Aragona Trust v. Commissioner: A Taxpayer Victory Against the 3.8% Surcharge

One of the hard-fought issues between taxpayers and the Internal Revenue Service (IRS) was whether a trust could qualify for the passive activities exception. Specifically, activities are grouped into one of two categories, either active or passive. The goal of §469 was to prevent losses from a passive activity from offsetting active income. If one can recall the heyday of the tax shelter industry when losses from passive activities offset earned income (e.g., salary) and cause less income tax to be collected.  The 1986 Tax Reform Act contained the passive loss rules §469 that were designed to segregate active and passive income and loss.

The passive loss rules contain an exception under §469(c)(7) whereby a taxpayer who satisfies the material participation test will be able to classify the income or loss as active.  Why is this important?  The Affordable Care Act introduced a 3.8% income tax surcharge on passive income that could be avoided if the trust materially participates.  The other alternative is that losses, rather than being trapped, can be used against active income.

How does a trust qualify for the §469(c)(7) exception? The Tax Court held the taxpayer meets the requirement if more than one-half of the services are in real property trades or businesses in which he materially participates.  The Tax Court agreed with the taxpayer and held that the activities of the trustee can be used to measure material participation. This is the pro-taxpayer aspect of the case.  IRS had maintained the legislative history referred only to natural persons and C corporations as qualifying for material participation under this provision.

Trustees and advisors should review their real estate holdings in order to determine if they can avail themselves of the holding.

Aragona has some unique facts.  The Trust owns rental real property and entities that hold and develop real estate. The Trust was managed by one independent trustee and the Grantor’s five children. One limited liability company (LLC) wholly owned by the Trust employed  three children and managed trust properties.

Each one of the six trustees was paid a fee by the Trust. In 2005 and 2006, the Trust treated these payments as losses from non-passive activities. The IRS wanted the losses classified as passive activity losses.

The ability of a taxpayer to avoid passive characterization is very  helpful as Aragona is a better reasoned opinion than the Mattie Carter Trust out of a District Court in Texas.