Trusts can provide many estate tax planning benefits, including wealth distribution, asset protection, and estate and gift tax reduction. However, some trusts may also provide income tax benefits as well. By reducing income tax, you may also preserve wealth for your heirs.
Last year, the U.S. Tax Court decided in The Frank Aragona Trust Case that a trust can “materially participate” in a business for purposes of passive activity loss (PAL) rules. The decision creates income tax benefits by allowing more deductions for many trusts.
What is a PAL?
The PAL rules prevent taxpayers from deducting losses generated by “passive” business activities against “non-passive” income, such as wages and portfolio interest and dividends. Passive activities are those in which a taxpayer does not “materially participate.” They include rental real estate activities, regardless of participation level, unless the taxpayer qualifies as a real estate professional. These rules require a review of time spent on the activities. Taxpayers who are not real estate professionals may deduct up to $25,000 in rental real estate losses from other “non-passive” income.
The ability of a trust to be a material participant in a business activity, or to qualify as a real estate professional, has significant income tax consequences. Non-grantor trusts are taxed at the highest marginal tax rate (currently 39.6%) to the extent that their income exceeds $12,300 (in 2015). They are also subject to a 3.8% net investment income tax (NIIT) to the extent their net investment income exceeds the same threshold.
If a trust materially participates in businesses it owns (or qualifies as a real estate professional in real estate activities), it can deduct losses generated by these activities against “non-passive” income, potentially reducing its overall income tax substantially. In addition, the trust’s income from these activities is exempt from the NIIT, which does not apply to income from a non-passive trade or business.
The definition of “material” is regular, continuous and substantial, however, this may be too subjective and unclear. Therefore, the tax rules have created “safe harbor” rules to meet the definition by participating in an activity for more than 500 hours during a tax year, performing substantially all of the work involved in an activity, and participating in an activity for more than 100 hours and as much as, or more than, any other participant.
The Tax Court Ruling
The Tax Court disagreed with the IRS that a trust cannot materially participate in a business or qualify as a real estate professional. The trust was established for the benefit of five children and the taxpayer served as trustee. After he died, he was succeeded by six trustees, including his five children plus one independent trustee. The trust’s assets included rental real estate properties managed through a wholly-owned, limited liability company (LLC). The trust also managed some of the properties directly or through majority-owned entities. Three of the children worked for the LLC full time.
The IRS disallowed the deduction of rental real estate losses against non-passive income, stating that 1) trusts cannot perform personal services or be able to materially participate, and 2) the trustee activities as employees of the LLC did not count toward the material participation thresholds. However, the Tax Court decided that the trust materially participated in the rental real estate businesses and qualified as a real estate professional by virtue of its trustee activities, even though some of the trustees were employed by the LLC.
It may be possible that the activities of a trust’s non-trustee employees are sufficient to establish material participation or real estate professional status, however, the court did not directly address this issue. Also, the outcome might have been different had the trust owned minority interests rather than majority interests in rental real estate businesses.
Review Your Estate Plan
Based on the Tax Court’s decision, this is another great reason to review your estate plan. If your plan includes trusts that own rental real estate or other passive business interests, you should determine whether your trusts materially participate in these businesses or qualify as real estate professionals based on the trustee activities. If they do not qualify, then consider naming one or more trust employees as trustees to help ensure that the trust can deduct passive losses against non-passive income and minimize the NIIT liability.
For more information on passive business interests, contact Tom Kosinski at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.