Filling in the ________ of § 1.469-5T(g): How Does a Trust Materially Participate?

Lilian Guzman

Section 469 of the Code limits the deductibility for passive-activity losses against portfolio income.[1]  A taxpayer is only engaged in a passive activity when that taxpayer lacks material participation in “any activity, which involves the conduct of any trade or business.”[2]  Even though rental real estate activity is passive regardless of “whether . . . the taxpayer materially participate[d],” paragraph (7) provides an exception for real estate professionals.[3]  A real estate professional is “any individual, estate or trust” that materially participates in more than half of the personal services performed in real estate trades or businesses for more than 750 hours.[4]

Absent regulatory language, Section 469(h)(1) unambiguously states that a taxpayer materially participates in an activity when “the taxpayer is involved in the operations of the activity on” a regular, continuous, and substantial basis.[5]  A real estate professional materially participates when a taxpayer specifically is involved in the “operation, management, [or] leasing” of real estate.[6]  A trust may materially participate as a real estate professional.[7]  It is undisputed that a taxpayer is a trust, and a trust is a legal entity generally established to hold, conserve and manage assets.[8]  In the context of Section 469, a trust materially participates through the activities of those acting on behalf of the trust.[9]  Hence, the fiduciaries, employees and agents acting on behalf of a trust must have regular, continuous, and substantial involvement in the operations of the activity for the trust to materially participate.[10]

A.           Carter Trust 

A trust as a legal entity can only “participate in an activity through the actions of its fiduciaries, employees, and agents.”[11]  In Carter Trust, the I.R.S. limited the deductions of losses suffered by a Plaintiff-Trust claiming that the trust did not materially participate in the operations of a ranch.[12]  The Plaintiff-Trust, however, owned the ranch, and through its trustee, hired an employee to manage the ranch and its operations.[13]  The trustee of the Plaintiff-Trust found it necessary to hire an additional employee to manage the ranch operations because he felt ill equipped to handle the day-to-day tasks while actively managing the Plaintiff-Trust, itself.[14]

The court in Carter Trust found that, “Common sense dictates that the participation of [the Plaintiff-Trust] in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch . . . on behalf of [the Plaintiff-Trust].”[15]  In fact, it is “the collective activities of those with relation to the [business] operations” that determine material participation.[16]  On the basis of its findings, the court held that material participation “should be determined by reference to the persons who conducted the business . . . on [the trust’s] behalf, including [employees hired by the trustee].”[17]

The rules of agency allow the principal to accomplish results through the services of its agents.[18]  Under the theory of agency, an agent acts on the principal’s behalf upon consent by both the principal and the agent.[19]  When an agent hires another person, that person is a sub-agent who is given the authority to “perform functions that the agent has consented to perform on behalf of the agent’s principal.”[20]  Ultimately, the principal is vicariously liable for the actions of its agents and sub-agents because it is intrinsically fair to hold the principal accountable when the principal also reaps the benefits from its agent’s and sub-agent’s actions.[21]  Since a principal is vicariously liable for the actions of an agent or sub-agent, then logically the principal also materially participates through the actions of its agents and sub-agents.[22]  Therefore, the court’s holding in Carter Trust that a trust can materially participate through “the collective activities of those with relation to the [business] operations” is harmonious with the principles of agency because a trustee or employee is acting on behalf of the taxpayer who is claiming the loss.[23]

Corporate fiduciaries only act on behalf of a trust through its employees.  When a bank or a private trust company is given the authority to manage the operations of the trust as trustee, only the employees of the bank or company are actively participating, and not the bank or company, itself.[24]  Unfortunately, if only a fiduciary or trustee can materially participate under Section 469, then corporate fiduciaries will be non-existent.

B.            Frank Aragona Trust

Even though a trust acts wholly through its fiduciaries, employees and agents, this Court may consider that a trust materially participates through its trustees.[25]  In Frank Aragona Trust, the I.R.S. limited the deduction of real estate losses associated with a trust-owned LLC, claiming that the Petitioner-Trust did not materially participate in the rental real estate activities.[26]  The I.R.S. strongly contended that the Petitioner-Trust could neither be a real estate professional under Section 469(c)(7)(C) of the Code nor materially participate under this section, yet the court found that the I.R.S. had no legal stance for such a contention.[27]  The court also found that “[t]hree [of the six] trustees participated in the real-estate operations full time.”[28]  Thus, the trustees “handled practically no other businesses on behalf of the trust” because the Petitioner-Trust had essentially no other operations.[29]  Although the court declined to determine whether a trust may materially participates through the activities of non-trustees, the court held that a trust may materially participate through its trustees.[30]

C.            Conclusion

Ultimately, the task to determine how a trust materially participates is left to the Department of Treasury. [31]  Both Carter Trust and Frank Argona Trust provide insight to how this task may be managed, but until then, there is an argument to be had before the courts.[32]


[1].          See I.R.C. § 469(a)(1) (2016).
[2].          I.R.C. § 469(c)(1) (2016).
[3].          I.R.C. § 469(c)(2), (4); Frank Aragona Trust v. Comm’r, 142 T.C. 165, 171 (2014)(stating that “any rental activity is passive per se,” unless it meets the two-test requirement of a real estate professional exception); see also I.R.C. § 469(c)(7).
[4] .         I.R.C. § 469(c)(7); see also I.R.C. § 469(a)(2).
[5].          I.R.C. § 469(h)(1) (2016)(creating a test relying on facts and circumstances); see also Temp. Treas. Reg. § 1.469-5T(g) (2016)(reserving subsection (g) for further guidance on the material participation of trusts).
[6].          I.R.C. § 469(c)(7)(C).
[7].          See Frank Aragona Trust, 142 T.C. at 178.
[8].          I.R.C. § 469(a)(2); Restatement (Third) of Trust § 2 cmt. a (Am. Law Inst. 2003); see also Frank Aragona Trust, 142 T.C. at 175.
[9].          Frank Aragona Trust, 142 T.C. at 178; Carter Trust, 256 F. Supp. 2d at 541; see also I.R.S. Priv. Ltr. Rul. 10-29-014 (July 23, 2010).
[10].        Frank Aragona Trust, 142 T.C. at 178; Carter Trust, 256 F. Supp. 2d at 541; see also I.R.S. Priv. Ltr. Rul. 10-29-014 (July 23, 2010).
[11].        Carter Trust, 256 F. Supp. 2d at 541. But see I.R.C. § 469(i) (2016) (creating an additional exception for a natural person, thus inferring that a trust is an artificial entity); The Internal Revenue Service, Passive Activity Loss Audit Technique Guide, Chapter 6: Entity Issues (Last Updated Nov. 8, 2016), https://www.irs.gov/businesses/small-businesses-self-employed/passive-activity-loss-atg-chapter-6-entity-issues.
[12].        Carter Trust, 256 F. Supp. 2d at 539.
[13].        Id. at 538–39; see also Frank Argona Trust, 142 T.C. at 168 (explaining that the Petitioner-Trust still materially participated even through separate entities in which the Petitioner-Trust owned majority interest and two trustees owned minority interest).
[14].        Carter Trust, 256 F. Supp. 2d at 538–39.
[15].        Id. at 541.
[16].        Id.
[17].        Id.
[18].        See Paula J. Dalley, A Theory of Agency Law, 72 U. Pitt. L. Rev. 495, 498–99 (2011).
[19].        See Restatement (Third) of Agency § 1.01 (Am. Law Inst. 2003).
[20].        See Restatement (Third) of Agency § 3.15 (Am. Law Inst. 2003).
[21].        Restatement (Third) of Agency § 7.01 (Am. Law Inst. 2003); see also Dalley, supra, at 498–99.
[22].        Carter Trust, 256 F. Supp. 2d at 541; see also I.R.C. §469(h)(1); Restatement (Third) of Agency § 7.01.
[23].        Carter Trust, 256 F. Supp. 2d at 541.
[24].        See Restatement (Third) of Trusts § 33 (Am. Law Inst. 2003).
[25].        See Frank Aragona Trust, 142 T.C. at 178.
[26].        Frank Aragona Trust, 142 T.C. at 168.
[27].        Id. at 175–78.  
[28].        Id. at 179.
[29].        Id.
[30].        Id. at 178 n. 15, 179 (the court explicitly states, “We need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.”).

[31].        See Temp. Treas. Reg. § 1.469-5T(g) (2016).
[32].        Frank Aragona Trust, 142 T.C. at 178; Carter Trust, 256 F. Supp. 2d at 541.

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