By Robert S. Keebler, CPA, MST, AEP (Distinguished), CGMA | Volume 2, Issue 5 (May 2014) [1]

In Frank Aragona Trust v. Commissioner, the U.S. Tax Court held that a trust can qualify for the IRC Section 469(c)(7) real estate professional exception.[2] Furthermore, the court held that the trust materially participated in real property businesses it owned.  Don’t get excited quite yet, though. Although the holding that a trust can be a real estate professional is very favorable, the case does little to resolve the issue of whose participation can be counted for purposes of determining whether a trust materially participates in an activity under the passive loss rules.

In Mattie K. Carter Trust [3],the only case that had considered the issue, a federal district court in Texas held that a trust could count the participation of its agents and employees as well the participation of its trustees in establishing material participation for a trust. The IRS issued a non-acquiescence in the Carter decision, however, and has consistently taken the position that only the activities of trustees can be counted.[4] When the Aragona case was docketed before the Tax Court, practitioners hoped that the court would resolve this issue.  However, the court in Frank Aragona Trust decided against providing clarity in favor of continuing the pandemonium, stating in footnote 15: “We need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.”

Although the court avoided the Mattie Carter issue, it did reach one favorable conclusion on the material participation of trusts: The participation of trustees as employees of a single member LLC owned by the trust could be counted as participation by the trust. The LLC in the case was a disregarded entity, but there is no indication that this affected the result.

Facts of the Case
In Frank Aragona Trust, the trust owned rental real-estate properties and was engaged in other real-estate activities. The trust had six trustees – Frank Aragona’s five children and an independent trustee. The trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. Three of the children trustees worked full time for Holiday Enterprises, LLC (“Holiday”). Holiday, a Michigan limited liability company that is wholly owned by the trust, is a disregarded entity for federal income tax purposes; which means that the trust and Holiday are one and the same for income tax purposes (i.e., one taxpayer). Holiday managed most of the trust’s rental real-estate properties and employed several people beyond the three children trustees. The trust conducted some of its rental real-estate activities directly, some through wholly owned entities, and the rest through entities in which it own majority interests (two of the children owned the minority interests).

The Real Estate Professional Test
Under Section 469(c)(2), the trust’s real-estate activities would have been considered per se passive activities unless it qualified for the real estate professional exception under Section 469(c)(7). A taxpayer qualifies for the real estate professional exception if:  (1) more than one-half of the personal services performed in trades or businesses by the taxpayer are performed in real-property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the year in real-property trades or businesses in which the taxpayer materially participates.

Personal Services
In order to reach the conclusion that a trust can qualify for the real estate professional exception, the court held that “[a] trust is capable of performing personal services within the meaning of” the real estate professional exception. This is important because under the first part of the real estate professional exception, the taxpayer must perform more than one-half of the taxpayer’s personal services in real-property trades or business in which the taxpayer materially participates. Furthermore, the court held that “[s]ervices performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.”

Material Participation in the Real-Property Trades or Businesses
Moreover, in order to reach its conclusion that a trust can qualify for the real estate professional exception, the court had to determine if the trust materially participated in the real-property trades or businesses. This is because under both parts of the real estate professional test, the taxpayer must materially participate in real-property trades or businesses.

The IRS raised similar arguments to those it had raised in Mattie Carter, arguing that in determining whether a trust is materially participating in an activity, only the activities of the trustees (in their narrow capacity as trustees) can be considered and the activities of the trust’s employees (both the trustee employees and the non-trustee employees) must be disregarded.

Unfortunately, the court decided not to address all of the IRS’ arguments; mainly, it stated in footnote 15 that “we need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.” Under the facts of Frank Aragona Trust, the court was able to find that the activities of the trustees – including their activities as employees of Holiday – were enough to determine that the trust materially participated in its real-estate operations without having to consider the participation of non-trustee employees. Furthermore, the court found that the fact that two of the trustees’ owned minority interests in some of the entities was of no consequence. This was because (1) the trustees’ combined ownership interest in each entity was not a majority interest, (2) their ownership was not greater than the trust’s ownership interest, (3) their interests as owners was generally compatible with the trust’s goals (they and the trust wanted the jointly held enterprises to succeed), and (4) they were involved in managing the day-to-day operations of the trust’s various real-estate businesses. Based on all these factors the court held that the trust materially participated in real-property trades or businesses.

Issues Not Raised By the IRS
However, of importance in this case was the fact that the IRS argued only that: (1) trusts are categorically barred from qualifying under the real estate professional exception and (2) the trust did not materially participate in real-property trades or businesses. The IRS never argued that the trust did not meet the requirements for the real estate professional exception; thus, the court did not consider that. Therefore, the court stated that “in the context of the arguments raised in this case …we hold the trust meets the section 469(c)(7) [real estate professional] exception.”

Furthermore, the IRS never argued that the trust did not materially participate in its rental real-estate activities. This issue is of importance because although the trust qualified for the real estate professional exception, that only means that the trust’s rental real-estate activities are not per se passive. In order to be characterized as non-passive, it must be determined whether the trust materially participated in its rental real-estate activities. If it did, then its rental real-estate activities are not passive activities. Here, since the IRS never raised that argument, the court held that “in the context of the arguments presented in this case, the trust’s rental real-estate activities are not passive activities.”

Conclusion
One thing is clear from this case – a trust can qualify for the real estate professional exception. As for the material participation issue, we already knew that the activities of the trustee in its capacity as such count. Furthermore, Frank Aragona Trust strongly suggests that the participation of trustees also counts if their services are performed in the capacity of a business owned by the trust. And last but not least, the court skated by probably the most important issue: whether the activities of the employees of the entity count for purposes of determining material participation of a trust.  The pandemonium continues.

RELATED ON-DEMAND PROGRAM
Robert Keebler held a special and timely 90-minute presentation entitled, “Trusts, Section 469 & Section 1411: Material Participation After Frank Aragona Trust” on April 22nd.  You can still purchase the handout materials and the audio recording.  For more information and to purchase, click here.

ABOUT THE AUTHOR

Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States.  Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters.  He can be reached at (920)593-1701 or at robert.keebler@keeblerandassociates.com.