Source: https://www.americanbar.org/groups/real_property_trust_estate/publications/probate_property_magazine_home/rppt_mo_premium_rp_publications_magazine_2008_ma_trusts_shenkman.html
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Matched Legal Cases: ['§ 469', '§ 469', '§ 1', '§ 469', '§ 469', '§ 469', '§ 469', 'art 3', '§ 162', '§ 404', '§ 1', '§ 355', '§ 469', '§ 7701', '§ 1', '§ 2503', '§ 1', '§ 1']

Trusts and Passive Loss Rules: How Does a Trust Materially Participate?
Martin M. Shenkman is a member of the New Jersey firm of Martin M. Shenkman, P.C., and is a vice-chair of the Individual and Fiduciary Income Tax Committee.
The common use of trusts in estate and asset protection planning makes a seemingly esoteric issue of the application of the passive loss rules to trusts, which was examined in a recent TAM, more important than many might realize. Determining when losses generated by trust assets can be deducted, or whether the deduction will be deferred under the passive loss limitation rules of Code § 469, can have a significant tax effect on trusts and their beneficiaries. This issue affects not only trust and estate attorneys but also real estate and corporate counsel planning and structuring transactions when significant equity positions will be held in trust. The result will often depend on whether the trust has “materially participated” in a trade or business in which the trust owns an interest. There is little guidance on this complex issue. The one court case and the recent TAM that deal with this issue take contrary views and do little to provide a conceptual framework within which to consider the myriad fact patterns that may have to be analyzed to determine “material participation.” The case and the TAM only deal with one of many scenarios practitioners have to address. This article provides an overview of the issues, an analysis of the applicable sources, and an identification of conceptual problems and planning considerations.
What Are the PassiveLoss Rules
In the simplest of terms, the passive loss rules divide activities into three general categories:
• Passive—Rental activities such as rental real estate, investments in limited partnership interests, and other active businesses in which the taxpayer does not “materially participate” in the operations.
• Non-Passive (Active)—Earnings from self-employment and profits from a business inwhich the taxpayer materially participates.
• Portfolio—Interest and dividends from securities investments.
In a nutshell, the passive loss rules of Code § 469 limit a taxpayer’s ability to deduct losses from “passive” activities against income from “active” endeavors or “portfolio” income. Initially the goal of these rules was to prevent wealthy taxpayers from buying tax shelters that would be used to offset other income such as income from a professional practice.
Example— A physician client purchases a 10% interest in a limited liability company (LLC) that triple net leases a warehouse property. The client has no involvement in the rental activity. The LLC loses $100,000. The client’s share is a $10,000 loss. The client can only deduct that loss against other passive income (from other passive real estate deals, for example, or active businesses in which he does not materially participate), not against salary from his medical practice.
Example— A client purchases a 30% interest in a widget manufacturing LLC and devotes substantial time (more than 500 hours) to the business’s operations. The LLC loses $100,000. The client would realize a $30,000 loss that he could deduct against salary and income from other active business endeavors.
Numerous exceptions and special rules affect the classifications. For example, a professional real estate investor will characterize his or her earnings from real estate rental activities as non-passive if he or she provides more than 750 hours of real estate services per year to real estate businesses in which he or she materially participates. In addition, more then half of the services she provides during the year must be in real property trades or businesses.
An individual who actively participates in a rental real estate operation is also excepted from the passive loss rules. If such an individual has gross income below a certain level, he or she can deduct up to $25,000 of losses in a year without regard to the passive loss limitations.
If an individual “materially participates” in a particular activity, then the tax losses from that activity would be characterized as “active” and can be used to offset income from other “active” endeavors, such as salary, without limit. The regulations provide a list of seven tests to evaluate to determine material participation.
In evaluating whether a particular taxpayer has materially participated, the participation of that taxpayer’s spouse is attributed to the taxpayer. Temp. Treas. Reg. § 1.469-5T(f)(3). How this test should be addressed in the context of trusts is uncertain.
Example— Husband is an active real estate developer. Wife’s father establishes a trust for Wife and her sister (“Sister Trust”). Wife is a co-trustee of Sister Trust with a bank. Wife’s father transfers rental real estate to the inter-vivos Sister Trust. Because Husband’s professional real estate activities are imputed to Wife, then sister’s gain or loss from Sister Trust, a trust that was likely set up to protect Wife’s interests in the assets from Husband, will be characterized as active. This result makes little sense but appears to be what the regulation provides.
Trusts and the PassiveLoss Rules
The common use of GRATs, defective note sale transactions, and other trust transactions to shift ownership of real estate and business enterprises makes it increasingly important to determine how to apply the passive loss rules to trusts. The tax implications can be substantial. A simple example will be presented and then the issues it raises noted.
Example— The Smith family establishes a dynasty trust that owns interests in several commercial rental properties. The properties, with depreciation and other deductions, generate a $100,000/year tax loss. The trust also owns a 25% stake in a manufacturing company that generates $100,000 profit. Can the real estate losses be offset against the manufacturing income? How is the material participation rule applied to this trust? A number of scenarios are possible:
• The rental real estate is passive (rental real estate is presumed passive unless an exception applies), and the distribution from the manufacturing company is passive (it is an active business in which the trustee does not materially participate). Both can offset each other at the trust level.
• The rental real estate loss is passive (the presumed result for rental activities), and the income from the manufacturing company is active (it is an active business and the trustee materially participates in its operations), so that the two cannot offset each other on the trust level.
• The rental real estate loss is active (the trustee is an active real estate professional), and the income from the manufacturing company is passive (it is an active business in which the trustee does not materially participate), so that the two cannot offset each other on the trust level.
• The rental real estate loss is deemed from a real estate professional and the income from the manufacturing company is active, so the two can offset each other at the trust level.
• If the funds are distributed to a beneficiary, the results will depend not only on how the income and loss are characterized at the trust level but also on the beneficiary’s personal tax situation.
• If the trust is a grantor trust, the results will depend on the grantor’s personal tax situation.
• To compound the complexity, the question remains who should be the touchstone for determining how the income or loss should be characterized at the trust level, specifically, whether material participation can change the characterization of an active business from passive to active or whether the real estate professional exception applies. The potential persons whose activities may be evaluated in this critical decision potentially include the grantor, the person treated as the grantor under the grantor trust rules (which can differ from the grantor), the trustee (which is the position of the TAM), another fiduciary, some combination of fiduciaries, persons retained by fiduciaries (the Carter case discussed below), or the beneficiaries. The determination of who is the person who has to materially participate is a key issue addressed in the case and recent TAM discussed below, but it is only one facet of the analysis.
Trust Losses Limited byCode § 469
If a trust incurs tax losses that are deemed passive as a result of the trust not materially participating in the activity generating those losses, then those losses are deferred, “suspended,” until future tax years when they can be offset by passive income then realized by the trust. If the trust sells its interests in the passive activity, the previously suspended losses will be triggered. Code § 469(g)(1). If, instead of selling its interests in the passive activity, the trustee distributes those interests to trust beneficiaries, the suspended income tax losses are added to the tax basis in the property. Code § 469(j)(12).
Authorities Addressing the Application of the Passive Loss Rules and the Material Participation Test to Trusts
A limited number of authorities address the issue of trusts and material participation, so it is helpful to review each before evaluating the planning implications and applications.
• The Statute. Material participation requires involvement “on a regular, continuous, and substantial basis.” Code § 469(h)(1).
• The Senate Finance Committee Report. Involvement in day-to-day operations, not merely intermittent management activity, is necessary. “An estate or trust is treated as materially participating in an activity . . . if an executor or fiduciary in his capacity as such, is so participating. Portfolio income of an estate or trust must be accounted for separately, and may not be offset by losses from passive activities.” Footnote 21 states: “In the case of a grantor trust, however, material participation is determined at the grantor rather than the entity level.” S. Rep. No. 99-313 (Pub. L. No. 99-514), at 735 [1986-3 C.B. (Part 3) 1]. A grantor trust is a trust whose income is reported by the grantor (usually the person who set up the trust), not to the trust itself.
• Staff of the Joint Committee on Taxation Report (Blue Book). Although the Blue Book does not constitute official legislative history, it is frequently cited for the guidance or insight to that history. In its discussion of material participation, the Blue Book, in Footnote 33, provides:
No special rule was provided for determining material participation by a trust . . . 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 . . . it is unlikely that a trust . . . will be materially participating in a trade or business activity, within the meaning of the passive loss rules. In the case of a grantor trust, to the extent that the grantor or beneficiary is treated as the owner for tax purposes . . . 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 owner. . . .
The committee’s rationale for why it is unlikely for a trust to materially participate in an activity is that such participation would result in the trust being treated as an association taxable as a corporation. This report, however, pre-dates the check-the-box regulations.
• Regulations. There are no regulations (yet), so the general rules of the statute must be applied.
• Case Law—The Mattie K. Carter Trust v. United States. The will in the Carter case provided for a trust that managed various assets, including the Carter Ranch, which involved cattle, oil, and gas. The trustee hired a ranch manager and other employees to carry out most ranching duties. The IRS argued that only the trustee’s efforts should be considered in determining if the trust met the test of materially participating in the ranch. If he did, almost $1.7 million in losses would have been deductible in the two years under audit. The trustee’s position was that the trust’s material participation in the ranching activity should be evaluated with consideration to the efforts of not only its fiduciaries, but also its employees and agents. The U.S. District Court for the Northern District of Texas determined that the law did not mandate that only the trustee’s activities could be considered. In the aggregate, the efforts of the trustee, ranch manager, and others showed regular, continuous, and substantial involvement, so that the trust was deemed to materially participate and could deduct the losses. 256 F. Supp. 2d 536 (N.D. Tex. 2003). The court’s rationale was that a trust is analogous to a closely held C corporation for purposes of this analysis.
Using the closely held C corporation as a paradigm, the law appears consistent with the position of the court in Carter. A closely held corporation can be treated as materially participating in an activity based on the activities of both owners and non-owner employees if three requirements are met: (1) at least three full-time, non-owner employees devote substantially all of their work time to the business; (2) at least one full-time employee (owner or non-owner) devotes substantially all his or her working time to the active management of the business; and (3) ordinary business deductions under Code § 162 and retirement plan contributions under Code § 404 exceed 15% of the gross income from the business. Clearly, for testing a business, the efforts of an employee can be considered (analogous to the ranch manager in Carter).
Special rules apply to the determination of whether a corporation that is a partner in a partnership is deemed active. Treas. Reg. § 1.469-1T(g)(3)(i)(B). In Rev. Rul. 92-17, 1992-1 C.B. 142, the IRS held that if the officers of a corporation that is a general partner in a limited partnership perform active and substantial management functions for the partnership, including the decision making regarding significant business decisions of the partnership and regular participation in the overall supervision, direction, and control of the employees of the partnership in operating the partnership’s rental business, the corporation is deemed to be engaged in the active conduct of a trade or business within the meaning of Code § 355(b). In Carter, by analogy, the trustee hired a ranch manager to perform business functions, and those activities, like the officers in the above ruling, should characterize the trust as actively involved. The application of the corporate model to the trust environment, however, is not certain.
• TAM 200733023. In this recent ruling, dated August 17, 2007, the IRS determined that a trust’s effort to characterize losses as not being passive (and hence currently deductible) failed. The IRS maintained that the trustee’s activities alone should be considered in determining if the trust materially participated in the activity. It is the material participation of the trustee that is the litmus test. The IRS expressly addressed the Carter court opinion above and stated that it disagreed. The will creating the trust in this ruling permitted the appointment of a special trustee for any part or all of the trust property. The special trustee, except as limited in the trust, had all the rights of a trustee. The IRS seemed swayed in part by the fact that “ultimate decision-making authority remained vested solely with the trustees.” The IRS rejected the trust’s argument that these “special trustees” were “fiduciaries” for purposes of the Code § 469 material participation test, even if they were so characterized under state law. The IRS then looked at the definition of “fiduciary” to evaluate this. The tax law defines a “fiduciary” as a trustee or any other person acting in any fiduciary capacity for any person. Code § 7701(a)(6). If someone is granted broad discretionary power of administration and management over an asset, a fiduciary relationship exists. Rev. Rul. 82-177, 1982-2 C.B. 365. If the person does not have administrative duties, he or she is not a fiduciary. Rev. Rul. 92-51, 1992-2 C.B. 102. Because the “special trustees” in this ruling were controlled by the trustees and had no power over the trust property, their participation was irrelevant to the
• AICPA. The AICPA has suggested that material participation be tested based on the activities of the trustee, as if the trust were evaluated under the rules applicable to an individual (not a closely held corporation); activities of the beneficiary should not be considered.
Applying the Above Authorities
The key problem in applying the material participation test is the determination of what constitutes material participation and whose endeavors may be considered in the analysis. Two areas are in issue. On this specific point, activities of those hired by the trustee should be considered in determining whether the trust is materially participating. That issue is unresolved because of the diametrically opposite positions of the IRS and the Carter court. Future court cases will likely face this identical issue, but a problem that will likely follow is that the fact-sensitive nature of these decisions will lend itself to a patchwork of fact-sensitive cases that will challenge practitioners to construct general rules to apply in practice.
But practitioners must grapple with a host of other aspects to this issue that neither Carter nor the TAM addresses. The practical difficulties extend well beyond that one issue. Consider the following scenarios:
Example— Father gifts stock in a family business to an irrevocable trust for Son. Uncle Joe is the trustee. Consider the following seven scenarios:
• Uncle Joe hires a manager to operate the family business. Based on Carter, the income or loss from the business would be active. Based on the TAM the interests would be passive.
• If Son were actively involved in the family business so that the income or loss from the business were active for him, the results of Son owning the stock outright instead of having it being held in a trust could be substantial. If the stock is held in the trust and the trustee was a bank or other nonmaterial participant in the family business, then losses from the business would be passive and would be trapped in the trust if no passive income offset it. The fact that the sole beneficiary is active would be irrelevant to the characterization of the gain or loss.
• Assume that gifts were made to the trust by Father each year using annual gifts that qualified by virtue of a Crummey power. The Crummey power would make the trust a grantor trust as to Son, so that Son’s activities would be the touchstone for determining material participation. PLR 200603040 held that the grantor trust rules override the Crummey rules. Cf. Treas. Reg. § 1.671-2(e)(1).
• Instead of including a Crummey power, the trust was structured as a Code § 2503(c) minor’s trust. Because now the trust is not a grantor trust, the efforts of Uncle Joe as trustee will again be determinative of material participation.
• The trust includes an administrative power that taints it as a grantor trust. Because Father is the grantor, Father’s involvement with the business, not Uncle Joe’s, would be the touchstone for determining whether the trust materially participates. The activities of the manager hired by Uncle Joe, however, will not be imputed to Father (or would they?), so that under both Carter and the TAM the income or loss from the stock would be characterized as passive (unless Father in his own right is a material participant).
• If the trust were structured as a grantor trust for Father so that he could pay the income tax on the trust to further leverage gifts, but also as a Crummey power to qualify the annual gifts for the gift tax annual exclusion, then the trust would be characterized as a grantor trust for both Father’s and Son’s. Uncle Joe and the manager’s activities would not be relevant, but would it be Father’s or Son’s activities that would be evaluated, or both?
• What if an administrative power was given to a third party that tainted the trust as a grantor trust for Father and that power could be toggled on or off by the third party? Would that change each time the characterization of the income or loss earned by the trust goes from passive to active?
Example —Dr. Smith transfers interests in a real estate rental property that is generating losses to a nongrantor Delaware trust naming Dan Developer as sole trustee. Although Dan is an active developer, Dr. Smith has no real estate involvement. The test of material participation is at the trust level, Dan Developer as trustee is used as the touchstone for the analysis, and all the losses are characterized as non-passive losses. Because the trust is structured as a nongrantor trust as to Dr. Smith, all losses are transmuted into active losses and are used to offset her income from her medical practice. Thus, a nongrantor trust can perhaps be used to accomplish modern day tax alchemy of converting unusable passive losses into usable active losses. This demonstrates the potential application of the simplistic general rules contained in the TAM.
When the passive loss rules were initially enacted, it became common for taxpayers to structure transactions to intentionally generate passive income to be used to offset otherwise unusable passive losses. These passive income generators were affectionately known by the acronym “PIGs.” Applying the IRS rationale in the recent TAM may provide support for a new type of trust PIG.
Example —Dan Developer, an active developer, has passive losses from side deals he invested in as a minority limited partner. Income from his active properties cannot be used to offset the losses on the passive LP deals. Dan has a new shopping center development opportunity. Instead of his owning the deal, he structures a nongrantor Delaware dynasty trust, with himself and his heirs all as beneficiaries. Uncle Joe is named as co-trustee with a bank. The trust, using cash from a gift received from Dan, and buttressed by Dan’s personal guarantee, invests the seed capital for the new center. The trustees are not active real estate developers and have no real estate involvement. The net rental income generated by the center flows through the trust and is distributed to Dan as beneficiary. Because the characterization of the income is based on the trustee’s activities according to the TAM, the income is characterized as passive and can be used to offset the otherwise unusable passive losses Dan realizes on his passive LP deals. Dan has used the trust structure, by avoiding grantor trust status, to transform what would have been ordinary income into passive income. The trust serves as a passive income generator for Dan.
The IRS clearly disagrees with the Carter court and insists that only “fiduciary” activities, not those of managers or others, will count toward constituting material
• What if there are multiple trustees? For a corporation, the Staff of the Joint Committee on Taxation Report (Blue Book) states: “A corporation that is subject to the passive loss provisions is treated as materially participating in an activity with respect to which one or more shareholders, owning in the aggregate more-than-50% of the outstanding stock of the corporation, materially participate.” Applying a more-than-50% test to trustees will make it impossible for a trust with an individual and corporate trustee to materially participate. Often, clients structure trusts with exactly that arrangement, an individual who may participate in a closely held business and an institutional fiduciary to provide independence and professional trust services. If the individual co-trustee materially participates in a family business, the trust will not materially participate under such a test. This seems inappropriate.
• What about the various fiduciary positions encountered with many trusts: trust protectors, investment advisers, and so on? The IRS did not address these types of fiduciaries. A common scenario for complex trusts is to appoint an investment adviser for marketable securities, a separate investment adviser for closely held business or real estate assets, and a trust protector that has certain decision-making authority over both and the trustee. Should the aggregate efforts of the business investment advisor, trustee, and trust protector all be considered? Although this seems to be the clearly appropriate response, will the IRS look beyond the efforts of the trustee? If a trust protector, investment adviser, or other fiduciary was involved in some manner with the activity, the aggregate of all their efforts should be considered. If there are multiple investment advisers, only those with power over the activities being tested should be considered (for example, an adviser with authority limited solely to marketable securities should not be considered in evaluating the activities of an adviser charged with making investment decisions for closely held business assets held in the trust). The IRS, however, may endeavor to apply the concepts of the TAM so that, any time an institutional (or other) trustee retains another person to manage the real estate or business held by the trust, as a mere manager or because an investment adviser is named in the trust agreement, the determination of material participation will not consider that person’s efforts. The next level down, whether the activities of those hired by such fiduciaries should be counted, remains uncertain.
• The IRS might have enunciated a test. If an investment adviser does not have “broad discretionary power of administration and management,” he will not be a fiduciary for this test. Will the IRS argue that a trust protector whose role is limited does not qualify for consideration? If a business investment adviser regularly and continuously participates in the business asset held by the trust, it would appear logical that if he is the appropriate benchmark, his involvement should be considered. Under the IRS test, however, what quantum of discretionary power must he hold to be counted? This could lead to fact-sensitive cases until the threshold level sufficient to satisfy the IRS is identified. Will the IRS consider an investment adviser in determining if the trust will qualify as a material participant? In Lewis Borle Denckla v. Hanson, 128 A.2d 819, 823 (Del. 1957), the trustee’s powers were in part limited so that they could only be exercised on the written direction of, or with the written consent of, a trust adviser. The trustee’s powers that were limited included the right to sell trust assets, to invest the proceeds of the sale of trust property, and to participate in mergers and reorganizations of corporations whose securities were held as part of the trust assets. The grantor in fact designated a trust advisor and reserved the right to nominate other advisers at any time during her lifetime. Would the activities of such an adviser be considered? State tax authorities recognize the activities of trust investment advisers in determining a nexus to assert state income taxation. For example, if a trust protector for a Delaware directed trust designates a New York person as investment adviser, New York may seek to tax the income of the trust, even though but for that designation the trust would not have any tax nexus to New York. TSB-A-04(7)I, 2004 N.Y. Tax LEXIS 259 (Nov. 12, 2004). This same analysis would seemingly suggest that the activities of a trust investment adviser be considered for passive loss purposes
• Will the use of a directed trust have a different result than a delegated trust investment adviser? Because the trustee is relieved of liability on a directed trust, but not on a delegated trust investment, should the efforts of a directed investment adviser be counted as participation by a fiduciary but not the efforts of an investment adviser under the delegated trust because the trustee remains responsible and the delegated investment adviser would fail the test of the recent TAM?
• Several tests are provided in the regulations to determine whether a shareholder materially participates. Temp. Treas. Reg. § 1.469-5T(a). One of these tests is that if the individual materially participated in the activity for any 5 of the 10 immediately preceding tax years, the activity will retain its active status for purposes of the passive loss rules. If the shareholder transfers the assets to a trust, what becomes of this rule? If the trustee is the touchstone for the determination of participation, then this regulation is circumvented. What if the trustee is not active, but the shareholder remains the investment adviser? In such an instance, should the investment adviser’s prior activities be imputed to the trust so that the application of this regulation would continue to characterize the income or loss of the trust as active?
• If the trust is intentionally structured as a grantor trust, then should the grantor’s efforts, not those of the trustee, count toward determining material participation?
Example —Father is an active real estate professional so that all of his income and losses from real estate activities are characterized as active. Father owns limited partnership positions in equipment leasing companies that generate passive losses that he cannot offset against active real estate income. Father forms a grantor retained annuity trust (GRAT) and names his nephew, a physician, as sole trustee. Father contributes a real estate venture to the GRAT. If the efforts of the trustee provide the touchstone because the trustee is not a real estate professional, and in any event cannot participate actively in the management of the real estate asset, then the income generated by the real estate venture must be passive. Because the GRAT is structured to be a grantor trust for Father, Father reports all income as passive income. But for footnote 21 of the Senate Finance Committee Report, Father could use the IRS approach to material participation by trusts to convert a GRAT into a passive income generator.
• If the trust were structured with annual demand ( Crummey) powers so that gifts to it qualify for the annual gift exclusion, then the beneficiarywould be taxable on trust income. In this scenario, should the beneficiary’s activities be evaluated to determine whether there is material participation, not the trustee’s?
Example— Father sets up a trust for his three children. Annual gifts of membership interests in an LLC, which holds a neighborhood strip shopping center, are given to the trust. The gifts qualify for the gift tax annual exclusion as a result of the annual demand powers in favor of the three children. If the trust is characterized as a grantor trust for the three children as a result of the Crummey powers, the children’s activities would be determinative. If the trust was not deemed a grantor trust to the children and the trustee is an active real estate professional and the children, all physicians, have no real estate involvement, then the losses should be able to pass through to the children as active losses. Losses from the shopping center will then be able to offset medical practice income.
In addition to having to make the determination of what character trust income is to have, the trustee, or other touchstone for passive loss purposes, has to demonstrate whether it materially participates or not. Although the regulations do not mandate contemporaneous time logs or reports, these must be used if the participation cannot be established by other reasonable means such as appointment books, calendars, and so on. Temp. Treas. Reg. § 1.469-5T(f)(4). It will be incumbent on the trustees and other fiduciaries, when they are or even may be the appropriate touchstone, to maintain adequate records.
The material participation test and the application of the passive loss rules can have substantial effect on trust planning, real estate structures, and estate planning. The law remains uncertain, and the limited authorities seem to imply a conceptually flawed framework that will likely lead to fact-specific cases that will not provide simplicity or bright-line tests. In the end, to be consistent with the purposes for which the passive loss rules were enacted, the approach to resolving this issue should consider the activities of all fiduciaries as well as who is taxable on trust income or loss in making the determination.