The Tax Reform Act of 1986 created the passive loss rules. The rules were enacted to prevent individuals from using tax shelters to reduce tax liability on their tax return by offsetting losses from passive activities (mere investment activities) against other taxable income. Passive losses are subject to stringent rules regarding deductibility – losses from passive activities can only be deducted against income from passive activities. In turn, for taxpayers involved in passive activities, IRS has the power to recharacterize passive activities as non-passive.
An activity is considered a passive activity, and the passive loss rules are invoked, if the activity involves a trade or business and the taxpayer does not materially participate in the activity “on a basis which is regular, continuous and substantial.” As mentioned above, the passive loss rules prevent deductions (losses) from passive trade or business activities, to the extent they exceed income from all passive activities, from being deducted against other income (non-passive activity gains). So, in order to deduct losses from trade or business activities, a “taxpayer” must materially participate in the activity. In other words, the taxpayer must be involved in the business activity on a regular, continuous and substantial basis. That’s a tough test for many individual taxpayers to meet.
While IRS regulations set forth several material participation tests for individual taxpayers, IRS has never issued regulations addressing the material participation requirement for non-grantor trusts (as well as estates). For pass-through entities, material participation is determined with respect to each member of the entity, with reference to the tax year of the entity. For closely held C corporations (and personal service corporations), material participation is generally required by shareholders with aggregate ownership of more than 50 percent in value of the corporation’s outstanding stock. Also, C corporations (but not personal service corporations) meet the test if the corporation’s business activities are exempt from the at-risk rules under I.R.C. §465(c)(7) – which attribute the activities of employees to the corporation.
So, for a non-grantor trust, who is the “taxpayer”? For purposes of the passive loss rules, the statute defines a “taxpayer” as “any individual, estate, or trust,” or any closely held C corporation as well as any personal service corporation. Thus, while the statute is clear that a trust (rather than a trustee) is the taxpayer whose material participation is decisive, the statute is silent on how to determine if the test has been satisfied. In other words, since the trust can only act through other people to satisfy the material participation test, who are the key other people whose activity counts?
The longstanding IRS position has been that only the trustee of a trust can satisfy the material participation test. While that position was rejected by a federal court in 2003, the IRS has continued to maintain its position with pronouncements in 2007, 2010 and 2013.