I am
remembering a tax issue from 2004. The firm I was with had a sizeable business client.
The business owner had two daughters and wanted them to participate in the
business. One daughter did; the other daughter went on to other pursuits. The
father transferred shares to his daughters using special trusts: first a QSST
(Qualified Subchapter S Trust), followed by an ESBT (Electing Small Business Trust).
Trusts are normally disallowed as eligible S corporation shareholders, but the
tax Code makes an exception for a QSST or an ESBT. Dad settled the trusts and
acted as their trustee. He was of course also the majority shareholder and CEO
of the underlying company.
The company
was impressively profitable, but in 2004 it had a loss. It happens.
The company
had been profitable. Its shareholders, including the trusts, had previously paid
taxes on that profit. Now there was a business loss. Could the shareholders –
more specifically, the trusts – use that loss to any tax advantage?
And we
walked right into IRS Regulation 1.469-8. As a heads up, there is no Regulation
1.469-8. The IRS reserved that slot to provide its position on material
participation by a trust. However the IRS never wrote the Regulation.
Practitioners were required to divine whether their client trusts would be
“materially participating” in an activity or whether the trust would be “passive”
in an activity.
You may
remember the “passive activity” rules in the Code. These were passed in 1986 as
another effort to limit tax shelters, a task which they accomplished to an
admirable degree. It did so by dividing business activities into material participation
and passive activities. Generally speaking, losses from passive activities
could not offset income from material participation activities. There were problems, of course, one of which
was Congress’ decision to label most real estate activities as “passive.” That
may be the case for many, but there are people out there who make their living
in real estate. For them real estate is about as passive as my involvement with
my CPA firm.
Seven years
later Congress corrected this error by enacting Section 469(c)(7), which said
that the passive loss rules did not apply to someone who worked at least 750
hours a year in real estate, provided that his/her real estate activities were
more than one-half of his/her hours worked for the year.
Now, our client
company had nothing to do with real estate but had a lot to do with plastics.
Section 469(c)(7) did not apply to them. I was aware that the IRS had
informally intimated that a trust could not materially participate because a
trust was not a person, and only a person could materially participate. I guess
their reasoning made sense if material participation was like breaking a sweat.
The law was
relatively new, and no one had yet challenged the IRS. The IRS was in no hurry
to publish a Regulation. Why? I thought both then and now that the IRS suspected
they had a losing hand, but they were not going to back off until they were
forced. The IRS could ride roughshod until someone brought suit.
And I am
looking at that someone. The case is Aragona v Commissioner, and it was a
Tax Court case decided March 27.
Frank
Aragona settled the trust in 1979. He died in 1981, at which time the trust
went irrevocable. The trust had several trustees, the majority of which were
family members. The trust owned a real estate LLC, which employed several
people: family, leasing agents, maintenance workers, clerks, a controller and
so on. Three of the trustees worked there and received a paycheck from the LLC.
It was clear the LLC was materially participating in a business activity.
During 2005
and 2006 the LLC incurred losses. The trust treated the losses as “material
participation” and carried the losses back to the 2003 and 2004 tax years for
tax refunds.
The IRS said
these were passive losses. No passive losses were allowed, much less operating
losses that the trust could carryback for tax refunds. The IRS wanted back almost
$600,000 of taxes. In addition, they asserted penalties.
Here was the
IRS argument before the Court: a trust is incapable of performing “personal
services” because Regulations define “personal services” to mean “any work
performed by an individual in connection with a trade or business.” Obviously a
trust is not an individual.
The Court
immediately spotted the obvious: a trust is a fiduciary vehicle whereby a
trustee agrees to act in the best interest of a beneficiary. The trustee may be
a “person.” If that “person” in turn performs personal services in his/her role
as trustee, then why cannot those personal services be attributed back to the
trust? How else could a trust possibly
do anything? The trust would have performed personal services in the only way
it can: through its trustees. The same concept applies for example to a
corporation. As an artificial entity, a corporation can only act through its
officers. It does not have arms and legs and cannot join a softball league. Its
officers can, however.
The IRS continued
that a trust cannot perform personal services because of words that Congress
used in committee reports and selected Code sections. Funny, said the Court. When Congress
intended that a Code section disallow trusts, it used the term “natural
person.” A trust, not being a natural person, cannot take advantage of that
Code section. Congress did not use that term in the Code section addressing
material participation. Why-oh-why would that be, asked the Court.
The IRS lost
and the Aragona trust won.
Let us say a
word about the penalties the IRS wanted. Obviously they became moot when the Aragona
trust won, but how could the IRS possibly defend asserting penalties in the
first place? It refused to publish Regulations for 28 years, and when someone
had the audacity to challenge them it responded by asserting penalties?
Here is an
observation from a tax pro: the IRS is all but automatically asserting
penalties these days. If there is an adjustment, the IRS clicks through its
quiver of available penalties and lobs a few your way. It does not care whether
you had authority for your position or whether you were just being zany. The government
is going broke and the IRS is chasing money under every seat cushion. However, is
this good tax policy? Shouldn’t penalties be reserved for those claiming unsubstantiated
deductions, masking transactions or just making up their own tax law?
Here is an
idea: if the IRS asserts a penalty and loses the issue, the IRS has to pay you
the penalty amount. Force them to risk a losing hand. Maybe that will prompt
them to back-off a bit.
Congratulations
to the Aragona trust for taking this on.
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