on the lesser of (1) their net investment income or (2) their taxable year adjusted gross income minus $12,150.[9]  Specifically excluded from the definition of net investment income is any income “derived in the ordinary course of a trade or business” which is not a passive activity.[10]  Accordingly, it is possible that a trust engaged in a trade or business may not be subject to the 3.8% Medicare tax.

The aftermath of Aragona Trust will likely clarify the court’s true holding, and provide further guidance on both the material participation and net investment income issues identified in this article.

 

Kenneth A. Grossberg, Esq.

 


[1] Note that the term “Passive Activity Loss” generally means the amount by which losses from passive activities exceed gains from such activities for a taxable year.  The term is meant as a net of all passive activities.

[2] I.R.C. 469(c)(1)

[3] I.R.C. 469(c)(7)(B)

[4] I.R.C. 469(h)(1)

[5] See, Treas. Reg. 1.469-5T(g) reserving a place for regulation regarding “Material Participation of Trusts and Estates”.

[6] 142 T.C. No. 9 (March 27, 2014).

[7] Id., at 18.

[8] Id.  See also, Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex 2003).

[9] See I.R.C. 1411

[10] I.R.C. 1411(c)

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