Tax Court Addresses Material Participation by Trusts: Tax Court Holds That Services Performed by Trustees Who Are Also Employees May Be Taken into Account in Determining Material Participation for Passive Loss Purposes; Holding Also Relevant for 3.8% Net Investment Income Tax

Sullivan & Cromwell LLP - March 31, 2014

On March 27, 2014, in Frank Aragona Trust et al. v. Comm’r, the Tax Court ruled that, in determining whether a trust’s activities are “passive” for purposes of the passive activity loss rules, (i) a trust can qualify for the material participation exception relating to certain taxpayers engaged in real property businesses; and (ii) services performed by individual trustees on behalf of a trust may be taken into account in determining whether the trust “materially participated” in the conduct of a trade or business, including services performed in a trustee’s capacity as employee of a disregarded entity wholly owned by the trust.

The decision is a victory for taxpayers that extends beyond the passive activity loss and real property contexts.  The Affordable Care Act of 2010 imposes, beginning in 2013, a new 3.8 percent Medicare tax on net investment income (“NII”) of non-corporate taxpayers.  In the case of certain trusts and estates, the NII tax is imposed on undistributed NII.  Income from a trade or business in which a taxpayer “materially participates” is generally excluded from NII and the definition of “materially participates” is explicitly cross-referenced to the definition for purposes of the passive loss rules.  Accordingly, Aragona Trust should provide guidance for determining whether a trust materially participates in a trade or business, and whether income from that trade or business may be excluded from NII.