March 27, 2023

Volume XIII, Number 86


March 24, 2023

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U.S. Tax Court Rejects Internal Revenue Service's (IRS) Restrictive View of Trust Material Participation

The U.S. Tax Court recently issued a taxpayer favorable opinion regarding how a trust materially participates in its activities. The court’s holding will make it easier for trusts to currently deduct expenses against non-passive income and to exclude income from the reach of the new 3.8% net investment income tax.

In Frank Aragona Trust v. Comm’r, the court held that in determining whether a trust materially participates in its activities, the activities of the trustees, including their activities as employees of the businesses owned by the trust, should be considered. The court’s opinion directly conflicts with recent IRS guidance that only a trustee’s time spent acting in a fiduciary capacity counts toward the trust’s material participation – a standard that would be very difficult for most trusts to meet. See Technical Advice Memorandum 201317010.

In Frank Aragona Trust, a Michigan trust owned rental real estate activities and engaged in holding and developing real estate. The trust conducted some of its activities directly, and others through its wholly-owned business, Holiday Enterprises, LLC. The trust had six trustees, three of whom worked full-time for Holiday Enterprises. The IRS argued that the participation of the trustee-employees should be disregarded. The court disagreed and concluded that the participation of the trustee-employees should be counted and further, that the participation of the trust’s six trustees was sufficient to meet the material participation standard. The court based its decision, in part, on the fact that Michigan law requires trustees to “administer the trust solely in the interest of the trust beneficiaries” even when they are participating through a business wholly-owned by the trust. This decision provides helpful authority for trusts, their trustees and their advisors in navigating the complex passive activity loss and net investment income tax rules.

However, the decision in Frank Aragona Trust does not answer all of the outstanding questions regarding material participation of trusts. In recently finalized regulations implementing the net investment income tax, the Treasury Department and the IRS requested public comments on rules regarding material participation of trusts, which indicates that the IRS may finally undertake a formal project to provide long-awaited guidance on this issue.

© 2023 BARNES & THORNBURG LLPNational Law Review, Volume IV, Number 107

About this Author

Michala Irons, Tax Attorney, Barnes Thornburg, Law Firm

Michala P. Irons is an associate in Barnes & Thornburg LLP’s Indianapolis, Indiana office and a member of the firm’s Tax Department. Ms. Irons assists individuals, businesses, and nonprofit organizations with federal tax planning, including income tax, employment and self-employment tax, excise tax, and net investment income tax issues.  Ms. Irons also represents taxpayers in matters before the Internal Revenue Service, including collections, examinations, appeals, and requests for private guidance from the IRS National Office.

Randal Kaltenmark, Barnes Thornburg Law Firm, Indianapolis, Tax Law Attorney

Randal J. Kaltenmark is a partner in Barnes & Thornburg LLP's Indianapolis, Indiana office. He concentrates his practice in federal, state, and local tax controversies and audits, as well as tax planning for both public and private clients, including joint mergers, mergers, and acquisitions. Mr. Kaltenmark represents clients in audit and administrative proceedings before the Internal Revenue Service and state/local tax authorities. He also represents clients in appeals to both federal and state courts, including the United States and Indiana Tax Courts. Mr. Kaltenmark is experienced in...

William M. Pope Estate Planning attorney Barnes Thornburg Law Firm Indianapolis

William M. Pope is a partner in the Indianapolis, Indiana office of Barnes & Thornburg LLP, serving in the Corporate Department and co-chairing the firm's Estate Planning Practice Group. Mr. Pope primarily works with family-owned and closely held businesses on succession planning, family wealth transfers, and the structure of family-owned enterprises.

Douglas S. Robson Tax Attorney Barnes Thornburg Law Firm, Chicago

Douglas S. Robson is a partner in the Chicago office of Barnes & Thornburg LLP. He also practices in the firm’s Grand Rapids, Michigan office. Doug is a member of the Corporate, Tax and Real Estate Departments and co-chairs the firm’s Estate Planning and Private Wealth Practice Group. He concentrates his practice on the advanced planning needs of business owners, entrepreneurs, and professionals. Mr. Robson combines the disciplines of business and corporate law, estate planning, asset protection and income tax planning to provide comprehensive solutions to business structuring,...

Howard J. Rubin Barnes Thornburg Law Firm Minneapolis Trust & Estates Attorney

Howard J. Rubin is a partner in the Minneapolis, Minnesota, office of Barnes & Thornburg LLP, where he is a co-chair of the firm's Private Client Services Practice Group.

Mr. Rubin focuses his practice on estate and general business succession planning. He works closely with his clients to understand their values and to provide customized and effective strategies for asset protection and wealth transition. Mr. Rubin offers clients a unique and sophisticated background in tax, possesses hands-on experience with foreign trusts, and frequently...