Trusts can accomplish a variety of estate planning goals, including wealth distribution, asset protection, estate and gift tax reduction, and probate avoidance. But don’t overlook their income tax treatment. By reducing a trust’s income tax bill, you can preserve more wealth for your heirs.
Last year, in Frank Aragona Trust v. Commissioner, the U.S. Tax Court held that a trust can “materially participate” in a business for purposes of the passive activity loss (PAL) rules. The decision creates new tax-saving opportunities for many trusts.
A PAL primer
The PAL rules prohibit taxpayers from deducting losses generated by “passive” business activities from “nonpassive” income, such as wages, interest and dividends. Passive activities are those in which a taxpayer doesn’t “materially participate.” They include rental real estate activities, regardless of participation level, unless the taxpayer qualifies as a real estate professional. (See the last section below, “‘Real estate professional’ defined.”) Taxpayers who aren’t real estate professionals may deduct up to $25,000 in rental real estate losses from nonpassive income.
The word “material” — defined as “regular, continuous and substantial” — is somewhat subjective. But the tax rules include several objective “safe harbors” you can use to establish material participation. They include participating in an activity for more than 500 hours during a tax year, performing substantially all of the work involved in an activity, and participating in an activity for more than 100 hours and as much as or more than any other participant.
The ability of a trust to be a material participant in a business activity or to qualify as a real estate professional has significant income tax consequences. Nongrantor trusts are taxed at the highest marginal rate (currently, 39.6%) to the extent their income exceeds $12,300 (in 2015). They’re also subject to the 3.8% net investment income tax (NIIT) to the extent their net investment income exceeds the same threshold.
If a trust materially participates in businesses it owns — and, in the case of rental real estate holdings, qualifies as a real estate professional — it can deduct losses generated by these activities from its nonpassive income, potentially reducing its income tax bill substantially. In addition, the trust’s income from these activities is exempt from the NIIT, which doesn’t apply to income from a nonpassive trade or business.
The Tax Court’s ruling
In Aragona, the Tax Court rejected the IRS’s argument that a trust can’t materially participate in a business or qualify as a real estate professional. This case involved a trust that the taxpayer established for the benefit of his five children. The taxpayer served as trustee, and after he died, was succeeded by six trustees: his five children plus one independent trustee.
The trust’s assets included rental real estate properties. The trust managed most of its rental real estate through a wholly owned limited liability company (LLC). It also managed some of the properties directly or through majority-owned entities. Three of the children worked for the LLC full time.
The IRS disallowed the trust’s deduction of its rental real estate losses from its nonpassive income, arguing that 1) trusts can’t perform “personal services” or otherwise materially participate, and 2) even if they can, the trustees’ activities as employees of the LLC didn’t count toward the material participation thresholds.
The Tax Court disagreed, finding that the trust materially participated in the rental real estate businesses and qualified as a real estate professional by virtue of its trustees’ activities — even though some of the trustees were employed by the LLC.
It’s possible that the activities of a trust’s nontrustee employees are sufficient to establish material participation or real estate professional status, but the court didn’t address this issue. Also, the outcome might have been different had the trust owned minority rather than majority interests in its rental real estate businesses.
Review your estate plan
In light of the Tax Court’s decision, it’s a good idea to review your estate plan. If your plan includes trusts that own rental real estate or other passive business interests, determine whether your trusts materially participate in these businesses or qualify as real estate professionals based on the trustees’ activities. If they don’t, consider naming one or more trust employees as trustees to help ensure that the trust can deduct passive losses from its nonpassive income and minimize NIIT liability.
“Real estate professional” defined
As noted above, taxpayers who qualify as real estate professionals may fully deduct rental real estate losses from their nonpassive income. Real estate professionals are those who, during the year, spend more than half of their working hours, and at least 750 hours, on real estate businesses in which they materially participate. This doesn’t include activities performed as an employee, unless the taxpayer owns at least 5% of the business.
Keep in mind that even if a taxpayer qualifies as a real estate professional, it’s still necessary to materially participate in a rental activity in order to deduct losses from nonpassive income. Taxpayers involved with multiple rental properties may elect to treat all of these properties as a single activity in order to satisfy the material participation requirements.