Applying the material participation standards to nongrantor trusts.

• Author: Williamson, Donald T.

A taxpayer may deduct losses generated from passive activities only to the extent of the income from such activities. (1) For this purpose, any trade or business or other income-producing activity is passive with respect to a taxpayer if the taxpayer does not materially participate in the activity.

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The question of when a nongrantor trust materially participates in an activity for purposes of the passive loss rules remains unanswered. Although the IRS has promulgated substantial regulatory guidance about what constitutes material participation by individuals and certain corporations, there is little authority regarding material participation by a trust.

While at least one court treats the activities of trust employees and agents as participation by the trust itself, the IRS looks solely to the efforts of trust fiduciaries. This article discusses a proposal that attempts to reconcile these positions whereby agent or employee efforts will count toward material participation if the trustee exercises sufficient day-today supervision over the activity to indicate that the activity is not passive.

Taxpayers Subject to Passive Loss Rules

Taxpayers subject to the passive loss rules include individuals, estates, nongrantor trusts, personal service corporations, and closely held C corporations. Passive income or loss from S corporations, partnerships, and grantor trusts are attributable to the owners or the grantor; therefore, the passive loss rules are applied at that level.

While the statute does not define what constitutes a trust for this purpose, Sec. 469 does provide special definitions of "personal service corporation" and "closely held C corporations."

A personal service corporation (PSC) is a corporation the principal activity of which is the performance of personal services substantially performed by employee-owners. To be a PSC, more than 10% of the corporation's stock must be held by employee-owners who do not have to perform the services at the same time during the year that they own the stock. (2) A corporation is a closely held C corporation if at any time during the tax year more than 50% of the corporation's outstanding stock is owned, directly or indirectly, by five or fewer individuals. (3)

Material Participation

A trade or business is treated as a passive activity when the taxpayer does not materially participate in the activity. (4) In addition, certain rental activities are considered passive regardless of the taxpayer's participation. (5) As discussed below, while there is substantial guidance for determining material participation for individuals, PSCs, and closely held C corporations, there is little authority to determine if a trust materially participates in an activity.

Individuals

In the case of individuals, the legislative history of Sec. 469 provides that an individual materially participates if he or she has "a significant nontax economic profit motive" for taking on the activities and selects them for their economic value. In contrast, a passive investor seeks a return from a capital investment as a supplement to an ongoing source of livelihood. (6) The regulations provide that an individual is considered to materially participate in an activity if any of the following seven tests are met:

* Test 1: It is an activity in which the individual participates for more than 500 hours during the year.

* Test 2: It is an activity in which the individual's participation constitutes substantially all the participation in the activity for the year.

* Test 3: The individual participates in the activity for more than 100 hours during the year, and the individual's participation is not less than the participation of any other individual for the year.

* Test 4: The individual participates in the activity for more than 100 hours during the year, and the individual's participation in all activities in which he or she participates for more than 100 hours exceeds 500 hours.

* Test 5: The individual materially participates in the activity for any 5 tax years during the 10 tax years immediately preceding the tax year.

* Test 6: For any personal service activity, an individual materially participates in a tax year if he or she materially participated in any three preceding tax years.

* Test 7: Based on all the facts and circumstances, the individual's participation in an activity is regular, continuous, and substantial during the tax year. (7)

In measuring an individual's participation in an activity, work performed by an individual does not include work that is not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses. Work done in an individual's capacity as an investor (e.g., reviewing financial reports) is not counted in applying the material participation tests. However, participation by an owner's spouse counts as participation by the owner. (8)

A limited partner of a partnership is not considered a material participant in activities of the partnership unless he or she meets Test 1 (the 500-hour test), Test 5 (the 5-out-of-10-year test), or Test 6 (the personal service activities test). However, a general partner may qualify as a material participant by meeting any of the material participation tests. If a general partner also owns a limited interest in the same limited partnership, all the interests are treated as general interests. (9)

Finally, regardless of their participation, individuals may deduct up to $25,000 of losses from real estate rental activities against nonpassive income. This annual $25,000 deduction is reduced by 50% of the taxpayer's modified adjusted gross income (AGI) in excess of $100,000, so no deduction is permitted once the taxpayer's AGI reaches $150,000. (10) Any rental loss in excess of the $25,000 allowance is treated as a passive loss.

To qualify for the $25,000 deduction, a taxpayer must actively participate in the real estate rental activity and own 10% or more of all interests in the activity during the entire tax year. Unlike material participation, active participation does not require regular continuous and substantial involvement in the activity but only participation in making management decisions that are significant and bona fide (e.g., approving new tenants, deciding on rental terms, and approving capital or repair expenditures). (11)

Personal Service Corps. and Closely Held C Corps.

A PSC or a closely held C corporation is treated as materially participating in an activity if one or more individuals, each of whom is treated as materially participating in an activity of the corporation under the rules described above for individuals, directly or indirectly hold more than 50% of the value of the corporation's outstanding stock. (12) Thus, if one or more shareholders...