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A taxpayer may deduct losses generated from passive activities only to the extent of the income from such activities. 1 For this purpose, any trade or business or other income-producing activity is passive with respect to a taxpayer if the taxpayer does not materially participate in the activity.
The question of when a nongrantor trust materially participates in an activity for purposes of the passive loss rules remains unanswered. Although the IRS has promulgated substantial regulatory guidance about what constitutes material participation by individuals and certain corporations, there is little authority regarding material participation by a trust.
While at least one court treats the activities of trust employees and agents as participation by the trust itself, the IRS looks solely to the efforts of trust fiduciaries. This article discusses a proposal that attempts to reconcile these positions whereby agent or employee efforts will count toward material participation if the trustee exercises sufficient day-to-day supervision over the activity to indicate that the activity is not passive.
Taxpayers Subject to Passive Loss Rules
Taxpayers subject to the passive loss rules include individuals, estates, nongrantor trusts, personal service corporations, and closely held C corporations. Passive income or loss from S corporations, partnerships, and grantor trusts are attributable to the owners or the grantor; therefore, the passive loss rules are applied at that level.
While the statute does not define what constitutes a trust for this purpose, Sec. 469 does provide special definitions of “personal service corporation” and “closely held C corporations.”
A personal service corporation (PSC) is a corporation the principal activity of which is the performance of personal services substantially performed by employee-owners. To be a PSC, more than 10% of the corporation’s stock must be held by employee-owners who do not have to perform the services at the same time during the year that they own the stock. 2 A corporation is a closely held C corporation if at any time during the tax year more than 50% of the corporation’s outstanding stock is owned, directly or indirectly, by five or fewer individuals. 3
Material Participation
A trade or business is treated as a passive activity when the taxpayer does not materially participate in the activity. 4 In addition, certain rental activities are considered passive regardless of the taxpayer’s participation. 5 As discussed below, while there is substantial guidance for determining material participation for individuals, PSCs, and closely held C corporations, there is little authority to determine if a trust materially participates in an activity.
Individuals
In the case of individuals, the legislative history of Sec. 469 provides that an individual materially participates if he or she has “a significant nontax economic profit motive” for taking on the activities and selects them for their economic value. In contrast, a passive investor seeks a return from a capital investment as a supplement to an ongoing source of livelihood. 6 The regulations provide that an individual is considered to materially participate in an activity if any of the following seven tests are met:
- Test 1: It is an activity in which the individual participates for more than 500 hours during the year.
- Test 2: It is an activity in which the individual’s participation constitutes substantially all the participation in the activity for the year.
- Test 3: The individual participates in the activity for more than 100 hours during the year, and the individual’s participation is not less than the participation of any other individual for the year.
- Test 4: The individual participates in the activity for more than 100 hours during the year, and the individual’s participation in all activities in which he or she participates for more than 100 hours exceeds 500 hours.
- Test 5: The individual materially participates in the activity for any 5 tax years during the 10 tax years immediately preceding the tax year.
- Test 6: For any personal service activity, an individual materially participates in a tax year if he or she materially participated in any three preceding tax years.
- Test 7: Based on all the facts and circumstances, the individual’s participation in an activity is regular, continuous, and substantial during the tax year. 7
In measuring an individual’s participation in an activity, work performed by an individual does not include work that is not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses. Work done in an individual’s capacity as an investor (e.g., reviewing financial reports) is not counted in applying the material participation tests. However, participation by an owner’s spouse counts as participation by the owner. 8
A limited partner of a partnership is not considered a material participant in activities of the partnership unless he or she meets Test 1 (the 500-hour test), Test 5 (the 5-out-of-10-year test), or Test 6 (the personal service activities test). However, a general partner may qualify as a material participant by meeting any of the material participation tests. If a general partner also owns a limited interest in the same limited partnership, all the interests are treated as general interests. 9
Finally, regardless of their participation, individuals may deduct up to $25,000 of losses from real estate rental activities against nonpassive income. This annual $25,000 deduction is reduced by 50% of the taxpayer’s modified adjusted gross income (AGI) in excess of $100,000, so no deduction is permitted once the taxpayer’s AGI reaches $150,000. 10 Any rental loss in excess of the $25,000 allowance is treated as a passive loss.
To qualify for the $25,000 deduction, a taxpayer must actively participate in the real estate rental activity and own 10% or more of all interests in the activity during the entire tax year. Unlike material participation, active participation does not require regular continuous and substantial involvement in the activity but only participation in making management decisions that are significant and bona fide (e.g., approving new tenants, deciding on rental terms, and approving capital or repair expenditures). 11
Personal Service Corps. and Closely Held C Corps.
A PSC or a closely held C corporation is treated as materially participating in an activity if one or more individuals, each of whom is treated as materially participating in an activity of the corporation under the rules described above for individuals, directly or indirectly hold more than 50% of the value of the corporation’s outstanding stock. 12 Thus, if one or more shareholders holding more than 50% of the corporation’s stock materially participate in an activity of the corporation, the corporation materially participates in that activity.
To determine if an individual is materially participating in an activity of a corporation, all activities of the corporation are treated as activities in which the individual holds an interest. But in applying Test 4 (the significant participation test), the individual’s participation in activities other than those of the corporation is disregarded. 13
In addition, a closely held C corporation is treated as materially participating in an activity for a tax year if the following requirements are met:
- The corporation had at least one full-time employee whose services were in the active management of the activity;
- The corporation had at least three full-time, nonowner employees whose services were directly related to the activity; and
- The amount of ordinary and necessary trade or business deductions attributable to the activity exceeds 15% of the gross income from the activity. 14
Material Participation in Real Estate Trade or Business
While losses incurred from rental activities are deemed passive regardless of the taxpayer’s participation, losses from real estate rental activities incurred by certain real estate professionals are not automatically passive losses. To qualify as a real estate professional, the taxpayer must meet the following requirements:
- More than 50% of the personal services that the taxpayer performs in trades or businesses is performed in real estate trades or businesses in which the taxpayer materially participates; and
- The taxpayer performs more than 750 hours of services per year in these real property trades or businesses as a material participant. 15
In the case of a closely held C corporation, the above requirements are met only if more than 50% of the corporation’s gross receipts for the tax year are derived from real property trades or businesses in which the corporation materially participates. Furthermore, personal services performed by an employee will not be treated as performed in real property trades or businesses unless the employee owns at least 5% of the employer. 16
While a spouse’s work counts in meeting the material participation requirements, it does not count for purposes of the taxpayer’s meeting the 750-hour test. 17 Services performed by an employee are not treated as being related to a real estate trade or business unless the employee owns more than 5% of the employer. 18
Nongrantor Trusts and Estates
While IRS guidance on what constitutes material participation in an activity by an individual or a corporation is extensive, regulations on material participation by nongrantor trusts and estates have not been issued. 19 The absence of regulations is surprising in that beneficiaries must know the character of a trust’s income because that character passes through to the beneficiaries when they receive trust distributions. 20 The Senate Finance Committee report on the legislation that enacted Sec. 469, however, provides that an estate or trust materially participates in an activity if the executor, trustee, or other fiduciary, in his or her capacity as a fiduciary, materially participates. 21
Material participation by a beneficiary of an estate or trust is apparently not relevant. An estate or trust is not treated as materially participating with respect to a limited partnership interest subject to the exceptions for limited partners discussed above.
For trusts, the Joint Committee on Taxation, in its Bluebook description of the Tax Reform Act of 1986 that enacted Sec. 469, explains:
No special rule is provided for determining material participation by a trust. Prior and present law provide that, generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint venture for the conduct of business for profit (Treas. Reg. §301.7701-4). A trust may be treated as an association taxable as a corporation, for tax purposes, if it is a joint enterprise for the conduct of business for profit. Thus, it is unlikely that a trust as such for Federal income tax purposes will be materially participating in a trade or business activity, within the meaning of the passive loss rule. In the case of a grantor trust, to the extent the grantor or beneficiary is treated as the owner for tax purposes (§671), the material participation of the person treated as the owner is relevant to the determination of whether income or loss from an activity owned through the grantor trust is treated as passive in the hands of the owners. 22
Therefore, Congress concluded that the material participation standard would generally not be an important issue for a trust because trusts do not generally conduct trades or businesses.
Trust vs. Association Status
The Joint Committee’s statement recognizes that the maintenance of a trade or business by a trust does not automatically transform it into an association taxable as a corporation. Instead, the regulations specifically state that a trust is not a business entity potentially taxable as a corporation. 23
In determining the factors that distinguish a trust from an association, the regulations provide, in part:
In general, the term “trust” refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries. . . . Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust . . . if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust . . . if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit. 24
The regulations go on to provide that a trust will be treated as a business trust taxable as a corporation where the arrangement between the beneficiaries and the trustee is not intended to protect or conserve property for beneficiaries but is instead a device created to carry on a profit-making business. 25
While a full discussion distinguishing trusts from corporations is beyond the scope of this article, case law and commentators generally conclude that an arrangement with a trustee and beneficiaries will be treated as a trust unless evidence is found of associates joining together to conduct an active trade or business that transcends a mere desire to share profits. 26 Where the beneficiaries and the trustee have not entered into a planned common effort to jointly conduct a business, including the ability to have some rights in the management of that enterprise, the trust should not be treated as a business trust. 27 Although a trust may have a profit-making objective whereby the trustee is granted the ability to vary or diversify the trust’s assets, such powers or purposes do not change the basic fiduciary relationship between the beneficiaries and their trustee. If the arrangement does not have associates joining together in a planned common effort to conduct a business, a trust should not be recast as an association.
Judicial and Administrative Interpretations of Material Participation by a Trust
The above discussion makes clear that trusts may conduct businesses where the income or loss may be passive or active under Sec. 469. Consequently, the determination of whether only the fiduciary’s participation is taken into account in measuring material participation is critical. However, as discussed below, the IRS and at least one court take sharply different positions regarding whether participation by employees and other nonfiduciary agents of a trust should be treated as participation by the trust.
Mattie K. Carter Trust
A district court in the Fifth Circuit has held that because Sec. 469(a)(1)(A) provides that the trust itself is a taxpayer subject to the passive loss rules, activities of persons other than the fiduciary may be attributed to the trust to find material participation. In Mattie K. Carter Trust, 28 a testamentary complex trust operated a 15,000-acre cattle ranch that incurred substantial losses. The parties agreed that the trust was not an association taxable as a corporation and that the ranch constituted a trade or business in which the trust intended to earn a profit. The issue then became whether the trust’s involvement in the business constituted material participation, thereby permitting the loss to offset other nonpassive income.
The trust employed a full-time ranch manager as well as many other full- and part-time employees. The ranch manager supervised the day-to-day operations of the ranch, making all important managerial decisions for the business. However, all the ranch manager’s decisions were subject to the approval of the trustee of the trust, and the trustee spent substantial time and attention on ranch activities.
The IRS took the position that the ranch losses were passive and could not offset the trust’s nonpassive income. Whether the losses (the amount of which was not in dispute) were passive activity losses turned on whether the trust materially participated in the trade or business of operating the ranch. That question, in turn, depended upon whose activities counted in making this determination.
Adhering to the legislative history of Sec. 469, the IRS took the position that only the activities of the trustee could be used in determining whether the trust was a material participant. The trust, on the other hand, contended that the work of its employees and agents also counted. The trust stated in its brief:
The Trust, however, is very similar to a closely held C corporation. The Trustee, like the board of directors of a C corporation, has the fiduciary obligation to the beneficiaries of the Trust for the benefit of such beneficiaries. Moreover, the Trust, like a C corporation, is a legal entity and is subject to entity-level U.S. federal income taxes. In addition, and most importantly, as a legal entity, the Trust, like a C corporation, can act only through its fiduciaries, employees and agents. Therefore, the Trust is most analogous to a closely held C corporation. 29
The district court adopted the trust’s view and held that the ranch losses were not passive. The court found that the taxpayer was the trust itself, a distinct legal entity similar to a corporation. Therefore, like PSCs and closely held C corporations, the trust should include the activities of those “who labor on behalf of the Carter trust” to determine the trust’s participation in its ranching business. Rejecting the idea that only the activities of the fiduciary could be counted to find material participation, the court stated:
Such a contention is arbitrary, subverts common sense, and attempts to create ambiguity where there is none. The court recognizes that IRS has not issued regulations that address a trust’s participation in a business . . . and that no case law bears on the issue. However, the absence of regulations and case law does not manufacture statutory ambiguity. The court has studied the snippet of legislative history IRS supplied that purports to lend insight on how Congress intended section 469 to apply to a trust’s participation in a business. . . . The court concludes that the material participation of the Carter Trust in the ranch operations should be by reference to the persons who conducted the business of the ranch on Carter Trust’s behalf. 30
The court found that the “collective activities” of those persons were regular, continuous, and substantial, with the result that the trust materially participated in the ranch. As a separate legal entity, a trust, like a corporation, can act only through its fiduciaries, employees, and agents, and attributing the efforts of these persons to the trust results in the trust being a material participant in the ranch business.
However, the court also held that even if the IRS position were correct, the activities of the trustee alone were sufficiently “regular, continuous and substantial” to make the trust a material participant in the ranching business. While the trustee did not perform daily operational activities, the court found that the trustee performed “active and substantial management functions” sufficient to amount to material participation, regardless of the participation of the trust’s employees. It is probably for this reason that the IRS did not appeal the court’s ruling.
TAM 200733023
To make clear its disagreement with Mattie K. Carter Trust, the IRS released Technical Advice Memorandum (TAM) 200733023, 31 where it continues to assert that only fiduciary efforts count in determining if a trust is a material participant in an activity. In the TAM, the IRS assumed that the trust at issue was not a business entity. The trust owned an interest in a limited liability company that was engaged in the active conduct of a trade or business. The trust had not only trustees but also “special trustees” appointed by the trustees to perform numerous tasks relating to the trust’s trade or business.
In characterizing whether the losses incurred in this trade or business were passive activity losses, the IRS noted that for individuals, the regular, continuous, and substantial standards for determining material participation had been supplemented with quantitative tests. However, the IRS refused to apply these quantitative tests to trusts and estates.
Rejecting the reasoning in Mattie K. Carter Trust, the IRS relied solely upon the legislative history of Sec. 469, which states that “a trust is treated as materially participating if the fiduciary is so participating.” 32 Based upon this expression of congressional intent, the IRS concluded that only the activities of the fiduciary can be taken into account in determining whether the trust itself materially participates in any activity. In addition, this fiduciary participation must be in the actual management and operation of the trust’s business activities such that time spent by fiduciaries in negotiating a sale of the trust’s interest in a certain business entity did not count.
In justifying this conclusion, the IRS noted that the legislative history of Sec. 469 makes it clear that the owner of a business may not look to the activities of the owner’s employees to satisfy the material participation requirement. 33 Likewise, according to the IRS, a trust conducting a business should not be able to look to its employees to find the trust materially participating in that business. A trustee performs his or her duties on behalf of the beneficial owners of the trust; consistent with the treatment of other business owners, only the activities of the trustee, rather than those of employees and agents, should be taken into account to determine whether the trust materially participates in an activity.
Finally, the IRS refused to consider the special trustees fiduciaries of the trust for purposes of measuring the fiduciary’s participation in the trust’s trade or business. The IRS noted in the TAM that a fiduciary is one vested with “some degree of discretionary power” to act on behalf of the trust. In this case, the special trustees were “powerless to commit the trust to any course of action” or to control the property of the trust without the express consent of the general trustee. Simply because the trust document refers to certain persons as special trustees does not make those persons fiduciaries when they lack discretionary power to make trust decisions.
Attributing Employee Participation to a Trust
Although the legislative history of Sec. 469 states that only fiduciary participation is counted in determining whether a trust or estate is a material participant in an activity, this view was based on the false assumption that a trust would rarely, if ever, conduct a trade or business. As Mattie K. Carter Trust and TAM 200733023 illustrate, trusts do in fact conduct trades and businesses. In addition, trustees often do not possess business management skills. It is unrealistic to expect an individual who infrequently and voluntarily serves as a trustee to devote himself or herself to the daily affairs of trust activity such that the trust itself meets the regular, continuous, and substantial standard. Even bank trust departments and other professional fiduciaries must rely on employees and agents to conduct trust activities and cannot directly assume the daily management and operation of a trust’s business.
Because of these practical considerations, the IRS should consider adopting rules for material participation for trusts and estates that are similar to those that apply for PSCs and closely held C corporations. 34 Thus, for example, if beneficiaries with a greater than 50% interest in a trust materially participate under the material participation rules that apply to individuals, the trust itself should be found to materially participate. Similarly, a trust with full-time employees and with ordinary and necessary business expenses exceeding 15% of its gross income should be considered to materially participate in that business activity. The following examples illustrate the application of these proposed rules.
Example 1: X is a trustee of a nongrantor trust with individual beneficiaries A, B, and C, who possess equal rights with respect to trust income and corpus. If A and B each meet the test for material participation in the trade or business of the trust, the trust itself will be found to materially participate in the trade or business.
Example 2: The facts are the same as in Example 1, except no beneficiary materially participates in the trust’s trade or business, but X employs a full-time manager to conduct the trust’s business. In addition, the trust’s ordinary and necessary business expenses under Sec. 162 exceed 15% of the trust’s gross income. Any profit or loss recognized by the trust would be active under Sec. 469.
The tests for material participation that apply to PSCs and closely held C corporations adopt many of the participation tests for individuals and can easily be extended to other legal entities, such as trusts and estates. Because all the tests for material participation are intended to distinguish the taxpayer’s involvement in legitimate business activities from mere investments in tax shelters, permitting the activities of beneficiaries, employees, and other agents of the trust to count as participation by the entity itself acknowledges the reality that trusts are in fact actively conducting trades or businesses that are in no way tax-avoidance schemes.
Conclusion
The present uncertainty about whether a trust is materially participating in an activity will undoubtedly spawn more litigation, perhaps all the way to the Supreme Court. Even if the IRS were to promulgate regulations adopting the position of the TAM or the alternative proposed above, taxpayers might still rely on the opinion in Mattie K. Carter Trust to take positions on tax returns not consistent with the regulations. In any event, using standards that currently apply to PSCs and closely held C corporations, the courts or the IRS should ultimately rule that the services of employees or other agents, in addition to fiduciaries, should count in measuring whether a trust materially participates in an activity.
Footnotes
1 Sec. 469(a)(1).
2 Secs. 469(a)(2)(C), (j)(2), and 269A(b).
3 Secs. 469(a)(2)(B), (j)(1), and 465(a)(1)(B).
4 Generally, a trade or business exists under Sec. 469 if the activity is engaged in with some regularity and continuity and is not incidental to holding property for investment. See Regs. Sec. 1.469-1(e)(2) and Groetzinger, 480 U.S. 23 (1987).
5 Sec. 469(c)(2).
6 General Explanation of the Tax Reform Act of 1986 prepared by the Joint Committee on Taxation, HR 3838, 99th Cong., 2d Sess. 212 (May 4, 1987).
7 Sec. 469(h)(1); Temp. Regs. Sec. 1.469-5T.
8 Temp. Regs. Sec. 1.469-5T(f)(3).
9 Temp. Regs. Sec. 1.469-5T(e)(3)(ii).
10 Modified AGI for this purpose is calculated without IRA deductions, Social Security benefits, interest deductions on education loans, or net losses from passive activities. If married taxpayers file separately, no deduction is permitted unless they lived apart for the entire year, in which case the deduction is $12,500 and is phased out when AGI reaches $50,000 (Sec. 469(i)).
11 Sec. 469(i).
12 Sec. 469(h)(4)(A).
13 Temp. Regs. Sec. 1.469-1T(g)(3).
14 Sec. 469(h)(4)(B); Temp. Regs. Sec. 1.469-1T(g)(3).
15 Sec. 469(c)(7).
16 Sec. 469(c)(7)(D).
17 Sec. 469(c)(7)(B); Regs. Sec. 1.469-9.
18 Sec. 469(c)(7)(D)(ii).
19 Temp. Regs. Sec. 1.469-5T(g).
20 Sec. 662(b) provides that trust distributions reported as income by beneficiaries will have the same character in the hands of the beneficiary as in the hands of the estate or trust. See IRS Letter Ruling 200608002 (2/24/06).
21 S. Rep’t No. 313, 99th Cong., 2d Sess. 735 (1986), 1986-3 C.B. 735. In the case of a grantor trust, the determination of material participation is made at the grantor rather than the entity level.
22 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), 242 n. 33 (May 4, 1987).
23 Regs. Sec. 301.7701-2(a).
24 Regs. Sec. 301.7701-4(a).
25 Regs. Sec. 301.7701-4(b).
26 See Doolin, “Determining the Taxable Status of Trusts That Run Businesses,” 70 Cornell L. Rev. 1143 (1985). See also Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders ¶2.03 (WG&L 2000).
27 See, e.g., Elm Street Realty Trust, 76 T.C. 803 (1981), citing Morrissey, 296 U.S. 344 (1935), for the requirements that associations require some concerted volitional activity on the part of those beneficially interested and that they have some voice in management decisions.
28 Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003).
29 Id. at 541.
30 Id.
31 IRS Technical Advice Memorandum 200733023 (8/17/07).
32 S. Rep’t No. 313, 99th Cong., 2d Sess. 735 (1986), 1986-3 C.B. 735.
33 Id.
34 Although the IRS appears unwilling to change its position, at least one business group is actively seeking a revision of TAM 200733023. The American Bankers Association, in a May 30, 2008, letter to the assistant secretary of tax policy and IRS chief counsel, urged the IRS to issue a ruling following the Mattie K. Carter Trust decision, noting that corporate trustees such as banks can act only through their employees.
EditorNotes
Donald Williamson is a professor of taxation and director of the Graduate Tax Program in the Kogod School of Business at American University in Washington, DC. Blair Staley is a professor of accounting in the College of Business at Bloomsburg University of Pennsylvania in Bloomsburg, PA. For more information about this article, please contact Prof. Williamson at dwillia@american.edu.
