Part 4: Estate & Trust Income Tax
By David A. Handler and Alison E. Lothes
Originally written for WealthManagement.com
In Frank Aragona Trust v. Comm’r, 142 T.C. No. 9, the Tax Court ruled in favor of the taxpayer, holding that a trust could and did materially participate in real estate rental activities, thus qualifying for the exception to the passive activity rules under Section 469. This case is helpful, as there are currently no regulations regarding how to apply the material participation rules to trusts and very few rulings on the issue. The IRS has been interpreting the exception to be very limited, but the court agreed with the taxpayer that the activities of the trustees, including those in their capacity as employees of the trust’s wholly owned LLC, could be considered when determining whether the trust materially participated in the real estate rental business.
Although a majority of the trust’s business was operated through a wholly owned LLC, it engaged in some of its real estate business activities directly and in others through various entities. The trustees were intertwined in the LLC, other entities and the business. The LLC employed three of the trustees as fulltime employees (along with other employees, including a controller, maintenance workers, leasing agents and clerks). Two of the trustees also held minority interests in several of the entities in which the trust was also a member.
The trust filed fiduciary income tax returns claiming losses relating to its rental real estate activities and characterized those activities as non-passive. The IRS disagreed and determined that the rental real estate activities were passive activities and, as a result, limited the allowable deductions and net operating loss carrybacks.
Under Section 469, a “passive activity” is any activity that involves the conduct of a trade or business in which the taxpayer doesn’t materially participate. Generally, rental activities are considered passive activities unless: (1) more than one-half of the personal services provided by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. “Material participation” requires that the taxpayer be involved in the operation of an activity on a basis that’s “regular, continuous and substantial.”
The IRS argued that a trust can’t qualify for the exception because it can’t perform “personal services.” It claimed that the legislative history indicates that “personal services” can only be performed by an individual. In the alternative, the IRS argued that, even if the trust could perform personal services, when assessing whether the trust materially participates in an activity, only the activities of the trustees (and not the employees) can be considered. In addition, the IRS sought to exclude the activities of the trustees that weren’t solely related to their fiduciary duties. For example, the IRS argued that the activities of the trustees who were employees of the LLC couldn’t be taken into account because those activities should be attributed to them as employees, not fiduciaries. It also argued that a portion of the activities of the trustees who owned interests in the entities should be attributed to their personal ownership, rather than the trust.
The Tax Court disagreed. It noted that the trustees’ fiduciary duties to administer the trust in the interest of the beneficiaries aren’t put aside when they work for the LLC owning the real estate. Therefore, their activities as employees of the LLC should be considered when determining whether the trust materially participated in its real estate operations. It’s interesting to note that the Tax Court didn’t determine whether the activities of the non-trustee employees should be considered because it wasn’t necessary to the decision. Lastly, the Tax Court held that the trustees’ individual minority interests in entities of which the trust was also a member didn’t impact the trust’s material participation because the combined minority interests in each entity held by the trustees were less than 50 percent and, in all cases, were less than the trust’s interest.
This case is very helpful for taxpayers in that the Tax Court adopted a relatively broad interpretation of whose activities may be attributed to the trust (and in what capacity those activities are undertaken) when determining if the trust materially participates in an activity. This issue has recently become even more important because of the 3.8 percent tax on net investment income (NII) under IRC Section 1411. Non-passive trade or business income isn’t considered NII and isn’t subject to the tax under Section 1411. This ruling may make it a little easier for trusts to prove that they’re materially participating in a trade or business to avoid this tax.
Treasury Decision 9664
Final regulations issued under IRC Section 67(e) regarding miscellaneous itemized deductions
In T.D. 9664 (May 9, 2014), the IRS issued final regulations regarding which costs incurred by estates or non-grantor trusts are subject to the 2 percent floor for miscellaneous itemized deductions. These final regulations, to be added as Treas. Regs. Section 1.67-4, only made a few minor modifications to the proposed regulations issued in 2007.
Under IRC Section 67(e), expenses relating to estate or trust administration that wouldn’t have been incurred if the property weren’t held in an estate or trust aren’t subject to the 2 percent floor of Section 67(a). The regulations require the taxpayer to determine whether a hypothetical individual holding the same property would commonly or customarily incur the cost. The type of the product or service is the determinative factor. For example:
Bundled fees: These must be allocated to both costs that are subject to the 2 percent floor and those that aren’t. If the fee isn’t billed on an hourly basis, only the investment advice portion is subject to the 2 percent floor. Otherwise, any reasonable method may be used to allocate a bundled fee between those costs that are and aren’t subject to the floor. Factors to consider include (among others) the percentage of the corpus subject to investment advice and the amount of the fiduciary’s attention to the trust or estate devoted to investment advice.
Ownership costs: Costs chargeable or incurred by an owner of property simply because he owns the property (such as condominium fees, insurance premiums, maintenance and landscaping services) would be subject to the 2 percent floor. The final regulations note that these costs may be fully deductible under other IRC sections.
Tax returns: The costs of preparing gift tax returns are commonly incurred by individuals, so they’re subject to the 2 percent floor. However, tax preparation fees relating to estate and generation-skipping transfer (GST) tax returns, fiduciary income tax returns and a decedent’s final individual income tax returns aren’t.
Appraisal fees: Costs of obtaining an appraisal related to insurance or other purposes commonly incurred by individuals are subject to the 2 percent floor. Appraisal fees related to FMV determinations for estate tax purposes, distribution purposes or to prepare estate or trust tax returns aren’t.
Fiduciary expenses: Those costs related to probate court fees, fiduciary bonds, legal publications and accounts aren’t subject to the 2 percent floor.
Investment advisory fees: Generally, investment advisory fees are subject to the 2 percent floor. However, additional costs beyond what would typically be charged to an individual investor, due to the nature of the property being held in an estate or trust, aren’t. For example, these fees could be due to an unusual investment objective or the need to balance the interests of various parties beyond the usual balancing of the interests of current beneficiaries and remaindermen.
The regulations were originally effective for taxable years beginning on or after May 9, 2014. However, taxpayers filed complaints with the IRS, stating that non-grantor trusts established after May 9, 2014, estates of decedents dying after May 9, 2014 and existing estates with fiscal years beginning after such date, would be immediately subject to such rules without time to adjust and implement changes necessary for compliance. As a result, the Treasury amended the regulations (79 FR 41636, July 17, 2014) so that they’re now effective for taxable years beginning after Dec. 31, 2014.
Linn v. Department of Revenue
Illinois appellate court holds Illinois can’t tax trust under due process clause
In Linn v. Department of Revenue (2013 Ill. App. (4th) 121055), an Illinois appellate court held that a trust wasn’t subject to Illinois income tax under the due process clause. The trust at issue was created when the trustees of an irrevocable inter vivos trust exercised their power to distribute trust property to a new trust. The original trust was established in 1961 by A.N. Pritzker, when he was an Illinois resident, and the original trust was subject to Illinois law by its terms. The trustees and beneficiaries of the original trust were also Illinois residents. However, the trustees exercised their power to transfer assets to or in trust for the beneficiaries to establish a new trust. The new trust stated that it was to be construed and regulated under Texas law, except for the interpretation of the terms “income,” “principal” and “power of appointment” (POA) and the provisions relating to such terms. Later, the trustees obtained an order from the Texas probate court reforming the trust to be subject to Texas law in all respects, as long as the reformation didn’t jeopardize the GST tax status of the trust.
The trustee of the new trust resided in Texas, and it was administered there. None of the beneficiaries of the new trust were Illinois residents, and it had no assets in Illinois. In 2006, the trustee filed a non-resident Illinois income tax return, reporting no income from Illinois sources and no Illinois tax. However, the Department of Revenue reclassified the trust as an Illinois trust and taxed 100 percent of its income. The trustee appealed.
The trial court held for the Department of Revenue that the new trust was subject to Illinois law under the trust agreement of the original trust from which it was created and that being subject to Illinois law was a sufficient contact to allow Illinois to tax the trust under the due process and commerce clauses of the U.S. Constitution. The trustee appealed again.
A trust is subject to Illinois tax if the grantor is domiciled in Illinois when the trust becomes irrevocable (the Illinois statute says a trust is considered irrevocable to the extent that the grantor isn’t treated as the owner of the trust under IRC Sections 671 through 678). On appeal, the parties agreed that Pritzker, the grantor of the original trust, is considered to be the grantor of the new trust as well. The main issue, therefore, was a constitutional one: Could Illinois tax the new trust if the only contact with the state was the resident grantor of the original trust?
The Illinois Court of Appeals held that Illinois couldn’t tax the trust. The due process clause requires there to be minimum contacts between the state and the person or property it taxes. The Department of Revenue argued that even though the trustee, beneficiary, trust protector and assets were all outside of Illinois, the new trust owed its existence to Illinois law and that Illinois provided legal benefits and opportunities to the trust. However, the court disagreed and held that the residence of the grantor alone was insufficient to establish a minimum connection that would permit Illinois to tax the trust. The court reasoned that the trust owed its existence to the exercise of a POA under the original trust agreement—not to Illinois law. It also noted that for the tax year in question, the new trust was subject to Texas law exclusively and would receive benefits and protections of Texas law.
The case is interesting, as decanting and exercises of POAs are becoming more common for income tax planning. The court noted that the trustees created the new trust by using a provision of the original trust, not by the Illinois decanting statute. It’s, therefore, not clear if the result would be the same if the trustees had relied on a state statute to decant the trust.