The Tax Court reduced 2013 income taxes for a lot of trusts yesterday. The court ruled that trustees can “materially participate” in rental real estate activities, and by extension in other activities. If a taxpayer “materially participates” in an activity, it is not subject to the Obamacare 3.8% “Net investment Income Tax” on that activity’s income.
This is a big deal for trusts because they are subject to this tax at a very low income level — starting at $11,950 in 2013. The IRS has said that it considers it nearly impossible for trusts to materially participate. Yesterday’s decision flatly rejects the IRS approach.
The IRS had stated its position in a ruling involving an “Electing Small Business Trust,” which is a type of trust that can hold interests in S corporations — and which tend to get hit hard by the NII tax. The IRS said that a president of the corporation who was also a trustee of the ESBT was participating in the business not “as trustee,” but as a corporation employee — and therefore the trust didn’t materially participate. The Tax Court disagreed with IRS thinking yesterday:
The IRS argues that because Paul V. Aragona and Frank S. Aragona had minority ownership interests in all of the entities through which the trust operated real-estate holding and real-estate development projects and because they had minority interests in some of the entities through which the trust operated its rental real-estate business, some of these two trustees’ efforts in managing the jointly held entities are attributable to their personal portions of the businesses, not the trust’s portion. Despite two of the trustees’ holding ownership interests, we are convinced that the trust materially participated in the trust’s real-estate operations. First, Frank S. and Paul V. Aragona’s combined ownership interest in each entity was not a majority interest — for no entity did their combined ownership interest exceed 50%. Second, Frank S. and Paul V. Aragona’s combined ownership interest in each entity was never greater than the trust’s ownership interest. Third, Frank S. and Paul V. Aragona’s interests as owners were generally compatible with the trust’s goals — they and the trust wanted the jointly held enterprises to succeed. Fourth, Frank S. and Paul V. Aragona were involved in managing the day-to-day operations of the trust’s various real-estate businesses.
That would seem to put to rest the IRS “as trustees” catch-22.
The Tax Court decision doesn’t make the NII go away for all trusts. Trusts with only “investment” income, like interest and dividends, are not helped by this decision. Also, the decision by its terms only covers situations in which the trustee is materially participating in the trust activity; “We need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.” In this respect the Tax Court doesn’t go as far as a Texas U.S. District Court did it the Mattie Carter Trust case, which counted participation of trust employees in determining whether the trust materially participated in an activity.
Still, even with limitations, the case is a big taxpayer win. It will especially help ESBTs avoid tax on operating income from S corporations when a trustee is also a corporation employee. Also, while the case doesn’t say that non-trustee employees can give trusts material participation, it doesn’t rule it out, either. That means bold trusts with employees that manage trust operations may be able to avoid the 3.8% tax, should the Tax Court adopt the Mattie Carter Trust approach. Future litigation will have to settle the issue. The IRS is also likely to appeal this case.
An aside: The IRS asserted its usual outrageously-routine 20% “accuracy-related” penalty — and it lost on its underlying argument. In a just tax system, the IRS would have to write a check to the taxpayer for the amount of the asserted penalties whenever this happens. The IRS assertion of penalties is far too routine, and should be reserved for cases in which the taxpayer is actually taking a flaky position, or doesn’t bother to substantiate deductions. When it asserts a penalty and the taxpayer actually wins on the merits, the IRS loses nothing under current law. Tax Analysts hosted a seminar yesterday on a Taxpayer Bill of Rights. Any bill worthy of the name would have a “sauce for the gander” rule that would make the IRS — and even IRS employees — as liable as taxpayers are for flaky positions.
Also: Paul Neiffer, Taxpayer Victory in Frank Aragona Trust Case, on the implications for farm interests held in trust.