Trusts 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 loose 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 he did, almost $1.7 million in losses would have
been deductible in the two years under audit. The steaks 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 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, not those of managers or others, will 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 Alice’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
Alice’s or Mike’s.  “That’s the way
– we became the Brady Bunch!”