Trust and Passive Loss Rules

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:

• 1: The Primary Source -- The Statute: Material participation requires your involvement “on a regular, continuous, and substantial basis”. IRC Sec. 469(h)(1).
• 2: The Senate Finance Committee Report: Involvement in day-to-day operations, not merely intermittent management activity, is necessary. “An estate or trust is treated as materially participating in an activity … if an executor or fiduciary in his capacity as such, is so participating. Portfolio income of an estate or trust must be accounted for separately, and may not be offset by losses from passive activities. Footnote 21 states: “In the case of a grantor trust, however, material participation is determined at the grantor rather than the entity level.” S Rept No. 99-313 (PL 99-514) p. 735 [1986-3 C.B. (Vol. 3) 1]. A grantor trust is a trust whose income is reported by the grantor (usually the person who set up the trust), not to the trust itself. See Practical Planner June 2007.
• 3: Staff of the Joint Committee on Taxation Report: Footnote 33 says: “No special rule was provided for determining material participation by a trust...an arrangement will be treated as a trust …if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility…it is unlikely that a trust…will be materially participating in a trade or business activity, within the meaning of the passive loss rules. In the case of a grantor trust, to the extent that the grantor or beneficiary is treated as the owner for tax purposes…the material participation of the person treated as the owner is relevant to the determination of whether income or loss from an activity owned through the grantor trust is treated as passive in the hands of the owner…”
• 4: Regulations: There are no regulations (yet) so the general rules of the statute must be applied.
• 5. Case Law --The Mattie K. Carter Trust v. US: Mattie’s will set up a trust which managed assets including the Carter Ranch which had cattle, oil and gas. The trustee hired a ranch manager and other employees to carry out most ranching duties. The IRS argued that only the trustee’s efforts should be considered in determining if the trust met the test of materially participating in the ranch. If it did, almost $1.7 million in losses would have been deductible in the two years under audit. The stakes were high! The trust said that its involvement should be evaluated with consideration to all of its fiduciaries, employees and agents. The court said the law didn’t mandate that only the trustee’s activities could be considered. So when it considered the aggregate of the efforts of the trustee, ranch manager and others, it was regular, continuous and substantial involvement so that the trust was deemed to materially participate and could deduct the losses. 256 F. Supp. 2d 536 (Tex. 2003).
• 6. IRS Ruling: In a recent private letter ruling, PLR 200733023, the IRS nixed a trust’s effort to characterize losses as not being passive (and hence deductible). The IRS maintained that the trustee’s activities alone (and not the activities of the whole trust,) should be considered. The IRS expressly addressed the court opinion above and stated that it disagreed. The will creating the trust in this Ruling permitted the appointment of a special trustee for any part or all of the trust property. The special trustee, except as limited in the trust, had all the rights of a trustee. The IRS seemed swayed in part by the fact that “ultimate decision-making authority remained vested solely with the trustees”. The IRS rejected the trust’s argument that these “special trustees” were “fiduciaries” for purposes of the Code Section 469 material participation test. The IRS then looked at the definition of “fiduciary” to evaluate this.

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!”