This case is the first Tax Court case addressing how a trust can “materially participate” in a business for purposes of the passive loss rules. The trust material participation issue is also quite important in determining when trust business income can be classified as “active” income so that it is not subject to the 3.8% net investment income tax under §1411.
The IRS has previously issued several rulings taking strict positions as to how a trust could materially participate in a business. The latest is TAM 201317010 in which the IRS ruled that activities by a trustee in serving as the president of a business owned by the trust did not constitute material participation by the trust because the activities were as employee rather than as trustee. The Frank Aragona Trust case undermines the IRS’s reasoning in that ruling.
The Tax Court ruled:
- Trusts with one or more individual trustees can qualify for the “real estate professional” exception (if they meet the detailed requirements of the exception), so that rental income is not automatically treated as passive income; and
- The trust materially participated in the trust’s real estate businesses, based on the activities of three of the six trustees who were employed full-time in a wholly owned LLC that managed the real estate businesses.
The timing of the decision is fortunate—as trusts filing their 2013 federal income tax returns are making decisions whether to report that the trust materially participates in a business so that the business income is not subject to the 3.8% tax on net investment income.
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