By: Martin M. Shenkman, CPA, MBA, JD
An increasing portion of wealth is structured to be held in trusts. Trusts hold an array of assets, including investments which might be subject to the passive loss limitations (e.g., losses from an equipment leasing or real estate rental LLC). Can the trust deduct those losses? A court said yes, the IRS recently said no, and a conflict is brewing. The tough issue is that there is really not much guidance for what to do with many common trust transactions.
What are the Passive Loss Rules The passive loss rules of Code Section 469 limit your ability to deduct losses from passive real estate rental (e.g. an investment in a real estate limited partnership) and other activities in which you don’t “materially participate”. The initial goal of these rules was to prevent wealthy taxpayers from buying tax shelters that would be used to offset other income, such as income from a professional practice. Example: You buy a 10% interest in a limited liability company (LLC) that rents out a condo. You have no involvement in the rental activity. The LLC looses $100,000. Your share is a $10,000 loss. You can only deduct that loss against other passive income (e.g., from other passive real estate deals), not against your salary from your OB-GYN practice. Example: You buy a 30% interest in a widget manufacturing LLCs and devote substantial time to the businesses operations. The LLC looses $100,000. You have a $30,000 loss which you may be able to deduct against your salary from your accounting practice. Thus, if you’re treated as materially participating in the activity you’ll get a current tax write-off. If not, the write off could be deferred indefinitely and even lost.
Key to Your Write-Off: Material Participation If you “materially participate” in a particular activity, then the tax losses from that activity would be considered “active” and can be used to offset your income from other “active” endeavors, such as salary, without limit.
Trusts and The Passive Loss Rules As more wealthy taxpayers shift investment interests to trusts it becomes increasingly important to determine whether the trust is materially participating in the particular investment activity in order to apply the passive loss rules to the trust. Why care? Apart from all this helping you be the hit at your next cocktail party, this stuff can affect a lot of wealthy taxpayers who frequently use trusts. In the old days trusts held cash and marketable securities; no longer. Example: The Brady Trust is a dynasty trust that owns a personal use condo for each of Greg, Peter and Bobby, and bling for each of Marcia, Jan and Cindy. The trust has a marketable securities portfolio, and owns interests in several rental properties, each in a single member limited liability company (“LLC”) owned by a parent/master LLC. The trust owns an architectural supply manufacturing company. A bank is named investment adviser for the marketable securities. Alice is named investment adviser for the closely held business interests. The rental properties and the supply company all lose money this year. Can these losses be deducted? How is the material participation rule applied to a trust? Let’s look at the law and then analyze it. Here’s the line-up:
The tax law defines a “fiduciary” as a trustee or any other person acting in any fiduciary capacity for any person. IRC Sec. 7701(a)(6). If someone is granted broad discretionary power of administration and management over an asset, a fiduciary relationship exists. Rev. Rule. 82-177. If the person doesn’t have administrative duties, they aren’t a fiduciary. Rev. Rul. 92-51. Since the “special trustees” in this ruling were controlled by the trustees and had no power over the trust property, their participation was irrelevant to the analysis.
What Does it all Mean
The IRS clearly disagrees with the Carter court and insists only “fiduciary” activities, and not those of managers or others should count. A private ruling is not binding on taxpayers other than the one who received it. But, the ruling is an indication of the IRS view. Do you follow the court or the IRS? What about the various fiduciary positions encountered with many trusts: trust protectors, investment advisers, etc.? The IRS did not address these types of fiduciaries, but the IRS might have enunciated a test. If an investment adviser doesn’t have “broad discretionary power of administration and management” he will not be a fiduciary for this test. A trust protector whose role is usually limited may not qualify. Will the IRS consider the activities of all fiduciaries together in determining if the trust will qualify? The entire decision process, and tax result seems rather arbitrary. If the trust is structured as a grantor trust (e.g., Mike Brady remains taxable) then his efforts, not Carol’s, would count. If the trust were structured with annual demand (Crummey) powers so that gifts to it qualify for the annual gift exclusion, then the six kids would be taxable on trust income. In this case the kids activities would be evaluated, not Carol’s or Mike’s. “That's the way – we all became the Brady Bunch!”
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