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Aragona Case May Have Significant Impact on Real Estate Professionals


A recent U.S. Tax Court decision provides guidance on avoiding the Net Investment Income Tax (NIIT) on trusts in certain situations.  Often individuals transfer ownership of their entities to family members through the use of trusts, making this ruling important.

S corporation, LLC, and partnership income is subject to the NIIT, a 3.8% surtax, if the business interest is considered a passive activity under the Internal Revenue Code.  Normally, an activity is considered passive if an individual does not “Materially Participate,” but the IRS has not provided clarification on how the material participation rules apply to trusts.  They have taken the position that material participation is determined based on the participation of the trustees, who frequently are third parties other than the grantor of the trust such as an attorney, a bank, an accountant, or a financial advisor. They have held that participation is counted by using the hours the trustee worked in the capacity of trustee, meaning that if the trustee was involved in the trust in another capacity (such as an employee), then the hours spent in a non-trustee capacity had to be disregarded.

Aragona to the rescue…..

Frank Aragona set up a non-grantor trust with him as trustee and his five children as beneficiaries. When Frank died, the five beneficiaries were appointed as non-independent trustees and Frank’s attorney was appointed as an independent trustee.  The trust was a 100% owner of an LLC with real estate holdings and the LLC had three of the non-independent trustees as employees. The Court rejected the IRS notion that a trust could not be a real estate professional (a more rigid standard of material participation for real estate activities) as a matter of law.  The court found in favor of the trust’s position that the employee/non-independent trustee’s hours should be considered in determining material participation. Consequently, the income/loss earned by the LLC was deemed nonpassive income, which would not be subject to the NIIT.

http://www.ustaxcourt.gov/InOpHistoric/FrankAragonaTrustDiv.Morrison.TC.WPD.pdf

Although Aragona was a clear victory for the taxpayer, the court’s findings are extremely fact specific and make it difficult to infer conclusions about other matters that were not specifically addressed by the court.