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The Tax Court recently handed down a decision that could prove to be just the break that trusts participating in business activities need to escape liability for the new 3.8% tax on investment-type income. Now that the tax filing deadline for 2013 is behind us, many trusts with business-related income are finally feeling the sting of the tax, which applied to all trust investment income for trusts with income in excess of a low $11,950 in 2013 ($12,150 for 2014). The decision paves the way for new planning techniques in 2014 and beyond, highlighting the importance of a trust’s operating structure in shielding income from the additional tax—and in gaining valuable loss deductions along the way.
Aragona Trust: Facts of the Case
The issue in the Aragona case was whether a trust entity could be found to materially participate in real estate activities so as to quality for an exception to the general rule that rental real estate is a per se passive activity. Importantly, rejecting the IRS’s argument to the contrary, the court found that for purposes of the material participation rules, a trust was capable of performing "personal services" and could, therefore, quality for the exception.
The original trustee in this case formed a grantor trust that was engaged in substantial rental real estate business activities, naming his five children as beneficiaries. When he passed away, the five children and one independent individual became trustees. Three of the children worked full-time in the trust’s real estate businesses through an LLC that was wholly owned by the trust, earning wages in addition to fees for serving as trustees. Two children had very little involvement in the business.
The trust incurred substantial losses, which the IRS sought to disallow as passive losses that could only be used to offset other passive income. The trust, on the other hand, argued that it qualified for an exception to the passive activity rules that applies if (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the year is performed in real property businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the year for the trade or business.
Rejecting the IRS’s argument that a trust was incapable of providing personal services, the court found that the trust here qualified for the exception because the individual trustees worked in the business as part of their duties as trustees. This was the case even though the three trustees who materially participated in the business were also employees of the trust (in that they received wages in exchange for services performed for the wholly-owned LLC).
Because the employee-trustees continued to owe a duty of loyalty to the trust in their capacity as trust fiduciaries even when technically acting as trust employees, activities performed as employees could not be separated from their duties as trustees.
Significance in the Face of the Investment Income Tax
While a trust’s ability to deduct losses from real estate related activities is significant, the decision is particularly important because the 3.8% Medicare tax applies to a trust’s net investment income, which includes all income from passive activities. The standard for determining whether an activity is passive for purposes of the investment income tax is tied to that which is applicable in the context of the passive activity rules generally.
As a result, the finding that a trust is capable of performing personal services based on the activities of its trustee-employees can allow many trusts to escape the additional tax liability if the trust’s operations are structured so that the trustees themselves are substantially involved in the trust’s underlying real estate business activities.
However, it should be noted that the Tax Court declined to address the issue of whether activities conducted by the trust’s non-trustee employees should be taken into account in establishing material participation.
While this decision does not resolve all of the questions that have arisen in light of the 3.8% investment income tax and its applicability to trust income, it does provide clarity for trusts with trustees who are substantially involved in the trust’s business activities. As a result of the issue’s importance, it is likely that further guidance from the IRS and the Treasury is likely to emerge in the coming months.
Originally published on National Underwriter Advanced Markets. National Underwriter Advanced Markets is the premier resource for financial planners, wealth managers, and advanced markets professionals who provide clients with expert financial and retirement planning advice.
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