Frank Aragona Trust, Paul Aragona, Executive Trustee v. Commissioner

FRANK ARAGONA TRUST, PAUL ARAGONA, EXECUTIVE

TRUSTEE, PETITIONER v. COMMISSIONER OF

INTERNAL REVENUE, RESPONDENT

Docket No. 15392–11. Filed March 27, 2014.

T is a trust that owned rental real-estate properties and

engaged in other real-estate activities. T’s rental real-estate

activities would be considered per se passive activities under

I.R.C. sec. 469(c)(2) unless T qualified for the exception found

in I.R.C. sec. 469(c)(7). This exception is applicable if more

165

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166 142 UNITED STATES TAX COURT REPORTS (165)

than one-half of the personal services performed in trades or

businesses by the taxpayer are performed in real-property

trades or businesses in which the taxpayer materially partici-

pates and if the taxpayer performs more than 750 hours of

services during the year in real-property trades or businesses

in which the taxpayer materially participates. Held: A trust

can qualify for the I.R.C. sec. 469(c)(7) exception. A trust is

capable of performing personal services within the meaning of

I.R.C. sec. 469(c)(7). Services performed by individual trustees

on behalf of the trust may be considered personal services per-

formed by the trust. Held, further, T materially participated

in real-property trades or businesses.

Richard S. Soble, for petitioner.

Brett Chmielewski and Meso T. Hammoud, for respondent.

MORRISON, Judge: The respondent (referred to here as the

‘‘IRS’’) issued a notice of deficiency to the Frank Aragona

Trust (sometimes referred to here as the ‘‘trust’’), deter-

mining the following deficiencies in federal income tax and

the following penalties:

Accuracy-related

penalty

Year Deficiency sec. 6662(a)

2003 $86,289 $17,257.80

2004 421,292 84,258.40

2005 -0- -0-

2006 84,540 16,908.00

The trust filed a petition as permitted by section 6213(a). 1

We have jurisdiction to redetermine the deficiencies and pen-

alties under section 6214(a). After concessions, 2 the two

issues remaining for decision are:

1 Even

though the petition was filed by Paul V. Aragona, the executive

trustee, for ease of reference we refer to the trust as having filed the peti-

tion. In any event we do not mean to suggest whether the petitioner in

this case is the trustee or the trust. See sec. 7482(b)(1)(A) (providing that

default appellate venue for deficiency cases is the circuit in which is lo-

cated the legal residence of the petitioner). We do not reach that particular

question.

All references to sections are to the Internal Revenue Code of 1986, as

in effect for the years at issue.

2 The IRS conceded that the trust is not liable for any accuracy-related

penalties for the 2003, 2004, and 2006 tax years. (The notice of deficiency

did not determine a penalty for 2005.)

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(165) ARAGONA TRUST v. COMMISSIONER 167

(1) Does section 469(c)(7) apply to the trust? Yes.

(2) Are the fees that the trust paid to its trustees properly

characterized as expenses of the trust’s rental real-estate

activities? We need not reach this issue because of our reso-

lution of the first issue.

FINDINGS OF FACT

Some facts have been stipulated by the parties. The stipu-

lated facts are incorporated in the Court’s findings of fact.

The trust is a complex residuary trust that owns rental real-

estate properties and is involved in other real-estate business

activities such as holding real estate and developing real

estate. Its principal place of business was in Michigan when

it filed the petition. In 1979 Frank Aragona formed the trust

with him as grantor and trustee and with his five children

as beneficiaries. According to the trust instrument, the five

children share equally in the income of the trust. Frank

Aragona died in 1981. He was succeeded as trustee by six

trustees. One of the six trustees was an independent

trustee. 3 The other five trustees were Frank Aragona’s five

children, including Paul V. Aragona, the executive trustee. 4

Although the trustees formally delegated their powers to the

executive trustee (in order to facilitate daily business oper-

ations), the trustees acted as a management board for the

trust and made all major decisions regarding the trust’s

property. During 2005 and 2006 the board met every few

months to discuss the trust’s business. Each of the six

trustees was paid a fee directly by the trust (referred to here

as a ‘‘trustee fee’’ or collectively as ‘‘trustee fees’’) in part for

the trustee’s attending board meetings. Three of the chil-

dren—Paul V. Aragona, Frank S. Aragona, and Annette

Aragona Moran—worked full time for Holiday Enterprises,

LLC, a Michigan limited liability company that is wholly

owned by the trust. Holiday Enterprises, LLC, is a dis-

regarded entity for federal income tax purposes. Holiday

Enterprises, LLC, managed most of the trust’s rental real-

estate properties. It employed several people in addition to

3 The

trust instrument gives the independent trustee the power to dis-

tribute the principal of the trust under limited circumstances.

4 When the petition was filed, Paul V. Aragona was a resident of Michi-

gan.

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168 142 UNITED STATES TAX COURT REPORTS (165)

Paul V. Aragona, Frank S. Aragona, and Annette Aragona

Moran, including a controller, leasing agents, maintenance

workers, accounts payable clerks, and accounts receivable

clerks. In addition to receiving a trustee fee, Paul V.

Aragona, Frank S. Aragona, and Annette Aragona Moran

each received wages from Holiday Enterprises, LLC.

The trust conducted some of its rental real-estate activities

directly, some through wholly owned entities, and the rest

through entities in which it owned majority interests and in

which Paul V. and Frank S. Aragona owned minority

interests. It conducted its real-estate holding and real-estate

development operations through entities in which it owned

majority or minority interests and in which Paul V. and

Frank S. Aragona owned minority interests.

The table below summarizes the activities of the six

trustees on behalf of the trust during 2005 and 2006:

Annual trustee

Name of trustee Role fee

Salvatore S. Aragona Full-time dentist; limited involve-

ment in trust’s business $72,000

Paul V. Aragona Executive trustee; full-time em-

ployee of Holiday Enterprises,

LLC 72,000

Anthony F. Aragona Disabled; limited involvement in

trust’s business 1 72,000

Frank S. Aragona Full-time employee of Holiday

Enterprises, LLC 72,000

Annette Aragona Moran Full-time employee of Holiday

Enterprises, LLC 72,000

Charles E. Turnbull Independent trustee; attorney

with O’Reilly Rancilio, P.C.;

limited involvement in trust’s

business 14,400

Total 374,400

1 The $72,000 annual trustee fee for Anthony F. Aragona was reported as a dis-

tribution from the trust for tax purposes.

During the 2005 and 2006 tax years, the trust incurred

losses from its rental real-estate properties. The losses were

reported on the trust’s income-tax returns, Forms 1041, ‘‘U.S.

Income Tax Return for Estates and Trusts’’ and on Schedules

E, ‘‘Supplemental Income and Loss’’, and were reflected on

line 5. Some of the losses were reported as being associated

with Holiday Enterprises, LLC, including $302,400 (the

$374,400 in trustee fees minus the $72,000 in trustee fees

paid to Anthony F. Aragona). The losses reported as being

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(165) ARAGONA TRUST v. COMMISSIONER 169

associated with Holiday Enterprises, LLC, were subdivided

into various categories of expenses; the $302,400 was

reported in the category of ‘‘other’’ expenses. On its returns

the trust treated its rental real-estate activities, in which it

engaged both directly and through its ownership interests in

a number of entities, as non-passive activities. So treated,

the losses from these activities contributed to the amounts of

net operating losses, which the trust carried back to its 2003

and 2004 tax years.

While reporting losses for its rental real-estate activities,

the trust also reported gains from its other (non-rental) real-

estate activities. The trust owned interests in a number of

entities engaged in real-estate holding activities and real-

estate development projects.

On its Form 1041 for each year, the trust did not enter an

amount on line 12, the line for deductions for ‘‘Fiduciary

fees’’.

In the notice of deficiency, the IRS determined that the

trust’s rental real-estate activities were passive activities, 5 a

determination that increased the passive-activity losses for

2005 and 2006. 6 The increase in the passive-activity losses

resulted in a decrease in the allowable deductions from gross

income for each of those years, 7 which decreased the net-

operating-loss carrybacks to the 2003 and 2004 years. The

notice of deficiency determined that for each of 2005 and

2006 the trust should be allowed a deduction of $302,400 for

‘‘Fiduciary fees’’. The notice of deficiency also determined

that the trust’s Schedule E expenses, which, as reported on

the returns, included the $302,400 in trustee fees, should be

reduced by $302,400. Thus, the notice of deficiency reclassi-

5 The

notice of deficiency stated that ‘‘[t]he rental losses incurred are

deemed passive’’.

6 A passive-activity loss is the amount by which aggregate losses from all

the taxpayer’s passive activities for the year exceed the aggregate income

from all the taxpayer’s passive activities for the year. Sec. 469(d)(1). The

trust’s losses from its rental real-estate activities exceeded its income from

the activities. Therefore, characterizing the trust’s rental real-estate activi-

ties as passive resulted in a net increase in the trust’s passive-activity loss

for each year.

7 The existence of a passive-activity loss for the year results in the dis-

allowance of current deductions in the amount of the passive-activity loss

for the year. Sec. 1.469–1T(a)(1)(i), Temporary Income Tax Regs., 53 Fed.

Reg. 5701 (Feb. 25, 1988).

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170 142 UNITED STATES TAX COURT REPORTS (165)

fied the $302,400 amounts as fiduciary fees to be deducted on

line 12 of Form 1041 instead of expenses deducted against

rental income on Schedule E (and reflected on line 5 of Form

1041). In explaining the reclassification of the $302,400 in

fees, the notice of deficiency stated:

It is determined your fiduciary fees of $302,400.00 and $302,400.00,

should be reported on line 12 on the face of the return Form 1041

instead of $302,400.00 and $302,400.00 shown as a rental expense

deduction on the Schedule E for taxable years 2005 and 2006, respec-

tively.

The adjustment was made to the rental loss claimed by Holiday Enter-

prises to disallow the trustee fees as an ‘‘other’’ expense and the expense

was moved to Line 12 on the face of the return where they are required

to be shown as ‘‘fiduciary fees’’.

Computationally, the notice of deficiency did not include the

$302,400 in the amount of the trust’s passive-activity-loss

deductions for each year.

OPINION

The petitioner generally bears the burden of proof (and

therefore must prove the relevant facts by the preponderance

of the evidence) except when the conditions of section 7491(a)

are satisfied. Tax Ct. R. Pract. & Proc. 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); Bronstein v. Commis-

sioner, 138 T.C. 382, 384 (2012). Our findings of fact in this

Opinion are based on the preponderance of the evidence.

Thus, it is unnecessary to determine which party (i.e., the

trust or the IRS) has the burden of proof. See Estate of

Bongard v. Commissioner, 124 T.C. 95, 111 (2005).

1. Does the section 469(c)(7) exception apply to the trust?

In 1986 Congress enacted section 469. Tax Reform Act of

1986, Pub. L. No. 99–514, sec. 501(a), 100 Stat. at 2233. Sec-

tion 469(a)(1) provides that a taxpayer’s passive-activity loss

is disallowed for the year if the taxpayer is ‘‘described in’’

section 469(a)(2). 8 The following taxpayers are ‘‘described in’’

section 469(a)(2): individuals, estates, trusts, closely held C

corporations, and personal service corporations. A passive-

activity loss is the amount by which the aggregate losses

8 A loss from an activity disallowed under sec. 469(a) is treated as a de-

duction allocable to such activity for the next tax year. Sec. 469(b).

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(165) ARAGONA TRUST v. COMMISSIONER 171

from all the taxpayer’s passive activities for the year exceeds

the aggregate income from all the taxpayer’s passive activi-

ties for such year. Sec. 469(d)(1); see also sec. 1.469–2T(b)(1),

Temporary Income Tax Regs., 53 Fed. Reg. 5711 (Feb. 25,

1988). A passive activity is any activity which involves the

conduct of any trade or business in which the taxpayer does

not materially participate. Sec. 469(c)(1). Under section

469(c)(2), any rental activity is considered a passive activity,

even if the taxpayer materially participates in the activity.

Sec. 469(c)(4). Thus, any rental activity is passive per se.

In 1993 Congress enacted section 469(c)(7), which provides

that section 469(c)(2) does not apply to the rental real-estate

activity of any taxpayer who meets the requirements of sec-

tion 469(c)(7)(B). Omnibus Budget Reconciliation Act of 1993,

Pub. L. No. 103–66, sec. 13143(a) and (b), 107 Stat. at 440,

441. 9 Section 469(c)(7)(B) consists of two tests. The first test

is met if more than one-half of the ‘‘personal services’’ per-

formed in trades or businesses by the taxpayer during the

taxable year is performed in real-property trades or

businesses in which the taxpayer materially participates.

Sec. 469(c)(7)(B)(i). The second test is met if the taxpayer

performs more than 750 hours of ‘‘services’’ during the year

in real-property trades or businesses in which the taxpayer

materially participates. Sec. 469(c)(7)(B)(ii). Both tests must

be met. 10

9 The following reason was given for the amendment:

The passive loss rules limit deductions and credits from passive trade

or business activities. Deductions attributable to passive activities, to the

extent they exceed income from passive activities, generally may not be

deducted against other income, such as wages, portfolio income, or busi-

ness income that is not derived from a passive activity. * * *

* * * * * * *

The committee considers it unfair that a person who performs personal

services in a real estate trade or business in which he materially partici-

pates may not offset losses from rental real estate activities against in-

come from nonrental real estate activities or against other types of in-

come such as portfolio investment income. * * *

[H. R. Rept. No. 103–111, at 612–613 (1993), 1993–3 C.B. 1, 188–189.]

10 Sec. 469(c)(7)(B) provides in part:

This paragraph shall apply to a taxpayer for a taxable year if—

(i) more than one-half of the personal services performed in trades or

businesses by the taxpayer during such taxable year are performed in

Continued

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172 142 UNITED STATES TAX COURT REPORTS (165)

Section 469(c)(7)(D)(i) provides a special rule for deter-

mining whether a closely held C corporation meets the

requirements of section 469(c)(7)(B):

In the case of a closely held C corporation, the requirements of subpara-

graph (B) shall be treated as met for any taxable year if more than 50

percent of the gross receipts of such corporation for such taxable year

are derived from real property trades or businesses in which the corpora-

tion materially participates.

Thus, the determination of whether a closely held C corpora-

tion meets the requirements of section 469(c)(7)(B) does not

involve the one-half-of-personal-services test and the 750-

hour test.

The requirements of section 469(c)(7)(B) can be met only by

a taxpayer who materially participates in a real-property

trade or business. This is because the one-half-of-personal-

services test, the 750-hour test, and the special rule for

closely held C corporations all presuppose that the taxpayer

materially participates in real-property trades or businesses.

Sec. 469(c)(7)(B)(i) and (ii); see sec. 469(c)(7)(D); see also sec.

1.469–9(c)(3), Income Tax Regs.

The term ‘‘real property trade or business’’ is defined as

any real-property development, redevelopment, construction,

reconstruction, acquisition, conversion, rental, operation,

management, leasing, or brokerage trade or business. Sec.

469(c)(7)(C).

Regulatory guidance regarding the section 469(c)(7) excep-

tion is found in section 1.469–9, Income Tax Regs. This regu-

lation states that only a ‘‘qualifying taxpayer’’ falls within

the exception. Sec. 1.469–9(e)(1), Income Tax Regs. (‘‘Section

469(c)(2) does not apply to any rental real estate activity of

a taxpayer for a taxable year in which the taxpayer is a

qualifying taxpayer[.]’’). The term ‘‘qualifying taxpayer’’ is

defined by the regulation as ‘‘a taxpayer that owns at least

one interest in rental real estate and meets the requirements

of paragraph (c) of this section.’’ Sec. 1.469–9(b)(6), Income

Tax Regs. Section 1.469–9(c), Income Tax Regs. (the para-

real property trades or businesses in which the taxpayer materially par-

ticipates, and

(ii) such taxpayer performs more than 750 hours of services during the

taxable year in real property trades or businesses in which the taxpayer

materially participates.

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(165) ARAGONA TRUST v. COMMISSIONER 173

graph (c) provision referred to in the quotation above), pro-

vides: ‘‘(1) In general.—A qualifying taxpayer must meet the

requirements of section 469(c)(7)(B).’’ Thus, to be a ‘‘quali-

fying taxpayer’’ within the meaning of the regulation a tax-

payer must own at least one interest in rental real estate

and satisfy the requirements of section 469(c)(7)(B). Two

other aspects of the regulation are of note. First, section

1.469–9(b)(4), Income Tax Regs., provides, in part, that

‘‘[ p]ersonal services means any work performed by an indi-

vidual in connection with a trade or business.’’ This is an

interpretation of the term ‘‘personal services’’ used in the

first test of section 469(c)(7)(B). Second, section 1.469–9(c)(2),

Income Tax Regs., provides that ‘‘[a] closely held C corpora-

tion meets the requirements of paragraph (c)(1) of this sec-

tion by satisfying the requirements of section 469(c)(7)(D)(i).’’

Section 469(h) provides that for the purposes of section 469

a taxpayer is treated as materially participating in an

activity only if the taxpayer is involved in the operation of

the activity on a basis which is regular, continuous, and

substantial. The test in section 469(h) has two functions.

First, it is used to determine whether a particular activity is

a passive activity. See sec. 469(c)(1) (defining passive activity

as an activity, involving the conduct of a trade or business,

in which the taxpayer does not materially participate).

Second, it is used to determine whether a taxpayer materi-

ally participates in real-property trades or businesses. See

sec. 469(c)(7)(B)(i) and (ii). Thus, a taxpayer is treated as

materially participating in real-property trades or businesses

if the taxpayer is involved in the operation of real-property

trades or businesses on a basis which is regular, continuous,

and substantial.

a. Can a trust qualify for the section 469(c)(7) exception?

i. The IRS’s arguments

For the section 469(c)(7) exception to apply, there must be

‘‘personal services performed * * * by the taxpayer’’. Sec.

469(c)(7)(B)(i). Because ‘‘[p]ersonal services’’ are defined by

regulation as ‘‘work performed by an individual in connection

with a trade or business’’, the IRS contends that a trust

cannot perform personal services. See sec. 1.469–9(b)(4),

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174 142 UNITED STATES TAX COURT REPORTS (165)

Income Tax Regs. Therefore, the IRS contends, a trust

cannot qualify for the section 469(c)(7) exception.

The IRS asserts that the legislative history of section

469(c)(7) supports its view that Congress did not intend the

section 469(c)(7) exception to apply to trusts. In describing

the provision in the bill that would be adopted by the House,

and enacted by Congress in amended form as section

469(c)(7), the report of the House Ways and Means Com-

mittee stated that the provision ‘‘applies to individuals and

closely held C corporations.’’ H.R. Rept. No. 103–111, at 614

(1993), 1993–3 C.B. 167, 190. The report further stated that

an ‘‘individual taxpayer’’ meets the requirements of the

exception ‘‘if more than half of the personal services the tax-

payer performs in a trade or business are in real property

trades or businesses in which he materially participates.’’ Id.

(The bill adopted by the House had provided that the section

469(c)(7) exception was applicable ‘‘if more than one-half of

the personal services performed in trades or businesses by

the taxpayer * * * are performed in real property trades or

businesses in which the taxpayer materially participates.’’

H.R. 2264, 103d Cong., sec. 14143 (1993). The bill did not yet

include the 750-hour test now codified in section

469(c)(7)(B)(ii).) The report also stated that a closely held C

corporation meets the requirements of the section 469(c)(7)

exception ‘‘if more than 50 percent of its gross receipts for

the taxable year are derived from real property trades or

businesses in which the corporation materially participates

(within the meaning of sec. 469(h)(4)).’’ H.R. Rept. No. 103–

111, supra at 614, 1993–3 C.B. at 190. The report did not

describe how any class of taxpayer other than an individual

or a closely held C corporation meets the requirements of the

exception. Id. The report of the conference committee, also

describing the bill adopted by the House, similarly stated

that an ‘‘individual taxpayer’’ meets the requirements of the

exception ‘‘if more than half of the personal services the tax-

payer performs in trades or businesses during the taxable

year are in real property trades or businesses in which he

materially participates.’’ H.R. Conf. Rept. No. 103–213, at

546 (1993), 1993–3 C.B. 393, 424. The conference report fur-

ther stated that a closely held C corporation meets the

requirements of the exception ‘‘if more than 50 percent of its

gross receipts for the taxable year are derived from real prop-

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(165) ARAGONA TRUST v. COMMISSIONER 175

erty trades or businesses in which the corporation materially

participates.’’ Id. The conference report also discussed the

final version of the bill. Id. at 547, 1993–3 C.B. at 425. It

described the section 469(c)(7) exception thus:

The conference agreement follows the House bill, with a modification.

Under the conference agreement, an individual taxpayer meets the eligi-

bility requirements if (1) more than half of the personal services the tax-

payer performs in trades or businesses during the taxable year are per-

formed in real property trades or businesses in which the taxpayer mate-

rially participates, and (2) such taxpayer performs more than 750 hours

of services during the taxable year in real property trades or businesses

in which the taxpayer materially participates. * * * [Id.]

ii. Analysis

The IRS argues that a trust is incapable of performing

‘‘personal services’’ because the regulation defines ‘‘personal

services’’ to mean ‘‘any work performed by an individual in

connection with a trade or business’’. Sec. 1.469–9(b)(4),

Income Tax Regs. We reject the IRS’s argument. A trust is

an arrangement whereby trustees manage assets for the

trust’s beneficiaries. 1 Restatement, Trusts 3d, sec. 2 (2003)

(a trust ‘‘is a fiduciary relationship with respect to property,

* * * subjecting the person who holds title to the property

to duties to deal with it for the benefit of ’’ others); see also

sec. 301.7701–4(a), Proced. & Admin. Regs. (‘‘In general, the

term ‘trust’ as used in the Internal Revenue Code refers to

an arrangement created either by will or by an inter vivos

declaration whereby trustees take title to property for the

purpose of protecting or conserving it for the beneficiaries

under the ordinary rules applied in chancery or probate

courts.’’). If the trustees are individuals, and they work on a

trade or business as part of their trustee duties, their work

can be considered ‘‘work performed by an individual in

connection with a trade or business.’’ Sec. 1.469–9(b)(4),

Income Tax Regs. We conclude that a trust is capable of per-

forming personal services and therefore can satisfy the sec-

tion 469(c)(7) exception.

Indeed, if Congress had wanted to exclude trusts from the

section 469(c)(7) exception, it could have done so explicitly by

limiting the exception to ‘‘any natural person’’. In section

469(i), the Internal Revenue Code does exactly that. Section

469(i) grants a $25,000 allowance to ‘‘any natural person’’

who fulfills certain requirements. That Congress did not use

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176 142 UNITED STATES TAX COURT REPORTS (165)

the phrase ‘‘natural person’’ but instead used the word ‘‘tax-

payer’’ in section 469(c)(7) suggests that Congress did not

intend to exclude trusts from the section 469(c)(7) exception,

despite what the IRS argues here.

We need not address the trust’s arguments regarding the

regulation, which are that:

(1) the word ‘‘individual’’ in the regulation should be inter-

preted to include a trust, and

(2) in the alternative, even if the word ‘‘individual’’ does

not include a trust, then the regulation is inapplicable to tax-

payers that are trusts.

We now turn to the legislative history of the section

469(c)(7) exception, which the IRS contends shows that trusts

cannot qualify for that exception. The Ways and Means Com-

mittee report states that the section 469(c)(7) exception

applies to individuals and closely held C corporations. H.R.

Rept. No. 103–111, supra at 614, 1993–3 C.B. at 190. The

report does not say that the exception applies only to individ-

uals and closely held C corporations. Therefore, the report

does not compel the conclusion that only individuals and

closely held C corporations can qualify for the section

469(c)(7) exception.

The legislative history states that an individual meets the

requirements of section 469(c)(7) by meeting the one-half-of-

personal-services test and, in discussing the final version of

the legislation, the 750-hour test. Id.; H.R. Rept. No. 103–

213, supra at 546, 1993–3 C.B. at 424. It is true that an indi-

vidual falls within the section 469(c)(7) exception by meeting

the two tests. But this does not mean that other types of tax-

payers cannot fall within the exception.

b. Does the trust qualify for the section 469(c)(7) exception?

The IRS’s fallback position is that even if some trusts can

qualify for the section 469(c)(7) exception, the trust does not

qualify because it did not materially participate in real-prop-

erty trades or businesses. The IRS concedes that the trust’s

real-estate operations qualify as real property trades or

businesses. Therefore the question to be resolved is whether

the trust materially participated in its real-estate operations.

We hold that it did so.

Section 469(h) supplies the definition of what it means to

materially participate in an activity. By that definition, a

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(165) ARAGONA TRUST v. COMMISSIONER 177

taxpayer is treated as materially participating in an activity

only if the taxpayer is involved in the operations of the

activity on a basis which is regular, continuous, and substan-

tial. Sec. 469(h). Interpreting section 469(h), the Department

of the Treasury has promulgated regulations for determining

whether taxpayers who are individuals materially participate

in an activity. See sec. 1.469–5T(a), (b), (c), and (d), Tem-

porary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).

Section 469(h)(4) provides a method for determining whether

certain types of corporations 11 have met the tests for mate-

rial participation. The statute does not provide a method for

determining how a trust may materially participate in an

activity, and no regulations have yet been promulgated for

taxpayers that are trusts. See sec. 1.469–5T(g), Temporary

Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988)

(reserving a place for a regulation to be titled ‘‘Material

participation of trusts and estates’’). Therefore, we must

make the determination of whether a trust materially

participates in an activity in the absence of regulatory guid-

ance. 12

The IRS argues that in determining whether a trust is

materially participating in an activity, only the activities of

the trustees can be considered and the activities of that

trust’s employees must be disregarded. In support, the IRS

cites S. Rept. No. 99–313, at 735 (1986), 1986–3 C.B. (Vol. 3)

1, 735, which states that a trust ‘‘is treated as materially

11 The

IRS does not take the position that the trust should be treated

as a corporation. See sec. 301.7701–4(b), Proced. & Admin. Regs. (business

trusts, defined as devices created by beneficiaries to carry on profit-making

businesses, are to be treated for federal tax law purposes as corporations

or partnerships).

12 A number of commentators have argued that there is a need for a reg-

ulation that resolves questions regarding material participation of trusts

and generally coordinates the passive-activity-loss rules of sec. 469 with

the rules on taxation of trusts in subch. J. See, e.g., 1 Byrle K. Abbin,

David K. Carlson, and Mark L. Vorsatz, Income Taxation of Fiduciaries

and Beneficiaries, sec. 801, at 8003 to 8004 (2012 ed.) (‘‘Section 469 does

not easily comport with subchapter J. To date no regulatory explanation

has been forthcoming * * * [on questions including] where and how mate-

rial participation is measured[.]’’); M. Carr Ferguson, James J. Freeland,

and Mark L. Ascher, Federal Income Taxation of Estates, Trusts, and

Beneficiaries, para. 8.01, at 8–1 to 8–8 (3d ed. 2003); Leo L. Schmolka,

‘‘Passive Activity Losses, Trusts, and Estates: The Regulations (If I Were

King)’’, 58 Tax L. Rev. 191 (2005).

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178 142 UNITED STATES TAX COURT REPORTS (165)

participating in an activity * * * if an executor or fiduciary,

in his capacity as such, is so participating.’’ The Senate com-

mittee report also states that ‘‘the activities of * * *

[employees] are not attributed to the taxpayer’’. 13

On the basis of these legal principles, the IRS would have

us ignore the activities of the trust’s non-trustee

employees. 14 Additionally, the IRS would have us ignore the

activities of the three trustees who are employees of Holiday

Enterprises, LLC. It reasons that the activities of these three

trustees should be considered the activities of employees and

not fiduciaries because (1) the trustees performed their

activities as employees of Holiday Enterprises, LLC, and (2)

it is impossible to disaggregate the activities they performed

as employees of Holiday Enterprises, LLC, and the activities

they performed as trustees.

If the Court adopts all these arguments made by the IRS,

then it should ignore the activities of the 20 or so non-trustee

employees and the 3 trustee-employees (Paul V. Aragona,

Frank S. Aragona, and Annette Aragona Moran). This would

leave only the relatively insignificant activities of the

trustees who are not employees (Salvatore S. Aragona, a den-

tist, Anthony F. Aragona, who is disabled and unable to

work, and Charles E. Turnbull, an outside attorney who is

the independent trustee).

Even if the activities of the trust’s non-trustee employees

should be disregarded, 15 the activities of the trustees—

including their activities as employees of Holiday Enter-

prises, LLC—should be considered in determining whether

the trust materially participated in its real-estate operations.

The trustees were required by Michigan statutory law to

13 The Senate committee report states:

The fact that a taxpayer utilizes employees or contract services to per-

form daily functions in running the business does not prevent such tax-

payer from qualifying as materially participating. However, the activities

of such agents are not attributed to the taxpayer, and the taxpayer must

still personally perform sufficient services to establish material partici-

pation. [S. Rept. No. 99–313, at 735 (1986), 1986–3 C.B. (Vol. 3) 1, 735.]

14 The IRS disagrees with Carter Trust v. United States, 256 F. Supp. 2d

536, 541 (N.D. Tex. 2003), which held that the activities of the trust’s non-

trustee employees (and of the trustee) are considered in determining

whether the trust materially participated in ranching activity.

15 We need not and do not decide whether the activities of the trust’s

non-trustee employees should be disregarded.

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(165) ARAGONA TRUST v. COMMISSIONER 179

administer the trust solely in the interests of the trust bene-

ficiaries, because trustees have a duty to act as a prudent

person would in dealing with the property of another, i.e., a

beneficiary. Mich. Comp. Laws sec. 700.7302 (2001) (before

amendment by 2009 Mich. Pub. Acts No. 46); see also In re

Estate of Butterfield, 341 N.W.2d 453, 459 (Mich. 1983) (con-

struing Mich. Comp. Laws sec. 700.813 (1979), a statute in

effect from 1979 to 2000 that was a similarly-worded prede-

cessor to Mich. Comp. Laws sec. 700.7302). Trustees are not

relieved of their duties of loyalty to beneficiaries by con-

ducting activities through a corporation wholly owned by the

trust. Cf. In re Estate of Butterfield, 341 N.W.2d at 457

(‘‘Trustees who also happen to be directors of the corporation

which is owned or controlled by the trust cannot insulate

themselves from probate scrutiny [i.e., duties imposed on

trustees by Michigan courts] under the guise of calling them-

selves corporate directors who are exercising their business

judgment concerning matters of corporate policy.’’). Therefore

their activities as employees of Holiday Enterprises, LLC,

should be considered in determining whether the trust mate-

rially participated in its real-estate operations. 16

Considering the activities of all six trustees in their roles

as trustees and as employees of Holiday Enterprises, LLC,

the trust materially participated in its real-estate operations.

Three of the trustees participated in the trust’s real-estate

operations full time. The trust’s real-estate operations were

substantial. The trust had practically no other types of oper-

ations. The trustees handled practically no other businesses

on behalf of the trust. The IRS argues that because Paul V.

Aragona and Frank S. Aragona had minority ownership

interests in all of the entities through which the trust oper-

16 We need not consider the effect of sec. 469(c)(7)(D)(ii), which provides

that for purposes of sec. 469(c)(7)(B) personal services performed as an em-

ployee are generally not treated as performed in real-property trades or

businesses. This rule has no application to the resolution of this case be-

cause, as we explain infra, the IRS has confined its challenges to the

trust’s qualification for sec. 469(c)(7) treatment to two challenges: (1) that

trusts are categorically barred from sec. 469(c)(7) treatment, and (2) the

trust did not materially participate in real-property trades or businesses.

Thus, we need not, and do not, determine how many hours of personal

services were performed by the trust in real-property trades or businesses.

We also note that the IRS does not cite sec. 469(c)(7)(D)(ii) in its brief.

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180 142 UNITED STATES TAX COURT REPORTS (165)

ated real-estate holding and real-estate development projects

and because they had minority interests in some of the enti-

ties through which the trust operated its rental real-estate

business, some of these two trustees’ efforts in managing the

jointly held entities are attributable to their personal por-

tions of the businesses, not the trust’s portion. Despite two

of the trustees’ holding ownership interests, we are convinced

that the trust materially participated in the trust’s real-

estate operations. First, Frank S. and Paul V. Aragona’s com-

bined ownership interest in each entity was not a majority

interest—for no entity did their combined ownership interest

exceed 50%. Second, Frank S. and Paul V. Aragona’s com-

bined ownership interest in each entity was never greater

than the trust’s ownership interest. Third, Frank S. and Paul

V. Aragona’s interests as owners were generally compatible

with the trust’s goals—they and the trust wanted the jointly

held enterprises to succeed. Fourth, Frank S. and Paul V.

Aragona were involved in managing the day-to-day oper-

ations of the trust’s various real-estate businesses.

We hold that the trust materially participated in real-prop-

erty trades or businesses. For a taxpayer who has materially

participated in real-property trades or businesses, the next

steps in ascertaining whether the taxpayer benefits from the

section 469(c)(7) exception are (1) to determine whether more

than one-half of the personal services performed in trades or

businesses by the taxpayer during the year are performed in

real-property trades or businesses, and (2) to determine

whether the taxpayer performed more than 750 hours of

services during the year in the real-property trades or

businesses. As to whether the trust qualifies for the section

469(c)(7) exception, however, the IRS has limited its argu-

ments to the two arguments discussed above, namely (1) that

trusts are categorically barred from qualifying under the sec-

tion 469(c)(7) exception, and (2) that the trust did not materi-

ally participate in real-property trades or businesses. In the

context of the arguments raised in this case, therefore, we

hold the trust meets the section 469(c)(7) exception for the

years at issue.

c. Conclusion

Once it is determined that the trust qualifies under the

section 469(c)(7) exception, and that therefore the trust’s

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(165) ARAGONA TRUST v. COMMISSIONER 181

rental real-estate activities are not per se passive activities,

a theoretical next step is to determine whether the trust

materially participated in its rental real-estate activities. If

the trust materially participated in its rental real-estate

activities, then its rental real-estate activities are not passive

activities. If the trust did not materially participate in its

rental real-estate activities, then its rental real-estate activi-

ties are passive activities. 17 The IRS argues only that the

trust is not excepted by section 469(c)(7). It does not argue

that—in the event that we determine that the trust is

excepted by section 469(c)(7)—the trust did not materially

participate in its rental real-estate activities. We hold that,

in the context of the arguments presented in this case, the

trust’s rental real-estate activities are not passive activities.

2. Are the fees that were paid by the trust to its trustees

properly characterized as expenses of the trust’s rental

real-estate activities?

The notice of deficiency determined that the trust’s rental

real-estate activities were passive activities, a determination

that if correct meant that all deductions related to the rental

real-estate activities were passive-activity-loss deductions.

The notice of deficiency treated the $302,400 in trustee fees

as deductions other than passive-activity-loss deductions

(and allowed the full deduction of $302,400). 18 The treat-

17 In

determining whether a taxpayer who qualifies for the sec. 469(c)(7)

exception has materially participated in a rental real-estate activity, each

interest in rental real estate is treated as a separate rental real-estate ac-

tivity unless the taxpayer has made an election under section 469(c)(7)(A).

If the taxpayer has made such an election, then all interests in rental real

estate are treated as a single rental real-estate activity. Sec. 469(c)(7)(A).

Before the years at issue, the trust made an election under sec.

469(c)(7)(A)—an election that was binding for subsequent tax years, absent

changed circumstances—to treat all of its interests in rental real estate as

a single activity.

18 A passive-activity loss is generally defined as the amount, if any, by

which the passive-activity deductions for the year exceed the passive-activ-

ity gross income for the tax year. Sec. 1.469–2T(b)(1), Temporary Income

Tax Regs., 53 Fed. Reg. 5711 (Feb. 25, 1988). Passive-activity gross income

is generally all items of gross income from a passive activity. Sec. 1.469–

2T(c), Temporary Income Tax Regs., supra. A passive-activity deduction is

generally defined as a deduction arising in connection with the conduct of

a passive activity. Sec. 1.469–2T(d)(1), Temporary Income Tax Regs., 53

Continued

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182 142 UNITED STATES TAX COURT REPORTS (165)

ment of the $302,400 in trustee fees as deductions other than

passive-activity-loss deductions assumes that the trustee fees

were not expenses of the trust’s rental real-estate activities.

On brief, the IRS appears to defend this assumption: it

apparently contends that the trustee fees were not the

expenses of the trust’s rental real-estate activities. 19 The

trust appears to disagree with the assumption in the notice

of deficiency: the trust apparently contends that the trustee

fees were the expenses of the trust’s rental real-estate activi-

ties. 20

The question of whether the trustee fees were the expenses

of the trust’s rental real-estate activities is relevant only if

the trust’s rental real-estate activities are passive activities.

Contrary to the notice of deficiency, we hold that the trust’s

rental real-estate activities were not passive activities. See

supra part 1.c. Because of this holding, the losses associated

with the trust’s rental real-estate activities are not passive-

activity-loss deductions. Therefore, it is unnecessary to decide

whether the trustee fees were expenses of the trust’s rental

real-estate activity.

3. Conclusion

We have considered all of the arguments the parties have

made, and to the extent that we have not discussed them, we

find them to be irrelevant, moot, or without merit.

Fed. Reg. 5716 (Feb. 25, 1988).

19 In its brief, the IRS frames the issue of proper characterization of the

trustee fees as: ‘‘Whether petitioner should have reported trustee fee ex-

penses on the front of its U.S. Income Tax Return for Estates and Trusts,

Form 1041, or on the Schedule E, for the 2005 and 2006 years.’’ It also

frames the issue as: ‘‘Trustee Fees Are An Expense Of The Trust and not

[Holiday Enterprises, LLC].’’ Both phrasings appear to be an obscure ref-

erence to the notice of deficiency’s assumption that the trustee fees are not

the expenses of the trust’s rental real-estate activity.

20 In its reply brief, the trust argues that the trustee fees are ‘‘properly

included in the determination of the Trust’s losses from its real estate ac-

tivities.’’ Strictly speaking, however, the computations in the notice of defi-

ciency assumed that the trustee fees were not the expenses of the trust’s

rental real-estate activities.

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(165) ARAGONA TRUST v. COMMISSIONER 183

To reflect the foregoing,

Decision will be entered under Tax Ct. R.

Pract. & Proc. 155.

f

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