Posts Tagged: IRS

Favorable Tax Court ruling upholds trustees’ activities as qualifying trust for material participation exception under IRC Section 469 (and the net investment income tax under IRC Section 1411)

Author:  Alison E. Lothes, Esq., Gilmore, Rees & Carlson, P.C.

In Frank Aragona Trust et al. v. Commissioner, 142 T.C. No. 9, the Tax Court ruled in favor of the taxpayer, holding that a trust could and did materially participate in real estate rental activities, qualifying for the exception to the passive activity rules under IRC Section 469.  This case is helpful, as there are currently no regulations and very few rulings on how to apply the “material participation” rules to trusts.  The IRS has been interpreting the exception to be very limited but the Court agreed with the taxpayer that the activities of the trustees, including those in their capacity as employees of an entity owned by the trust, could be considered when determining whether the trust materially participated in the real estate rental business.

A majority of the trust’s business was operated through a wholly owned LLC but the trust also operated some of its real estate business directly and some through other entities.  The trustees were intertwined in the LLC, other entities and the business.  The LLC employed three of the trustees as full time employees (along with other employees, including a controller, maintenance workers, leasing agents and clerks).   Two of the trustees also held minority interests in several of the entities in which the trust was also a member.

The trust filed fiduciary income tax returns claiming losses relating to its rental real estate activities and characterized those activities as non-passive.  The IRS disagreed and determined that the rental real estate activities were passive, and as a result limited certain deductions and net operating loss carrybacks.

Under IRC Section 469, a passive activity is any activity which involves the conduct of a trade or business in which the taxpayer does not materially participate.  Generally, rental activities are considered passive activities unless (1) more than one-half of the personal services provided by the taxpayer during the taxable year 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.  “Material participation” requires that the taxpayer be involved in the operation of an activity on a “regular, continuous and substantial” basis.

The IRS argued that a trust cannot qualify for the exception because it cannot perform “personal services.”  It claimed that the legislative history indicates that “personal services” can only be performed by an individual.  In the alternative, the IRS argued that even if the trust could perform personal services, when assessing whether the trust materially participates in an activity, only the activities of the trustees (and not the employees) can be considered.  In addition, the IRS sought to exclude the activities of the trustees that were not solely related to their fiduciary duties.  For example, the IRS argued that the activities of the trustees who were employees of the LLC could not be taken into account because those activities should be attributed to them as employees, not fiduciaries.  It also argued that a portion of the activities of the trustees who owned interests in the entities should be attributed to their personal ownership in the entities, rather than to their activities on behalf of the trust.

The Tax Court disagreed.  It noted that the trustees’ fiduciary duties to administer the trust in the interest of the beneficiaries are not put aside when they work for the LLC owning the real estate.  Therefore, their activities as employees of the LLC should be considered when determining whether the trust materially participated in its real estate operations.  It is interesting to note that the Tax Court did not determine whether the activities of the non-trustee employees should be considered because it was not necessary to the decision.  Lastly, the Tax Court held that the trustees’ individual minority interests in entities of which the trust was also a member did not impact the trust’s material participation because the combined minority interests in each entity held by the trustees were less than 50% and in all cases were less than the trust’s interest.

This case is very helpful for taxpayers in that the Tax Court adopted a relatively broad interpretation of whose activities (and in what capacity those activities are undertaken) may be attributed to the trust when determining if the trust materially participates in an activity.  This has recently become even more important because of the new 3.8% tax on net investment income under IRC Section 1411.  Non-passive trade or business income is not considered net investment income and so is not subject to the tax under IRC 1411.  This ruling may make it a little easier for trusts to prove that they are “materially participating” in a trade or business to avoid the 3.8% tax.

2014 Inflation-Adjusted Figures

Nikki Marie Oliveira, Esq., LL.M., Bass, Doherty & Finks, P.C.
Michelle B. Kalas, Esq., Riemer & Braunstein LLP

The IRS recently announced the following inflation-adjusted items for 2014:

Gift Tax 

  • Annual Exclusion for Gifts.  The annual exclusion for gifts remains at $14,000 for 2014.
  • Annual Exclusion for Gifts to Non-U.S. Citizen Spouse.  The annual exclusion for gifts to a non-U.S. citizen spouse under §§ 2503 and 2523(i)(2) increases to $145,000 for 2014 (up from $143,000 in 2013).
  • Notice of Large Gifts Received from Foreign Persons.  For 2014, gifts from foreign persons in excess of $15,358 in a taxable year are required to be reported (the threshold in 2013 was $15,102).

Estate Tax

  • Federal Estate Tax Applicable Exclusion Amount. For estates of decedents dying in 2014, the federal estate tax applicable exclusion amount under § 2010 is $5,340,000 (an increase of $90,000 from 2013).
  • Valuation of Qualified Real Property in Decedent’s Gross Estate.  For estates of decedents dying in 2014, if the personal representative elects to use the special use valuation method under § 2032A for qualified real property, the aggregate decrease in the value of qualified real property resulting from the election for purposes of the estate tax cannot exceed $1,090,000 (formerly $1,070,000 in 2013).
  • Interest on a Certain Portion of the Estate Tax Payable in Installments. The dollar amount used to determine the “2-percent portion” for calculating interest under § 6601(j) of the estate tax extended as provided in § 6166 is $1,450,000 for 2014 (up from $1,430,000 in 2013).

Income Tax

  • Foreign Earned Income Exclusion.  Under § 911(b)(2)(D)(i), this figure is now $99,200 (previously $97,600 in 2013).
  • Tax Responsibilities of Expatriation. The exemption for appreciation in assets recognized by a covered expatriate is increased to $680,000 for expatriations that occur in 2014.
  • Expatriation to Avoid Tax. The standard for determining whether an expatriate is a “covered expatriate” under section 877A(g)(1) is based on whether his or her average annual net income tax exceeded $157,000 for the five taxable years ending before the date of expatriation for tax years beginning in 2014.

Long-Term Care Insurance Premiums

  • For 2014, the limitations under § 213(d)(10) regarding a portion of eligible long-term care insurance policy premiums to be treated as a medical expense for itemizing deductions is based on the taxpayer’s age, as follows:

Age  Per Individual
40 and under               $370
41-50                           $700
51-60                           $1,400
61-70                           $3,720
71+                              $4,660

Please see Rev. Proc. 2013-35 for additional inflation updates.