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.
