The U.S. Tax Court recently held, in Frank Aragona Trust v. Commissioner, that a trust can “materially participate” in a trade or business. When a taxpayer materially participates in a trade or business, it is not subject to the Internal Revenue Code’s passive activity loss rules with respect to that trade or business. Under the passive loss rules, a taxpayer cannot deduct “passive” activity losses from non-passive income. In addition, when a taxpayer materially participates in a trade or business, the income from that business can avoid “net investment income” classification subject to the additional 3.8% Medicare tax.
In Frank Aragona Trust, the U.S. Tax Court addressed the issue of whether a trust can materially participate in a rental real estate trade or business. Generally, rental real estate activities are considered to be passive. Under the Code, passive activity losses generally are deductible only to the extent of passive activity income. Further, passive activity income is included in the definition of “net investment income” for purposes of calculating the additional 3.8% Medicare tax. The 3.8% Medicare tax, which first became effective for taxable years beginning after December 31, 2012, applies to individuals, as well as certain trusts and estates, under certain circumstances. For applicable trusts, the 3.8% tax applies to the lesser of their (a) undistributed net investment income or (b) “adjusted gross income” (as defined) over the dollar amount at which their highest applicable tax bracket begins ($11,950 in 2013).
An exception to the passive activity classification of rental real estate, sometimes referred to as the real estate professional exception, provides that if a taxpayer meets certain requirements, including performance of certain personal services and material participation in a real estate business, the rental real estate is not considered a passive activity. Prior to the recent Tax Court decision, it was unclear whether a trust could satisfy this exception. The Internal Revenue Service (IRS), in fact, said that a trust could never qualify for the exception, arguing that a trust could not perform the required personal services or materially participate in a real estate business. However, in Frank Aragona Trust, the U.S. Tax Court held that under certain circumstances, a trust can perform the required personal services and materially participate through the activities of its trustees. (The U.S. Tax Court did not address whether the activities of employees hired by the trustees to perform work on behalf of the trust are considered in this analysis.)
While Frank Aragona Trust provides guidance on whether a trust can materially participate in a trade or business, it is important to remember that the decision in this case is not final, and is appealable by the IRS. Further, the Treasury Department has not issued guidance on the extent to which a trust can materially participate in a trade or business.