Trust Material Participation and the Sec. 469(h) “Regular, Continuous, and Substantial” Standard

Editor: Alan Wong, CPA

Gains & Losses

Earlier this year, in a much-anticipated decision, the Tax Court held that a trust qualified for the Sec. 469(c)(7) real estate professional exception and materially participated in its rental real estate business under Sec. 469(h) through the activities of its trustees (Frank Aragona Trust, 142 T.C. No. 9 (2014)). This item focuses on the material participation portion of the decision by taking a closer look at what the Sec. 469(h) “regular, continuous, and substantial” test means and how the IRS has interpreted and applied this test in the past.

Brief Overview of Sec. 469 Material Participation for Trusts

Sec. 469(h) provides that a taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Although Treasury has yet to issue regulations specifically addressing the material participation requirement for trusts, the IRS has on more than one occasion relied upon Sec. 469(h) to define material participation for trusts. The IRS has taken the position that a trust may materially participate in an entity’s activities if the fiduciary, in his or her capacity as such, is involved in the operations of the entity’s activities on a regular, continuous, and substantial basis.

Notably, the IRS has declined to apply to trustees the more quantitative regulatory tests for individuals, found in Temp. Regs. Sec. 1.469-5T, holding instead that, until regulations are promulgated, the qualitative Sec. 469(h) regular, continuous, and substantial test remains the sole standard for determining whether a trust, through the actions of its trustee(s), satisfies the material participation requirement. Additionally, the IRS has continued to emphasize the fiduciary’s acting in his or her capacity as a trustee, which it has interpreted as not including time spent as an employee of a business conducting the activity, if the trustee also was so employed.

For example, in Technical Advice Memorandum (TAM) 201317010, the IRS held that the sole means for a trust to establish material participation in an activity is if the fiduciary, in his or her capacity as fiduciary, is involved in the operations of the relevant activity on a regular, continuous, and substantial basis. Additionally, in Letter Ruling 201029014, the IRS held that a trust materially participates in an entity’s activities if the trustee is involved in the operations of the entity’s activities on a regular, continuous, and substantial basis. See also TAM 200733023, in which the IRS held that the sole means for a trust to establish material participation in an activity is to show that its fiduciaries are involved in the operations of the activity on a regular, continuous, and substantial basis.

In one of only two cases that address the application of Sec. 469(h) to trusts, a district court in Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003), held that in determining material participation for a trust, the activities of its employees and agents should be included with the activities of its trustee in determining whether the trust’s participation is regular, continuous, and substantial. This conclusion went much further than any of the IRS rulings by introducing persons other than the trustee into determining material participation. As shown by the TAMs and letter rulings cited above, which were all issued after 2003, the IRS has not acquiesced to this court ruling.

The only other case on point is the recent Tax Court decision of Frank Aragona Trust. In this decision, the court found that a trust materially participated in a real estate activity because the individual trustees were involved in the operations of the activity on a regular, continuous, and substantial basis. Since the activities of the trustees met the regular, continuous, and substantial threshold, the court chose not to address whether the activities of the trust’s nontrustee employees should be considered.

The “Regular, Continuous, and Substantial” Standard

While it seems clear that the gauge of material participation for trusts is the Sec. 469(h) regular, continuous, and substantial standard, what exactly does “regular, continuous, and substantial” mean? No definition is provided in the Code or regulations. As cited and relied upon in TAM 200733023 and Letter Ruling 201029014, the legislative history of Sec. 469 contains a general notion that for a taxpayer to materially participate, the taxpayer must be involved in the day-to-day management and operations of the trade or business. “Even an intermittent role in management, while relevant, does not establish material participation in the absence of regular, continuous, and substantial involvement in operations” (S. Rep’t No. 313, 99th Cong., 2d Sess. 734 (1986)).

Relying upon legislative history, the IRS in TAM 200733023 found that a trust did not materially participate in a business because the special trustees were not fiduciaries under Sec. 469 and neither the special trustees’ nor the regular trustees’ involvement in the business rose to the level of regular, continuous, and substantial.

In TAM 200733023, a testamentary trust owned an interest in a limited liability company (LLC) that engaged in a business. The trustees provided services to the LLC that encompassed a range of administrative and operational activities relating to the business, including direct participation in operations, oversight of bond financings and borrowing activities, and approval of operating budgets. The trustees also contracted with special trustees to perform a number of tasks related to the business. The contract entered into between the trust and the special trustees explicitly stated that the special trustees’ involvement in the business was intended to satisfy the material participation standard of Sec. 469(h). The contract also provided that the special trustees could not legally bind the trust and that the regular trustees would retain all decision-making responsibilities related to the trust’s financial, tax, or business matters.

Neither the regular trustees nor the special trustees were employed in the business. Time logs submitted indicated that the special trustees spent most of their working hours reviewing operating budgets, analyzing a tax dispute that arose among the partners, and preparing and analyzing other financial documents. The logs showed repeated contacts with the trustees relating to those issues. Further, the special trustees appeared to have spent a considerable number of hours negotiating the sale of the trust’s interest in the LLC to a newly admitted partner. Although the trustees relied heavily upon the recommendations of the special trustees, ultimate decision-making authority remained vested solely with the trustees. Time logs were also submitted by the trustees indicating the number of hours spent on matters related to the business. The trustees spent some of those hours on issues related to the proposed sale of the trust’s interest in the LLC to the newly admitted partner. The trustees’ remaining hours were spent reviewing and analyzing operating budgets and other financial documents related to the business.

The IRS held that many of the trustees’ logged hours must be disregarded. In particular, the IRS stated that the hours the trustees spent negotiating the sale of the trust’s interest in the LLC should not count toward their involvement in the business for Sec. 469 purposes. The IRS also stated that the limited number of hours that arguably did constitute participation in the management or operations of the business did not constitute regular, continuous, and substantial involvement in the business.

As to the special trustees, the IRS found they were not fiduciaries of the trust under Sec. 469 because of the limited powers granted them under their contract with the trustees. The IRS stated that a fiduciary must be 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 control the trust property without the express consent of the trustees. As such, the IRS held that the special trustees were not fiduciaries of the trust, and the services they performed were indistinguishable from those that would be expected of any other nonfiduciary business personnel or employees.

The IRS further stated that even if the special trustees had been fiduciaries of the trust, a number of the hours reflected in their time log should be disregarded for purposes of analyzing their involvement in the business under Sec. 469. The IRS concluded that many of the duties performed by the special trustees had a questionable nexus to the conduct of the business. In citing the legislative history of Sec. 469—specifically­ that the material participation standard must be satisfied through participation in the operations and management of the business—the IRS concluded that many hours reflected in the time logs of the special trustees should be disregarded for purposes of analyzing their involvement in the business. The IRS focused on the hours the special trustees spent negotiating the sale of the trust’s interest in the LLC as well as those spent resolving the tax dispute, and disregarded those hours as not spent managing or operating the business.

The IRS reached a similar result in TAM 201317010. The trust document that appointed a special trustee vested the special trustee with only limited powers over two trusts. The special trustee was granted the power to control all decisions regarding the sale or retention of a business’s stock and all voting of the stock. Although the taxpayer trusts argued that the special trustee was also the president of a business owned by the trust and involved in the day-to-day operations and management of the business, the IRS held that the work performed by the special trustee outside the scope of his authority as special trustee was not done in a fiduciary capacity.

The IRS stated that the special trustee’s powers were restricted pursuant to the trust agreement. The special trustee lacked the power to commit the trusts to any course of action or control the trust property beyond selling or voting the company stock. As such, the IRS found that the work performed by the special trustee, beyond the scope of selling or voting the company stock, was done as an employee of the company and not in the role of fiduciary. Therefore, the only activities that would count in determining material participation were the special trustee’s time spent voting the company stock or considering its sale. As the special trustee’s time spent performing these activities did not rise to the level of being regular, continuous, and substantial, the IRS found that the trusts did not materially participate in the business activities.

In Frank Aragona Trust, the Tax Court held that the trust materially participated in real property trades or businesses that it owned. The court applied the Sec. 469(h) regular, continuous, and substantial standard to determine whether the trustees met the material participation threshold. The court included the trustees’ time spent as employees of the real estate businesses in that determination, concluding that the trustees’ “hat” was always on, even while performing duties as employees of the businesses. Three of the trust’s six trustees were employed full time by an LLC wholly owned by the trust. The LLC managed most of the trust’s rental real estate properties.

The court gave the following reasons for holding that the trustees’ involvement in the operations of the real estate activities as trustees and employees was regular, continuous, and substantial: Three of the trustees participated in the trust’s real estate operations full time; the trust’s real estate operations were substantial; the trust had practically no other types of operations; and the trustees handled practically no other businesses on behalf of the trust. Although the court did not discuss the hours tests of Sec. 469(c)(7), one can conclude that it thought the trustees’ full-time involvement in the businesses would have satisfied those tests.

Reflections

The Sec. 469(h) regular, continuous, and substantial test appears to be a subjective, fact-based determination. In past pronouncements, the IRS generally has looked only to the hours in which trustees, acting only in their capacity as trustees, are involved in the day-to-day management and operations of the trade or business in determining whether the trustees’ activities rise to a level of regular, continuous, and substantial. Activities that fell outside this parameter, as in work performed as an employee, have been disregarded. Further, based upon past IRS pronouncements, it appears that the powers granted to the fiduciary in the governing document play a part in determining whether the trustee or special trustee is a fiduciary that can bind the trust for purposes of the Sec. 469(h) determination.

One might conclude that the decision reached by the IRS in TAM 200733023 would not have been affected by the Tax Court’s decision in Frank Aragona Trust because the special trustees in the TAM were evidently not involved in the day-to-day operations of the business and were not fiduciaries of the trust due to their inability to bind it.

However, many questions remain. For example, what about the IRS’s decision in TAM 201317010? But for the limited powers granted to the special trustee in the governing document, could one argue that, in light of Frank Aragona Trust, the actions of the special trustee in his role as president of the business should have counted in the Sec. 469(h) analysis? Is the perfect scenario a trustee with full fiduciary powers who is an employee of the business owned by the trust and involved in the business’s day-to-day management and operations? Will the IRS continue to issue rulings, or will it wait until it issues regulations? And if the latter, when will that be?

EditorNotes

Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.

For additional information about these items, contact Mr. Wong at 212-792-4986 or alan.wong@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP