Tax Law and Business Organization Strategy

IRS Still Says That Trust's Material Participation Depends on Trustees' Activities

In a new private letter ruling, IRS continues to take the position that trusts materially participate in an activity for purposes of the Code Sec. 469 passive activity loss (PAL) rules only when their trustees participate in the operations of the activity on a regular, continuous, and substantial basis.

Query: Does this mean that you look at the participation of all of a corporate trustee's employees, but not the agent's of an individual trustee?

Background. In general, losses from a trade or business are suspended (i.e., may not be currently deducted) under the PAL rules if the taxpayer does not materially participate in it. Participation is material under Code Sec. 469(h)(1) only if the taxpayer is involved in the activity on a regular, continuous, and substantial basis. While Reg. § 1.469-5T(a) provides quantitative tests on how individuals can meet the Code Sec. 469(h)(1) test, there aren't any regs on the material participation requirement for trusts and estates. The legislative history to Code Sec. 469 provides, however, that an estate or trust materially participates in an activity if an executor or fiduciary, in his capacity as such, so participates. (S Rept No. 99-313 (PL 99-514) p. 735)

In Mattie K. Carter Trust v. U.S. (ND Tex., 4/11/03) 91 AFTR 2d 2003-1946, a district court held that in determining material participation for trusts, the activities of its employees should be included in determining whether a trust's participation is regular, continuous, and substantial (see Federal Taxes Weekly Alert 04/24/2003).

In a Technical Advice Memorandum (TAM) issued as PLR 200733023, IRS said that notwithstanding the decision in Mattie K. Carter, in the absence of regs, material participation by a fiduciary requires the fiduciary's “regular, continuous, and substantial” participation required by Code Sec. 469(h)(1). Moreover, this “regular, continuous, and substantial” participation must be in the estate's or trust's business activities.

Facts. Taxpayer A is the beneficiary and a trustee of a complex trust. The trust holds various assets including a partnership interest in B, which in turn owns C, which in turn wholly owns D. The trust asked IRS to rule as to whether the trust can materially participate in the activities of D.

IRS sticks to its position. Without mentioning the Mattie K. Carter Trust decision (or the 2007 TAM), IRS ruled that the trust may materially participate in D's activities if the trustee, in this case A, is involved in the operations of D's activities on a regular, continuous, and substantial basis. IRS didn't rule on whether A in fact materially participated in D's activities or whether D's activities constitute an appropriate economic unit under Reg. § 1.469-4(c).

The PLR said that determining the proper focus in Code Sec. 469 for the trust's activities is a question of federal tax law and must include an examination of the treatment of trusts under Subchapter J. The taxation of trusts under Subchapter J is a hybrid regime involving an entity-level tax as well as the pass-through of income to the beneficiaries. While a trust is sometimes required to pay tax on its own income under Code Sec. 641 , it may also generally deduct under Code Sec. 661 income that is passed through to its beneficiaries under Code Sec. 662. Although the beneficiaries of a trust do not generally participate in the activities of the trust, the designated trustee acts on behalf of, and in the interests of, the beneficiaries.

IRS said that focusing on a trustee's activities for PAL purposes accords with the general policy rationale underlying the PAL rules. Generally, the owner of a business can't look to the activities of the owner's employees to satisfy the material participation requirement. Indeed, because an owner's trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of other business owners, therefore, IRS said it is appropriate in the trust context to look only to the activities of the trustee. Thus, the sole means for a trust to establish material participation is if its fiduciary is involved in the operations of the activity on a regular, continuous, and substantial basis.

Trackbacks (0) Links to blogs that reference this article Trackback URL
Comments (0) Read through and enter the discussion with the form at the end
Sprouse Shrader Smith PC
701 S. Taylor, Suite 500, Amarillo TX 79101

Phone: 806.468.3300