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Fiduciary Income Tax Handout and Resource Guide
July 2014
Jeffrey F. Winter Director of Fiduciary Tax Services 516-508-9689 [email protected]
Kevin M. Barry Senior Fiduciary Tax Consultant 516-508-9648 [email protected]
Table of Contents Tab 1: Estate Planning: Current Developments and Hot Topics by Steve Akers
Tab 2: Illinois Official Reports: Linn v. Department of Revenue, 2013 IL App (4th) 121055
Tab 3: Pennsylvania Court Decision on No. 651 F.R. 2010 and No. 173 F.R 2011
Tab 4: Estate Planning Update: Changes to the Taxation of New York Estates, Gifts, and the Income of Certain Trusts by Peter Slater
Tab 5: New Proposed Regulations Under §67(e); Expenses of Trusts and Estates That Are Subject to the “2% Floor” on Deductions (September 7, 2011) by Steve Akers
Tab 6: Don W. Crisp, Trustee of the Caroline Hunt Trust Estate, Plaintiff, v. The United States
Tab 7: Material Participation by Trusts, Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014) by Steve Akers
Tab 8: 142 T.C. No. 9: United States Tax Court: Frank Aragona Trust, Paul Aragona, Executive Trustee, Petitioner v. Commissioner of Internal Revenue, Respondent
Tab 9: Refreshing Expiring Distribution Carryovers of Private Foundations (IRS.gov)
Tab 10: Bessemer Trust’s Advisor Site
Appendix: Resource Guide
Copyright © 2014 Bessemer Trust Company, N.A. All rights reserved.
Important Information Regarding This Summary This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.
Estate Planning: Current Developments and Hot Topics
June 2014
Steve R. Akers Senior Fiduciary Counsel — Southwest Region, Bessemer Trust 300 Crescent Court, Suite 800 Dallas, TX 75201 214-981-9407 [email protected] www.bessemer.com
www.bessemer.com/advisor i
TABLE OF CONTENTS
Introduction ....................................................................................................................... 1
1. Legislative Developments ............................................................................................ 1
2. Treasury-IRS Priority Guidance Plan; “BDITs” ............................................................... 6
3. General Approaches to Estate Planning Following ATRA; The “New Normal” .................... 7
4. Planning for Couples Having Under $10 Million ............................................................ 9
5. Portability................................................................................................................ 18
6. Estate and Income Tax Intersection—Basis Planning for Larger Estates ......................... 31
7. Basis Adjustment Flexibility Planning ......................................................................... 36
8. Joint Spousal Trusts (To Facilitate Funding Credit Shelter Trusts and for Basis Adjustment); Section 2038 Marital Trust .................................................................... 46
9. Trust and Estate Planning Considerations for 3.8% Tax on Net Investment Income and Income Taxation of Trusts ................................................................................... 49
10. Drafting for Maximum Flexiblity (and “Dead Hand Control”); But Can It Go Too Far? ...... 67
11. Gift Planning Issues for 2014 and Beyond .................................................................. 76
12. Defined Value Clause Updates ................................................................................... 80
13. Sale to Grantor Trust Transaction (Including Note with Defined Value Feature) Under Attack, Estate of Donald Woelbing v. Commissioner and Estate of Marion Woelbing v. Commissioner .......................................................................................................... 83
14. Grantor Trust Miscellaneous Issues ............................................................................ 88
15. Self-Canceling Installment Notes (SCINs); CCA 201330033 and Estate of William Davidson ................................................................................................................. 88
16. Same-Sex Marriage Issues ......................................................................................... 94
17. Life Insurance Developments—Right to Dividends, Shark-Fin CLATs, Intergenerational Split Dollar Insurance ............................................................................................... 97
18. Life Insurance Management, Particularly for Life Insurance Trusts ................................ 98
19. Business Life Insurance .......................................................................................... 101
20. Charitable Planning Reminders, Strategies and Creative Ideas .................................... 102
21. Planning for Surviving Spouse Who is Beneficiary of QTIP Trust; Sale of Assets for Deferred Private Annuity, Estate of Kite v. Commissioner, T.C. Memo. 2013-43 and Rule 155 Order ............................................................................................... 108
22. IRS Appeals........................................................................................................... 112
23. Generation Skipping Transfer Tax: Post-ATRA Planning and Practical Pointers ............. 116
24. Fixing Trusts—Modifying Irrevocable Trusts .............................................................. 125
25. Residence and Domicile Issues—State Income Tax Issues ......................................... 127
26. Power to Adjust or Unitrust Election ......................................................................... 129
www.bessemer.com/advisor ii
27. Funding Unfunded Testamentary Bypass Trusts ........................................................ 132
28. Practical Tips in Dealing With Aging Clients (and Diminished Capacity Issues) ............. 134
29. Gifts of Fractional Interests in Art ............................................................................ 137
30. Mandatory Income Requirement For Marital Trust ..................................................... 137
31. Malpractice Issues From Reviewing Documents Prepared by Others ............................ 138
32. Recent Cases Addressing Asset Protection Planning and Domestic Asset Protection Trusts ................................................................................................................... 139
33. IRS Valuation Art Panel .......................................................................................... 141
34. Interest on Graegin Loan Not Deductible; Majority Interest in LLC Valued With Low Marketability Discount, Estate of Koons v. Commissioner, T.C. Memo. 2013-94 .......... 142
35. Net Gift Offset by Donee’s Assumption of Potential §2035(b) Estate Tax Liablility if Donor Dies Within Three Years, Steinberg v. Commissioner...................................... 142
36. Reciprocal Powers, PLRs 201345004, 201345026, 201345027, 201345028. ........ 143
37. Valuation of Investment Holding Company; Valuation Method, Built-In Gains Tax Adjustment, Lack of Control and Marketability Discounts, and Undervaluation Penalty, Estate of Richmond v. Commissioner, T.C. Memo 2014-26 ........................................ 144
38. New York Estate, Gift, GST, and Trust Income Tax Issues ........................................... 152
39. Family Limited Partnership Attack for Estate Inclusion Without Any Discounts, Estate of Williams .................................................................................................. 154
40. Valuation of Real Property in 2009 (When Comparables Were Not Available Reflecting Depresed Values Folliwing the 2008 “Crash” Because Properties Were Not Selling), Estate of Lovins ..................................................................................................... 155
41. Appraiser Failed to Testify; Estate Arguing Lower Value Than on Form 706, Estate of Tanenblatt ............................................................................................................. 155
42. Early Termination of Charitable Remainder Trusts ..................................................... 155
43. Garnishment from Discretionary Spendthrift Trusts .................................................... 156
44. Material Participation by Trustee , Frank Aragona Trust .............................................. 157
45. SOGRAT Patent Under Review ................................................................................. 166
46. Interesting Quotations ............................................................................................ 166
APPENDIX A .................................................................................................................. 176
APPENDIX B ................................................................................................................. 178
Illinois Official Reports
Appellate Court
Linn v. Department of Revenue, 2013 IL App (4th) 121055
Appellate Court Caption
LEWIS LINN, as Trustee of the Autonomy Trust 3, Plaintiff- Appellant, v. THE DEPARTMENT OF REVENUE; BRIAN HAMER, in His Official Capacity as Director of The Department of Revenue; and DAN RUTHERFORD, in His Official Capacity as Treasurer of the State of Illinois, Defendants-Appellees.
District & No.
Fourth District Docket No. 4-12-1055
Filed
December 18, 2013
Held (Note: This syllabus constitutes no part of the opinion of the court but has been prepared by the Reporter of Decisions for the convenience of the reader.)
In an action seeking the return of a 2006 income-tax payment made under protest by plaintiff trustee on behalf of a trust on the ground that the trust had no connection with Illinois and that taxation of the trust was unconstitutional, the appellate court reversed the entry of summary judgment for defendants, including the Illinois Department of Revenue, because taxation of the trust by Illinois would violate due process where the trust was an inter vivos trust, it was not a testamentary trust under the jurisdiction of an Illinois probate court, and although the predecessors of the trust were related to Illinois, the choice of law provision of the trust provided for the application of Texas law, the trust had the benefits and protections of Texas law, the trust had nothing in Illinois in 2006, its business was all in Texas, the trustee, the protector, and the noncontingent beneficiary resided outside Illinois, no trust property was in Illinois, and the trust met none of the criteria that would give Illinois personal jurisdiction in litigation involving the trust.
Decision Under Review
Appeal from the Circuit Court of Sangamon County, No. 07-TX-0001/01; the Hon. John Schmidt, Judge, presiding.
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Judgment
Reversed and remanded with directions.
Counsel on Appeal
Fred O. Marcus (argued) and David S. Ruskin, both of Horwood Marcus & Berk Chtrd., of Chicago, and Alan Y. Ytterberg, of Ytterberg Deery Knull LLP, of Houston, Texas, for appellant. Lisa Madigan, Attorney General, of Chicago (Michael A. Scodro, Solicitor General, and Evan Siegel (argued), Assistant Attorney General, of counsel), for appellees.
Panel JUSTICE TURNER delivered the judgment of the court, with opinion. Justices Knecht and Steigmann concurred in the judgment and opinion.
OPINION
¶ 1 In May 2007, plaintiff, Lewis Linn, as trustee of the Autonomy Trust 3, filed a verified complaint for declaratory and injunctive relief against defendants, the Department of Revenue (Department); Brian Hamer, as the Department’s director; and Dan Rutherford, as the Illinois Treasurer. Plaintiff’s complaint sought the return of an income-tax payment it had made under protest because any income taxation on the Autonomy Trust 3 was unconstitutional as the trust had no connections with Illinois. The parties filed cross-motions for summary judgment. After memoranda and oral arguments, the Sangamon County circuit court granted defendants’ motion for summary judgment and denied plaintiff’s.
¶ 2 Plaintiff appeals, arguing the trial court erred in granting summary judgment in defendants’ favor because (1) the Illinois choice-of-law provision in the original trust agreement does not apply to the Autonomy Trust 3, and (2) the imposition of Illinois income taxation on the Autonomy Trust 3 is unconstitutional as it violates both the due process and commerce clauses. We reverse and remand with directions.
¶ 3 I. BACKGROUND ¶ 4 In March 1961, A.N. Pritzker entered into a trust agreement establishing “P.G. Trusts”
with trustee Meyer Goldman, in which 20 separate, irrevocable trusts were created. At the time of the agreement, both A.N. and Goldman were Illinois residents, and the trust assets were deposited in Illinois. Article IX of the March 1961 trust agreement allowed the trustee to distribute the whole or part of the corpus of the trust to a different trustee or trustees to hold in further trust for the exclusive benefit of the beneficiary of each of the 1961 trusts. Article V, section 2(b), also gave the trustee the power, in his discretion, to distribute the whole or part of the trust corpus to its beneficiary after the beneficiary had attained 30 years of age. Further,
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article XIV of the March 1961 agreement stated the following: “This Agreement shall be construed and administered and the validity of the trusts hereby created shall be determined in accordance with the laws of the State of Illinois.” One of the trusts was for the primary benefit of A.N.’s granddaughter Linda Pritzker and was named the “Linda Trust.”
¶ 5 Beginning in 1968, other adult beneficiaries of the P.G. Trusts (not Linda) created a new set of trusts called the A.N.P. Trusts with assets from the P.G. Trusts. In 1975, Goldman filed a complaint, addressing, inter alia, the adult beneficiaries’ right to transfer their interests to the A.N.P. Trusts. Goldman v. Pritzker, No. 75-CH-4214 (Cir. Ct. Cook Co.). In June 1977, the circuit court entered a lengthy order granting the relief requested in Goldman’s complaint, as amended, and thus approving the creation of the A.N.P. Trusts. In the written order, the court retained jurisdiction of the cause and parties for the purpose of paying the fees, costs, and expenses of the proceedings and for any further orders necessary to interpret or implement the provisions of the court’s order.
¶ 6 A.N. died in 1986 as an Illinois resident, and his estate was probated in Illinois. At some point, Thomas Pritzker of Illinois, Marshall Eisenberg of Illinois, and Arnold Weber succeeded Goldman as trustees of the Linda Trust and were the trustees of the Linda Trust in 2002. (In 2008, the trustees of the Linda Trust still included two Illinois residents and one nonresident.) On January 2, 2002, the trustees of the Linda Trust exercised their limited power of appointment contained in articles V and IX of the March 1961 trust agreement and irrevocably distributed assets from the Linda Trust to plaintiff, as trustee of the Autonomy Trust 3, for the exclusive benefit of Linda.
¶ 7 Along with the power of appointment, the trustees of the Linda Trust and plaintiff entered into a trust agreement that created the Autonomy Trust 3. Provision 9 of the January 2002 trust agreement named Jay Robert Pritzker of Illinois as protector of the trusts created hereunder. We note that Jay was replaced as protector of the Autonomy Trust 3 in December 2002 by Basil Zirinis of Connecticut. Moreover, provision 14 of the January 2002 trust agreement contained the perpetuities savings clause and referenced the lives of those named in the March 1961 trust agreement. Last, provision 15 stated the Autonomy Trust 3 was to be construed and regulated under Texas law, “except that the terms ‘income,’ ‘principal,’ and ‘power of appointment’ and the provisions relating thereto shall be interpreted under the laws of the state of Illinois.”
¶ 8 In February 2004, plaintiff filed a complaint in the probate court of Harris County, Texas, seeking reformation of provision 15 of the Autonomy Trust 3 and other trusts that applied Illinois law to some of their terms. Plaintiff sought to strike the language referring to Illinois law, leaving the trusts to be construed and regulated by only Texas law. On November 4, 2005, the probate court entered an order, granting the relief plaintiff requested. However, the judgment stated the following: “This Judgment shall become effective as to each of the Trusts as of the date that the Internal Revenue Service issues a favorable ruling holding that the modifications and declarations of this Judgment to the Trust do not result in the loss of such Trust’s generation-skipping transfer tax exempt status or otherwise subject such Trust to the generation-skipping transfer tax.”
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¶ 9 In 2006, Linda, her children, and the other contingent beneficiaries of the Autonomy Trust 3 were not Illinois residents. Plaintiff resided in Texas, and the Autonomy Trust 3 was administered in Texas. The Autonomy Trust 3 had no assets in Illinois.
¶ 10 In April 2007, the Autonomy Trust 3 filed a 2006 nonresident Illinois income and replacement tax return, reporting no income from Illinois sources and thus no tax was owed. The Department reclassified the Autonomy Trust 3 as an Illinois resident under section 1501(a)(20)(D) of the Illinois Income Tax Act (Tax Act) (35 ILCS 5/1501(a)(20)(D) (West 2006)), taxed 100% of the trust’s reported income, and assessed a deficiency liability of $2,729. Pursuant to section 2a of the State Officers and Employees Money Disposition Act (30 ILCS 230/2a (West 2006)), the Autonomy Trust 3 paid the $2,729 in income tax under protest.
¶ 11 In May 2007, plaintiff filed the verified complaint for declaratory and injunctive relief, asserting Illinois’s imposition of income tax on the Autonomy Trust 3 violates the commerce, due process, and equal protection clauses of the United States Constitution (U.S. Const., art. I, § 8; amend. XIV, § 1) and the uniformity clause of the Illinois Constitution of 1970 (Ill. Const. 1970, art. IX, § 2). Former Illinois Treasurer Alexi Giannoulias was originally listed as one of the defendants and was later replaced by current Illinois Treasurer Dan Rutherford when Giannoulias’s term ended.
¶ 12 In September 2011, plaintiff filed a motion for summary judgment with a supporting memorandum. Along with the memorandum, plaintiff submitted a declaration by him and one by Zirinis. In his declaration, plaintiff states the Texas probate court’s judgment became effective on November 4, 2005, the date it was entered. Zirinis stated the duties of the Autonomy Trust 3’s protector include the power to remove any trustee, revoke the designation of a successor trustee, and appoint a successor protector.
¶ 13 In May 2012, defendants filed a cross-motion for summary judgment and a response to plaintiff’s motion for summary judgment. Defendants first asserted the case could be decided on nonconstitutional grounds and argued (1) the grantor of the Autonomy Trust 3 voluntarily established all of the trusts and subsequent trusts pursuant to Illinois law, (2) the Texas probate court judgment is not binding on this court, and (3) the Department assessed tax on the Autonomy Trust 3 in accordance with Illinois statutes. Defendants then argued the income tax on the Autonomy Trust 3 was constitutional. In support of their motion, defendants attached the following: (1) the March 1961 trust agreement; (2) plaintiff’s first response to defendants’ interrogatories (in interrogatory No. 9, plaintiff states the Internal Revenue Service had not issued a ruling regarding the generation-skipping transfer tax); (3) plaintiff’s response to defendants’ second set of supplemental interrogatories; (4) plaintiff’s response to defendants’ request to admit; (5) the January 2002 trust agreement; (6) the exercise of the power of appointment establishing the Autonomy Trust 3; (7) plaintiff’s response to defendants’ first supplemental interrogatories; (8) plaintiff’s petition in the Texas probate court; and (9) the Texas probate court judgment. In July 2012, plaintiff filed a memorandum in response to defendants’ cross-motion for summary judgment and did not attach any supporting documents. In September 2012, defendants filed a reply, attaching the June 1977 judgment of the Cook County circuit court.
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¶ 14 On October 12, 2012, the trial court heard oral arguments on the cross-motions for summary judgment. Twelve days later, the court entered a written order, granting defendants’ motion for summary judgment and denying plaintiff’s. In reaching that judgment, the court found the March 1961 trust agreement provided Illinois law was to govern the trust agreement and any trusts hereby created, which would include the Autonomy Trust 3. The court then concluded the fact Illinois law governed the Autonomy Trust 3 was a sufficient contact to satisfy the due process and commerce clauses.
¶ 15 On November 9, 2012, plaintiff filed a timely notice of appeal, which was in sufficient compliance with Illinois Supreme Court Rule 303 (eff. May 30, 2008), despite its failure to list the Department as a defendant. See Harry W. Kuhn, Inc. v. County of Du Page, 203 Ill. App. 3d 677, 684-85, 561 N.E.2d 458, 463 (1990) (finding the failure to list all of the defendants in notice of appeal did not render the notice fatally defective where the defendants were all represented by the same attorney and the appellee did not suffer prejudice). Thus, this court has jurisdiction under Illinois Supreme Court Rule 301 (eff. Feb. 1, 1994).
¶ 16 II. ANALYSIS ¶ 17 A. Summary Judgment ¶ 18 A grant of summary judgment is only appropriate when the pleadings, depositions,
admissions, and affidavits demonstrate no genuine issue of material fact exists and the movant is entitled to judgment as a matter of law. 735 ILCS 5/2-1005(c) (West 2010); Williams v. Manchester, 228 Ill. 2d 404, 417, 888 N.E.2d 1, 8-9 (2008). “ ‘As in this case, where the parties file cross-motions for summary judgment, they invite the court to decide the issues presented as a matter of law.’ ” A.B.A.T.E. of Illinois, Inc. v. Giannoulias, 401 Ill. App. 3d 326, 330, 929 N.E.2d 1188, 1192 (2010) (quoting Liberty Mutual Fire Insurance Co. v. St. Paul Fire & Marine Insurance Co., 363 Ill. App. 3d 335, 339, 842 N.E.2d 170, 173 (2005)). We review de novo the trial court’s ruling on a motion for summary judgment. See Williams, 228 Ill. 2d at 417, 888 N.E.2d at 9.
¶ 19 B. Illinois Income Tax ¶ 20 The starting point for income taxation in Illinois is section 201(a) of the Tax Act (35 ILCS
5/201(a) (West 2006)), which provides, in relevant part: “A tax measured by net income is hereby imposed on every individual, corporation, trust and estate *** on the privilege of earning or receiving income in or as a resident of this State.” (Emphases added.) See also Rockwood Holding Co. v. Department of Revenue, 312 Ill. App. 3d 1120, 1123-24, 728 N.E.2d 519, 523 (2000). For residents, “[a]ll items of income or deduction which were taken into account in the computation of base income for the taxable year by a resident shall be allocated to this State.” 35 ILCS 5/301(a) (West 2006). Section 1501(a)(20)(D) of the Tax Act (35 ILCS 5/1501(a)(20)(D) (West 2006)) defines “resident,” in pertinent part, as “[a]n irrevocable trust, the grantor of which was domiciled in this State at the time such trust became irrevocable.” The parties agree the Autonomy Trust 3 is an irrevocable trust, and A.N. Pritzker, who was an Illinois resident, is considered to be the grantor of the Autonomy Trust 3. Thus, under the Tax Act, the Autonomy Trust 3 is an Illinois resident and subject to Illinois income tax.
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¶ 21 On appeal, the parties now agree this case cannot be resolved on a nonconstitutional basis. Thus, we turn to plaintiff’s allegations of constitutional violations. Plaintiff asserts the imposition of Illinois income tax on the Autonomy Trust 3 is unconstitutional as applied to the trust as it violates both the due process and the commerce clauses. “In undertaking our review, we presume that statutory enactments are constitutional. The burden is on the party challenging the statute to clearly establish any constitutional invalidity. The burden is a formidable one, and this court will uphold a statute’s validity whenever it is reasonably possible to do so.” Allegis Realty Investors v. Novak, 223 Ill. 2d 318, 334, 860 N.E.2d 246, 255 (2006).
¶ 22 1. Due Process ¶ 23 For a tax to comply with the due process clause, (1) a minimum connection must exist
between the state and the person, property, or transaction it seeks to tax, and (2) “the income attributed to the State for tax purposes must be rationally related to values connected with the taxing State.” (Internal quotation marks omitted.) Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992) (quoting Moorman Manufacturing Co. v. Bair, 437 U.S. 267, 273 (1978)). In Quill Corp., 504 U.S. at 307-08, the Supreme Court equated that analysis with the determination of whether a state has personal jurisdiction over a given entity. After analyzing the case law regarding personal jurisdiction, the Quill Corp. Court held the due process clause did not require physical presence in a state for the collection of a use tax. Quill Corp., 504 U.S. at 308. There, the company’s ongoing solicitation of business in North Dakota was more than enough to subject it to North Dakota’s use tax. Quill Corp., 504 U.S. at 308.
¶ 24 Plaintiff asserts the Autonomy Trust 3 has no connections to Illinois. He notes the Autonomy Trust 3 is a Texas trust that is governed by the laws of and administered in Texas. Moreover, in 2006, the Autonomy Trust 3’s trustee, beneficiary, and protector were all not residents of Illinois. Without any connections to Illinois, the imposition of Illinois income tax on the Autonomy Trust 3 would be unconstitutional under the due process clause. Plaintiffs have shown no connections appear to exist with the trust in this case. However, defendants contend connections do exist because (1) the Autonomy Trust 3 owes its existence to Illinois, and (2) Illinois provides the Autonomy Trust 3’s trustee and beneficiary with a panoply of legal benefits and opportunities. We note that, on appeal, defendants do not argue that, in 2006, the Autonomy Trust 3 still contained terms to be interpreted under Illinois law and that the Illinois choice of law provision in the March 1961 agreement applies to the Autonomy Trust 3.
¶ 25 Both parties cite the Connecticut Supreme Court’s decision in Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999), which was decided after the United States Supreme Court’s Quill Corp. decision. There, the plaintiffs asserted Connecticut’s income taxation on the undistributed taxable income of four testamentary trusts and one inter vivos trust was unconstitutional because it violated the due process and commerce clauses. Gavin, 733 A.2d at 785-86. Since the case before us involves an inter vivos trust, we focus on the facts and analysis related to the inter vivos trust. Under Connecticut law, a resident inter vivos trust is “ ‘a trust, or a portion of a trust, consisting of the property of (i) a person who was a resident of this state at the time the property was transferred to the trust if the trust was then irrevocable.’ ”
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Gavin, 733 A.2d at 789 (quoting Conn. Gen. Stat. § 12-701(a)(4)(D) (1993)). However, with an inter vivos trust, taxable income is then modifiable under a formula that takes into account whether the trust has any resident, noncontingent beneficiaries. Gavin, 733 A.2d at 790. Thus, Connecticut taxes only that portion of the inter vivo trust’s undistributed income that corresponds to the number of noncontingent beneficiaries that live in Connecticut. Gavin, 733 A.2d at 790. Accordingly, in Gavin, 733 A.2d at 790, the taxability of the inter vivos trust’s income was based on the facts the trust’s settlor was a Connecticut resident when he established the trust and the trust’s beneficiary was a Connecticut resident.
¶ 26 Regarding due process, the Connecticut Supreme Court found the critical link between Connecticut and the undistributed income sought to be taxed was the fact the inter vivos trust’s noncontingent beneficiary was a Connecticut resident during the tax year in question. Gavin, 733 A.2d at 802. It explained that, as a Connecticut resident, the noncontigent beneficiary’s rights to the eventual receipt and enjoyment of the accumulated income were protected by Connecticut law so long as the beneficiary remained a resident of the state. Gavin, 733 A.2d at 802. The Gavin court recognized the connection was “more attenuated” than in the case of a testamentary trust but still found the connection was sufficient to satisfy due process. Gavin, 733 A.2d at 802.
¶ 27 In support of its conclusion, the Gavin court noted the United State Supreme Court had held a state may tax the undistributed income of a trust based on the presence of the trustee in the state because it gave the trustee the protection and benefits of its laws (Greenough v. Tax Assessors, 331 U.S. 486, 496 (1947)), which are the same benefits and protections provided a resident, noncontingent beneficiary. Gavin, 733 A.2d at 802. The Gavin court also noted its conclusion was consistent with the California Supreme Court’s decision in McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964). Gavin, 733 A.2d at 802. There, the California Supreme Court did not find a due-process violation where California taxed the undistributed income of an out-of-state testamentary trust based solely on the California residence of the trust’s beneficiary. McCulloch, 390 P.2d at 418. It reasoned California law provided benefit and protection to the resident beneficiary. McCulloch, 390 P.2d at 418-19.
¶ 28 Defendants begin their argument the Autonomy Trust 3 owes its existence to Illinois by noting the trust’s grantor was an Illinois resident. In support of that argument, they cite portions of the Gavin opinion that found the grantor’s in-state residency was sufficient to establish a minimum contact as to the four testamentary trusts as well as other case law addressing testamentary trusts. However, we are dealing with an inter vivos trust. Since an inter vivos trust is not created by the probate of the decedent’s will in a state court, its connection with the state has been described as more attenuated than a testamentary trust. Gavin, 733 A.2d at 802; District of Columbia v. Chase Manhattan Bank, 689 A.2d 539, 547 n.11 (D.C. 1997). Moreover, an irrevocable inter vivos trust does not owe its existence to the laws and courts of the state of the grantor in the same way a testamentary trust does and thus does not have the same permanent tie. District of Columbia, 689 A.2d at 547 n.11. With the inter vivos trust, the Connecticut Supreme Court found the critical link between the state and the inter vivos trust was the trust’s noncontingent beneficiary was a Connecticut resident during the tax year in question. Gavin, 733 A.2d at 802. Autonomy Trust 3 does not have a
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noncontingent beneficiary in Illinois. Defendants cite no cases finding a grantor’s in-state residency is a sufficient connection for due process with an inter vivos trust.
¶ 29 On the other hand, we note decisions from other states have found the grantor’s in-state residence insufficient to establish a minimum connection. In Blue v. Department of Treasury, 462 N.W.2d 762, 764 (Mich. Ct. App. 1990), the Michigan appellate court found insufficient connections between an inter vivos trust whose grantor was a Michigan resident and the State of Michigan’s imposition of an income tax. There, the only thing in Michigan was one non-income-producing parcel of real estate, and thus the court concluded Michigan provided no ongoing protection or benefit to the trust. Blue, 462 N.W.2d at 764. In Mercantile-Safe Deposit & Trust Co. v. Murphy, 242 N.Y.S.2d 26, 28 (N.Y. App. Div. 1963), a New York appellate court found a due process violation where New York imposed an income tax on income accumulated in a trust created by a New York resident where the trustee resided in Maryland, the trust was administered in Maryland, and trust assets were in the trustee’s exclusive possession and control in Maryland. Accordingly, we find the fact the Autonomy Trust 3’s grantor was an Illinois resident is not a sufficient connection to satisfy due process.
¶ 30 Defendants further argue the Autonomy Trust 3 exists only because of Illinois law. However, Autonomy Trust 3 resulted from a January 2002 exercise of the limited power of appointment by the trustee of the P.G. Linda Trust, which was provided for in the March 1961 trust agreement. Assuming arguendo, an Illinois court ruling validated a provision of the March 1961 agreement that allowed for the limited power of appointment that was later invoked to create the Autonomy Trust 3, the Autonomy Trust 3 was created by the provisions of the March 1961 agreement allowing for powers of appointment and not Illinois law. Further, with income taxation, the focus of the due process analysis is on the tax year in question, which would be 2006 in this case. See Gavin, 733 A.2d at 802 (noting the connection for the inter vivos trust was the fact a noncontingent beneficiary was an in-state resident during the tax year in question); see also In re Swift, 727 S.W.2d 880, 882 (Mo. 1987) (addressing income taxation on a testamentary trust and stating, “An income tax is justified only when contemporary benefits and protections are provided the subject property or entity during the relevant taxing period”). Thus, what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.
¶ 31 Additionally, defendants argue the State of Illinois provides the trustee and beneficiary of the Autonomy Trust 3 with a panoply of legal benefits and opportunities. In support of its assertion, it again cites case law addressing testamentary trusts. See Gavin, 733 A.2d at 799; District of Columbia, 689 A.2d at 544. As we have stated, this case involves an inter vivos trust, not a testamentary trust. The Autonomy Trust 3 was not in existence when A.N. Pritzker died and thus was not part of his probate case. Accordingly, no Illinois probate court has jurisdiction over the Autonomy Trust 3, unlike in the testamentary trust cases.
¶ 32 Defendants also cite several Illinois statutory provisions and claim the Autonomy Trust 3, plaintiff, Linda, or a contingent beneficiary can seek those statutory provisions at any time. However, the parties agree that, after the November 2005 Texas reformation order, the Autonomy Trust 3 choice of law provision provided for only the application of Texas law. Further, as stated earlier, the 1977 Cook County case has no application at all to the Autonomy
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Trust 3 because it dealt with beneficiary powers of appointment, not trustee powers of appointment in the March 1961 trust agreement. Accordingly, we find the Autonomy Trust 3 receives the benefits and protections of Texas law, not Illinois law.
¶ 33 Last, we note the company in Quill Corp. mailed catalogs into North Dakota, seeking business there. Quill Corp., 504 U.S. at 302. Here, in 2006, the Autonomy Trust 3 had nothing in and sought nothing from Illinois. As plaintiff notes, all of the trust’s business was conducted in Texas; the trustee, protector, and the noncontingent beneficiary resided outside Illinois; and none of the trust’s property was in Illinois. Moreover, the Autonomy Trust 3 meets none of the following factors that would give Illinois personal jurisdiction over the trust in a litigation: “the provisions of the trust instrument, the residence of the trustees, the residence of its beneficiaries, the location of the trust assets, and the location where the business of the trust is to be conducted.” Sullivan v. Kodsi, 359 Ill. App. 3d 1005, 1011, 836 N.E.2d 125, 131 (2005) (citing People v. First National Bank of Chicago, 364 Ill. 262, 268, 4 N.E.2d 378, 380 (1936)). Accordingly, we find insufficient contacts exist between Illinois and the Autonomy Trust 3 to satisfy the due process clause, and thus the income tax imposed on the Autonomy Trust 3 for the tax year 2006 was unconstitutional. Thus, summary judgment should have been granted in plaintiff’s favor.
¶ 34 2. Commerce Clause
¶ 35 Since we have found the income taxation of the Autonomy Trust 3 in 2006 violates the due process clause, we do not address plaintiff’s commerce clause argument.
¶ 36 III. CONCLUSION ¶ 37 For the reasons stated, we reverse the Sangamon County circuit court’s judgment and
remand the cause for that court to enter an order granting plaintiff’s summary-judgment motion and denying defendants’.
¶ 38 Reversed and remanded with directions.
IN THE COMMONWEALTH COURT OF PENNSYLVANIA
Robert L. McNeil, Jr. Trust for : Nancy M. McNeil, et al., : : Petitioner : : v. : No. 651 F.R. 2010 : Commonwealth of Pennsylvania, : : Respondent : Levine R L JRV MCN Levine, : a/k/a Robert L. McNeil, Jr. Trust : for Mary Victoria McNeil, et al., : : Petitioners : : v. : No. 173 F.R. 2011 : Commonwealth of Pennsylvania, : Argued: March 13, 2013 : Respondent : BEFORE: HONORABLE DAN PELLEGRINI, President Judge HONORABLE BERNARD L. McGINLEY, Judge HONORABLE BONNIE BRIGANCE LEADBETTER, Judge HONORABLE RENÉE COHN JUBELIRER, Judge HONORABLE ROBERT SIMPSON, Judge HONORABLE MARY HANNAH LEAVITT, Judge HONORABLE P. KEVIN BROBSON, Judge OPINION BY JUDGE COHN JUBELIRER FILED: May 24, 2013
In 2007, the Department of Revenue (Department) assessed Pennsylvania
Income Tax (PIT) and interest on all of the income of two inter vivos trusts, which
2
are located in, administered in, and governed by the laws of Delaware and which
had no Pennsylvania income or assets in 2007. The Department imposed the PIT
because the trusts’ settlor, Robert L. McNeil, Jr. (Settlor), resided in Pennsylvania
when he established the trusts in 1959 and the trusts’ discretionary beneficiaries
are Pennsylvania residents. On appeal, the Robert L. McNeil, Jr. Trust for Nancy
M. McNeil (NMM Trust) and the Levine R L JRV MCN Levine, a/k/a Robert L.
McNeil, Jr. Trust for Mary Victoria McNeil (MVM Trust) (collectively, the
Trusts), argue that this tax is contrary to the Department’s interpretation of the Tax
Reform Code of 19711 (Tax Code) and violates the Uniformity Clause of the
Pennsylvania Constitution2 and/or the Commerce,3 Due Process,4 and Equal
Protection5 Clauses of the United States (U.S.) Constitution. Because we conclude
that the imposition of PIT here violates the Commerce Clause of the U.S.
Constitution, we reverse.
1 Act of March 4, 1971, P.L. 6, as amended, 72 P.S. §§ 7101-8297.
2 Article VIII, Section 1 of the Pennsylvania Constitution provides that “[a]ll taxes shall
be uniform, upon the same class of subjects, within the territorial limits of the authority levying
the tax, and shall be levied and collected under general laws.” Pa. Const. art. VIII, § 1.
3 Article I, Section 8, Clause 3 of the U.S. Constitution provides that “The Congress shall
have Power . . . [t]o regulate Commerce . . . among the several States.” U.S. Const. art. I, § 8, cl.
3.
4 The Fourteenth Amendment to the U.S. Constitution states: “No State shall make or
enforce any law which shall abridge the privileges or immunities of citizens of the United States;
nor shall any State deprive any person of life, liberty or property, without due process of
law . . . .” U.S. Const. amend. XIV.
5 The Fourteenth Amendment of the U.S. Constitution also provides that “No State
shall . . . deny to any person within its jurisdiction the equal protection of the laws.” U.S. Const.
amend. XIV.
3
I. Factual History
The parties stipulated to the following facts. On January 2, 1959, Settlor, a
Pennsylvania resident, executed the Trusts’ Agreements and, by January 3, 1959,
all of the Trusts’ trustees had executed those Agreements. (Stipulation of Facts
(Stip.) ¶¶ 14-16, 51-53.) The Trusts’ Agreements provide that the Trusts are
Delaware trusts that are to be governed, administered, and construed under the
laws of Delaware, (Stip. ¶¶ 17, 54), and named the Wilmington Trust Company
(WTC), located in Wilmington, Delaware, as the sole administrative trustee; WTC
was the administrative trustee in 2007 (Stip. ¶¶ 19-21, 56-57; NMM Trust
Agreement at 4; MVM Trust Agreement at 4). WTC had no offices, conducted no
trust affairs, and did not act as administrative trustee for the Trusts in Pennsylvania
in 2007. (Stip. ¶¶ 23-24, 58.) All of the Trusts’ books and records are maintained
in WTC’s Wilmington, Delaware office. (Stip. ¶ 22.) In 2007, the Trusts’ three
general trustees resided outside of Pennsylvania and did not conduct trust affairs or
act as general trustees for the Trusts in Pennsylvania. (Stip. ¶¶ 25-30, 59-60.)
None of the Trusts’ assets or interests in 2007 were located in Pennsylvania,
and the Trusts had no income from Pennsylvania sources. (Stip. ¶¶ 31-34, 39-40,
61-65, 70-71.) All of the Trust’s discretionary beneficiaries6 were residents of
Pennsylvania in 2007. (Stip. ¶¶ 36, 66-67.) NMM Trust made no distributions to
the discretionary beneficiaries in 2007. (Stip. ¶ 38.) The trustees of the MVM
Trust were not required to make any distributions of income or principal during
6 The NMM Trust’s discretionary beneficiaries were Settlor’s wife, Nancy M. McNeil,
and certain of Settlor’s lineal descendants and their spouses. (Stip. ¶ 35.) The MVM Trust’s
discretionary beneficiaries were certain lineal descendants of Settlor and their spouses. (Stip. ¶
67.)
4
2007, but did make a distribution of $1,400,000.00 to one of its discretionary
beneficiaries. (Stip. ¶¶ 68-69.)
As fiduciary of the NMM Trust, WTC reported that the NMM Trust had no
taxable income from Pennsylvania sources and had a net Pennsylvania taxable
income of zero. (Stip. ¶¶ 41-42.) As fiduciary of the MVM Trust, WTC reported
that the MVM Trust had taxable income from Pennsylvania sources in the amount
of $1,349,817.00; however, no portion of that $1,349,817.00 was, in fact, derived
from Pennsylvania sources. (Stip. ¶¶ 72-74.) The MVM Trust reported the taxable
income because the tax preparation software required it to report taxable income
from Pennsylvania sources in order to report the distribution of $1,400,000.00.
(Stip. ¶ 75.) The MVM Trust claimed a deduction in the amount of $1,349,817.00
with respect to the distribution and reported its net Pennsylvania taxable income of
zero. (Stip. ¶ 76.)
II. Procedural History
On June 23, 2009 and May 21, 2010 the Department issued Notices of
Assessments for the 2007 Tax Year (TY) in the amounts of $232,164.00 and
$276,263.00, including underpayment, interest, and penalties against the NMM
Trust and MVM Trust, respectively, based on all of the Trusts’ 2007 reported
income. (NMM Trust Notice of Assessment, Ex. 6; MVM Trust Notice of
Assessment, Ex. 10.) The Trusts filed Petitions for Reassessment with the Board
of Appeals, which denied reassessment. (NMM Board of Appeals Decision, Ex. 7;
MVM Board of Appeals Decision, Ex. 11.) The Trusts then appealed to the Board
of Finance and Revenue (Board), arguing that they were non-resident trusts with
no taxable income, no assets, and no trustees in Pennsylvania. Rather, the Trusts
5
argued that they were Delaware resident trusts administered in Delaware and that
the imposition of PIT violates the Due Process and Commerce Clauses of the U.S.
Constitution. (Board NMM Op. at 2, Ex. 8; Board MVM Op. at 2, Ex. 12.) In its
appeal, the MVM Trust also relied on Department Ruling No. PIT-01-040 (Ruling
01-040), to support its argument that it was a non-resident trust and asserted that,
in addition to the Due Process and Commerce Clauses of the U.S. Constitution,
imposing the PIT also violated the Uniformity Clause of the Pennsylvania
Constitution and the Equal Protection Clause of the U.S. Constitution. (Board
MVM Op. at 2, Ex. 12.) In addition to reassessment, the Trusts requested that the
Board abate the assessed penalties and interest.
The Board did not rule on the Trusts’ constitutional claims and held that,
pursuant to Sections 301(s) (defining resident trusts) and 302(a) (indicating that all
resident trusts are subject to a tax) of the Tax Code7 and the Department’s
regulations, the Trusts were resident trusts because Settlor was a Pennsylvania
resident when he created the Trusts and, as such, are subject to PIT. (Board NMM
Op. at 4-5, Ex. 8; Board MVM Op. at 5-6, Ex. 12.) With regard to Ruling 01-040,
the Board noted that such rulings were not binding on the Department or the Board
and that, even if Ruling 01-040 applied, it could only be relied upon for five years,
a period that expired on July 27, 2006. The Board did strike the underpayment and
estimated underpayment of penalties, but upheld the imposition of interest. (Board
7 72 P.S. §§ 7301(s), 7302(a). Section 301 was added by Section 4 of the Act of August
31, 1971, P.L. 362, as amended. Section 302 was added by Section 8 of the Act of August 4,
1991, P.L. 97, as amended.
6
NMM Op. at 6, Ex. 8; Board MVM Op. at 6, Ex. 12.) The Trusts petitioned this
Court for review, and our Court consolidated the Trusts’ appeals.8
III. Taxing Trusts in Pennsylvania
We begin by reviewing the relevant statutory and regulatory provisions that
apply to the taxation of trusts in Pennsylvania. Section 302(a) of the Tax Code
provides that: “Every resident . . . trust shall be subject to, and shall pay for the
privilege of receiving . . . income . . . a tax upon each dollar of income received by
that resident during that resident’s taxable year . . . .” 72 P.S. § 7302(a). Section
301(s)(2) defines “resident trust” as including “[a]ny trust created by . . . a person
who at the time of such creation . . . was a resident.” 72 P.S. § 7301(s)(2). The
Department’s regulations explain:
The single controlling factor in determining if a trust is a resident trust for purposes of this article shall be whether the decedent, the person creating the trust or the person transferring the property was a resident individual or person at the time of death, creation of the trust or the transfer of the property. The residence of the fiduciary and the beneficiaries of the trust shall be immaterial. A resident trust shall be one of the following:
(i) A trust created by the will of an individual who at the time of his death was a resident individual.
(ii) A trust created by a person who at the time of the creation was a resident.
8 “This Court is entitled to the broadest scope of review when considering the propriety
of an order of the Board of Finance and Revenue because, although we hear such cases in our
appellate jurisdiction, we function essentially as a trial court.” Senex Explosives, Inc. v.
Commonwealth, 58 A.3d 131, 135 n.3 (Pa. Cmwlth. 2012). In reviewing constitutional
questions, an appellate court’s standard of review is de novo and our scope of review is plenary.
City of Philadelphia v. Fraternal Order of Police Lodge No. 5 (Breary), 604 Pa. 267, 283 n.13,
985 A.2d 1259, 1269 n.13 (2009).
7
61 Pa. Code § 101.1. Section 305 of the Tax Code,9 states:
The income of a beneficiary of [a] . . . trust in respect of such . . . trust shall consist of that part of the income or gains received by the . . . trust for its taxable year ending within or with the beneficiary’s taxable year which, under the governing instrument and applicable State law, is required to be distributed currently or is in fact paid or credited to said beneficiary. The income or gains of the . . . trust, if any, taxable to such . . . trust shall consist of the income or gains received by it which has not been distributed or credited to its beneficiaries.
72 P.S. § 7305. Section 314 of the Tax Code10
provides, in relevant part, a credit
“against the tax otherwise due under this article for the amount of any income
tax . . . on him . . . by another state with respect to income which is also subject to
tax under this article,” but such credit “shall not exceed the proportion of the tax
otherwise due under this article that the amount of the taxpayer’s income subject to
tax by the other jurisdiction bears to his entire taxable income.” 72 P.S. § 7314.
With these principles in mind, we turn to the issues presently before this Court.
IV. Trusts’ Challenges to the PIT
a. Ruling 01-040
The Trusts first argue that imposing the PIT on all of the Trusts’ income is
arbitrary, capricious, and contrary to Ruling 01-040, in which the Department
opined that a resident testamentary trust, with no Pennsylvania income or
administration, may change its situs to outside Pennsylvania if it obtains an
Orphan’s Court order approving that change, thereby avoiding the imposition of
the PIT. The Trusts assert that the Department should not treat an inter vivos trust
9 Section 305 was added by Section 4 of the Act of August 31, 1971, P.L. 362.
10
Section 314 was added by Section 4 of the Act of August 31, 1971, P.L. 362.
8
whose situs is outside Pennsylvania pursuant to the trust instrument11 differently
than a testamentary trust that changes its situs pursuant to an Orphan’s Court order
under Ruling 01-040. To do so, according to the Trusts, is arbitrary and
capricious.
The Department’s regulation at 61 Pa. Code § 3.3 provides that Department
rulings, such as Ruling 01-040: may only be relied upon by the taxpayer who
requested the ruling, these rulings expire after five years, and are based on the
specific factual situations of the request. The Trusts were not parties to Ruling 01-
040, Ruling 01-040 expired five months before the 2007 TY, and there are factual
differences between these two cases; specifically, Ruling 01-040 was based on the
assumption that none of the testamentary trust’s beneficiaries were located in
Pennsylvania and the Trusts’ discretionary beneficiaries are all located in
Pennsylvania. (Ruling 01-040.) Therefore, the Trusts’ reliance on Ruling 01-040
is misplaced, and this is not a basis upon which we will reverse the Board’s Orders.
Having concluded that the non-constitutional issue raised is not a basis upon
which we will reverse the Board’s Orders, we now turn to the Trusts’ assertions
that the Department’s imposition of the PIT to all of the Trusts’ 2007 income
11
Specifically, the Trusts assert that Section 7708(a) of the Pennsylvania Probate, Estates
and Fiduciaries Code (PEF Code), 20 Pa. C.S. § 7708(a), provides, in relevant part, that in both
types of trusts, the “provisions of a trust instrument designating the situs of the trust are valid and
controlling if: (1) a trustee’s principal place of business is located in or a trustee is a resident of a
designated jurisdiction; [or] (2) all or part of the trust administration occurs in the designated
jurisdiction.” Id. Accordingly, the Trusts argue that the Trusts’ Agreements, which designate
Delaware as the Trusts’ situs, are valid and controlling because the Trusts’ principal place of
business and their administration is in Delaware.
9
violates the Pennsylvania Constitution and/or U.S. Constitution.12 The Trusts bear
a heavy burden of rebutting the presumption that the Tax Code is constitutional
“by a clear, palpable, and plain demonstration that the statute violates a
constitutional provision.” James v. Southeastern Pennsylvania Transportation
Authority, 505 Pa. 137, 142, 477 A.2d 1302, 1304 (1984). In taxation matters, the
burden is particularly heavy because “[w]here an important governmental interest
such as collecting revenue exists, private property rights must yield to
governmental need.” Bureau of Corporation Taxes v. Marros, 431 A.2d 392, 393
(Pa. Cmwlth. 1981).
b. U.S. Constitution – The Commerce Clause
We first consider whether the Department’s imposition of the PIT on all of
the Trusts’ income violates the Commerce Clause of the U.S. Constitution. Article
I, Section 8, Clause 3 of the U.S. Constitution provides: “The Congress shall have
Power . . . [t]o regulate Commerce . . . among the several States.” U.S. Const. art.
I, § 8, cl. 3. Commerce Clause cases are governed by Complete Auto Transit, Inc.
v. Brady, 430 U.S. 274 (1977), in which the U.S. Supreme Court established a four
prong test to determine whether a state tax withstands constitutional scrutiny.
Those four prongs are: (1) the taxpayer must have a substantial nexus to the taxing
jurisdiction; (2) the tax must be fairly apportioned; (3) the tax being imposed upon
the taxpayer must be fairly related to the benefits being conferred by the taxing
jurisdiction; and (4) the tax may not discriminate against interstate commerce. Id.
12
“It is well settled that when a case raises both constitutional and non-constitutional
issues, a court should not reach the constitutional issue if the case can properly be decided on
non-constitutional grounds.” Ballou v. State Ethics Commission, 496 Pa. 127, 129, 436 A.2d
186, 187 (1981).
10
at 279. To pass constitutional muster, all four prongs must be satisfied and the
failure to meet any one of these requirements renders the tax unconstitutional. Id.
The Trusts contend that the imposition of the PIT here does not satisfy prongs (1),
(2), and (3).
1. Substantial Nexus
In Quill Corporation v. North Dakota, 504 U.S. 298 (1992), the U.S.
Supreme Court articulated the standard for establishing the substantial nexus prong
of the Complete Auto test – physical presence within the taxing state. In Quill,
North Dakota filed an action to require the Quill Corporation (Quill) to collect and
pay a use tax on goods purchased for use in that state.13 Id. at 301. Quill was an
out-of-state mail-order business with no outlets, employees, or tangible property in
North Dakota, its products were delivered via common carrier, and its business in
North Dakota accounted for only $1 million of Quill’s $200 million annual sales
nationally. Id. at 301-02. Quill argued that the imposition of the tax violated the
Due Process Clause of the Fourteenth Amendment and/or the Commerce Clause by
creating an unconstitutional burden on interstate commerce. Id. at 301, 303. The
state trial court agreed with Quill, but the North Dakota Supreme Court reversed.
Id. at 303-04. Quill appealed to the U.S. Supreme Court, which reversed, in part,
13
The North Dakota “use tax” is a “corollary to its sales tax,” is imposed “upon property
purchased for storage, use, or consumption with the State,” and “every ‘retailer maintaining a
place of business in’ the State [is required] to collect the tax from the consumer and remit it to
the State.” Quill, 504 U.S. at 302 (quoting N.D. Cent. Code § 57-40.2-07). North Dakota
defined retailer “to include ‘every person who engages in regular or systematic solicitation of a
consumer market in th[e] state’” and “‘regular systematic solicitation’ to mean three or more
advertisements within a 12-month period.” Id. at 302-03 (quoting N.D. Cent. Code § 57-40.2-
01(6) and N.D. Admin. Code § 81-04.1-01-03.1).
11
finding that the imposition of the use tax violated the Commerce Clause.14 Id. at
318-19. Noting that the Commerce Clause contains both an affirmative grant of
power and a “negative sweep” that “‘by its own force’ prohibits certain state
actions that interfere with interstate commerce,” the U.S. Supreme Court applied
the “negative” or “dormant” Commerce Clause standard to limit North Dakota’s
ability to tax Quill where it lacked the necessary physical presence to establish a
substantial nexus between Quill and North Dakota. Quill, 504 U.S. at 309-19
(quoting South Carolina State Highway Department v. Barnwell Brothers, Inc.,
303 U.S. 177, 185 (1938)).
In considering whether the Trusts are subject to the PIT in regards to all of
their income, we are mindful that we are reviewing the presence that the Trusts, as
the taxpayers, have within Pennsylvania. The Trusts argue that they do not have
the required physical presence in Pennsylvania under Quill. They assert that the
Trusts only presence in Pennsylvania was Settlor’s status as a resident in 1959
when he created the Trusts and the residences of the Trusts’ discretionary
beneficiaries, neither of which provides the necessary substantial nexus with
Pennsylvania for the Trusts to be subject to the PIT on all of their income. The
Trusts point out that, in creating the Trusts, Settlor retained no continuing control
or power of appointment over the Trusts’ property and the in-state beneficiaries are
discretionary and have no current or future right to the Trusts’ income or assets.
14
The U.S. Supreme Court did not find a violation of the Due Process Clause, but noted
that “while a State may, consistent with the Due Process Clause, have the authority to tax a
particular taxpayer, imposition of the tax may nonetheless violate the Commerce Clause” and
that the “minimum contacts” standard applied in Due Process Clause cases is not the same as the
“substantial nexus” standard applied to inquiries under the Commerce Clause. Id. at 305, 312.
12
The Trusts contend that its presence in Pennsylvania is even more attenuated than
Quill’s presence was in North Dakota.
The Commonwealth of Pennsylvania (Commonwealth), in contrast,
maintains that these contacts are sufficient to create the requisite physical presence
to establish a substantial nexus between the Trusts and Pennsylvania pursuant to
Quill. The Commonwealth asserts that this matter is similar to Chase Manhattan
Bank v. Gavin, 733 A.2d 782 (Conn. 1999), in which the Supreme Court of
Connecticut examined the state’s taxation of the undistributed income of an inter
vivos trust similar to Trusts here, as well as testamentary trusts. All of the trusts
were resident trusts based on the residency of the settlor at the time the trusts were
created, but all of the trusts’ assets were located outside of Connecticut and were
administered by out-of-state entities and trustees. Id. at 787, 790. Pursuant to the
terms of the inter vivos trust, the trust’s beneficiary would receive the trust
property when she turned forty-eight or it would go to her living descendants if she
died before she reached forty-eight. Id. at 788. Additionally, the inter vivos trust
was required to distribute all of its income to the beneficiary in quarterly
installments. Id. at 788 n.8. The Connecticut Supreme Court concluded that the
state tax did not violate the Commerce Clause because there was only a “remote
and speculative” risk of systematic, multiple taxation or that the taxing scheme
would cause discrimination against out-of-state trustees by providing an incentive
to choose in-state trustees that would result in a dormant Commerce Clause
violation. Id. at 805. The Connecticut Supreme Court pointed out that the plaintiff
did not assert any particular argument regarding the four requirements set forth in
13
Complete Auto and, therefore, it did not address those requirements in rendering
its opinion. Id.15
After reviewing Quill, Chase Manhattan, and the relevant statutory and
regulatory provisions governing this matter, we agree with the Trusts that they lack
the necessary physical presence in Pennsylvania to establish a substantial nexus
between the Trusts and Pennsylvania. The Trusts have two contacts with
Pennsylvania: 1) the residency of the Trusts’ discretionary beneficiaries; and 2)
the residency of Settlor in 1959, neither of which, we conclude, establishes the
necessary substantial nexus required to meet the first prong of the Complete Auto
test.
First, we question the Commonwealth’s reliance on the discretionary
beneficiaries’ residences in light of the Department’s own regulations, which
specifically state that, for residency purposes of a trust, “[t]he residence of . . . the
beneficiaries of the trust shall be immaterial.” 61 Pa. Code § 101.1 (emphasis
added). This Court is unpersuaded by the Commonwealth’s assertion that a factor
that is considered to be legally immaterial for determining whether a trust is
subject to the PIT as a resident trust under Section 302(a) of the Tax Code provides
the necessary support for the Commonwealth’s position that it can tax the Trusts
without violating the Commerce Clause.
15
The Connecticut Supreme Court also held that the state’s taxation of the undistributed
income of the inter vivos trust did not violate the Due Process Clause because the sole, non-
contingent beneficiary was domiciled in the state, would eventually receive all of the
accumulated income, and her rights were protected by Connecticut’s laws. Chase Manhattan,
733 A.2d at 790, 802-03. Accordingly, the Connecticut Supreme Court concluded that this
established the minimum contacts necessary to satisfy the Due Process Clause. Id. at 802-03.
14
More importantly, the beneficiaries’ status in Pennsylvania is similar to that
of Quill’s customers, who resided in North Dakota and whose purchases of Quill’s
products were the trigger for the tax imposed in Quill. In finding the state tax
unconstitutional in Quill, the U.S. Supreme Court focused on whether the presence
of Quill, as the taxpayer, in North Dakota was sufficient, and not on the fact that
there were North Dakota citizens participating and benefiting from Quill’s sale of
products in North Dakota. Our focus here, likewise, must be on whether the
Trusts’ presence in Pennsylvania is sufficient, and not on the fact that there are
discretionary beneficiaries who are Pennsylvania residents and who may, at some
time in the future, benefit from the existence of the Trusts.
Finally, the inter vivos trust in Chase Manhattan had a single, non-
discretionary beneficiary to whom the trust was required to pay any accumulated
income in quarterly installments and to whom the trust property would be
distributed when the beneficiary turned forty-eight. That trust is distinguishable
from this case, where the Trusts’ beneficiaries are discretionary, the Trusts have no
obligation to pay any distributions to the beneficiaries, and the present
beneficiaries have no current or future right to the income or assets of the Trusts.
In fact, the Trusts have no obligation to make any distribution until “20 years and
11 months after the death of the last survivor of Nancy and all my lineal
descendants living at the time of creation of this trust,” (NMM Trust Agreement at
3), or until “20 years and 11 months after the death of the last survivor of all my
lineal descendants living at the time of creation of this trust,” (MVM Trust
Agreement at 3). Additionally, the Connecticut Supreme Court did not address
any of the Complete Auto factors in making its determination. Therefore, the
15
residency of the discretionary beneficiaries in Pennsylvania does not provide the
physical presence of the Trusts necessary to establish a substantial nexus here.
Second, we conclude that Settlor’s residency in Pennsylvania when he
created the Trusts in 1959 does not provide the physical presence necessary to
establish a substantial nexus. Settlor did reside in Pennsylvania when he
established the Trusts in 1959; however, he chose to have the Trusts governed by
Delaware law, established the administration of the Trusts in Delaware, and did not
reserve in himself any continuing control or power of appointment over the Trusts’
property. (NMM Trust Agreement at 11-12; MVM Trust Agreement at 11.) The
U.S. Supreme Court, in Quill, rejected a “slightest presence” standard to establish a
substantial nexus. Quill, 504 U.S. at 315 n.8 (holding that while Quill’s licensing
of software to some of its North Dakota clients and its title to “a few floppy
diskettes” in the state might create a “minimal nexus” it did not meet the
“substantial nexus” requirement of the Commerce Clause) (citations omitted). We
hold that to rely on Settlor’s residence in Pennsylvania approximately forty-eight
years before the TY in question to establish the Trusts’ physical presence in
Pennsylvania in 2007 would be the equivalent of applying the slightest presence
standard rejected by the U.S. Supreme Court in Quill.
For these reasons, we hold that neither Settlor’s residency nor the residency
of the beneficiaries provides the Trusts with the requisite presence in Pennsylvania
to establish a substantial nexus and, therefore, the first prong of Complete Auto is
not met and the imposition of the PIT here violates the Commerce Clause of the
U.S. Constitution. Complete Auto, 430 U.S. at 279 (requiring all four prongs to be
16
satisfied for a statute to withstand constitutional scrutiny). Although we conclude
that the substantial nexus prong of the Complete Auto test has not been met and,
therefore, the imposition of the PIT on all of the Trusts’ income violates the
Commerce Clause, id., we will nevertheless address the remaining Complete Auto
prongs the Trusts challenge.
2. Fair Apportionment
To satisfy the fair apportionment prong of the Complete Auto test, a tax
must be both internally and externally consistent. Goldberg v. Sweet, 488 U.S.
252, 261-62 (1989). To be internally consistent, the tax must be structured so that,
if every taxing jurisdiction were to apply the identical tax, the taxpayer would not
be subject to double taxation. Philadelphia Eagles Football Club, Inc. v. City of
Philadelphia, 573 Pa. 189, 225, 823 A.2d 108, 131 (2003). The external
consistency test asks whether a state taxed only that “portion of the revenues from
the interstate activity which reasonably reflects the intrastate component of the
activity being taxed.” Goldberg, 488 U.S. at 262. External consistency examines
the economic justification for the taxing authority’s claim upon the value being
taxed to determine whether the jurisdiction is taxing economic activity that occurs
in other jurisdictions and “there must be a ‘rational relationship between the
income attributed to the [s]tate and the intrastate values’ of the business being
taxed.” Philadelphia Eagles, 573 Pa. at 226, 823 A.2d at 131 (quoting Hunt-
Wesson, Inc. v. Franchise Tax Board of California, 528 U.S. 458, 464 (2000))
(alteration in original). Our Supreme Court has held that a taxpayer will
successfully challenge a tax where the income attributed to the state is either: (1)
out of all appropriate proportion to the business transacted by the taxpayer in the
17
state; or (2) inherently arbitrary or produces an unreasonable result. Id. at 227, 823
A.2d at 132.
The Trusts contend that, given the minimal amount of contacts and presence
they have with Pennsylvania, the application of the PIT to all of their income does
not satisfy the fair apportionment prong because such application is out of
proportion to the Trusts’ activities in Pennsylvania. In other words, the Trusts
contend that the imposition of the PIT to all of their income results in external
inconsistency. The Commonwealth responds, inter alia, that the imposition of the
PIT is not out of appropriate proportion to the business the Trusts transact in
Pennsylvania and would not be a grossly distorted result because Delaware
chooses not to tax the Trusts.
In Philadelphia Eagles, the City of Philadelphia attempted to assess a
Business Privilege Tax (BPT) against the Philadelphia Eagles Football Club, Inc.
(Football Club), which is domiciled in Philadelphia, based on 100% of the Football
Club’s media receipts. Philadelphia Eagles, 573 Pa. at 220-21, 226, 823 A.2d at
128, 131. The Football Club challenged the assessment, asserting, inter alia, that
imposing the BPT upon all of its media receipts violated the external consistency
test by taxing business activity that occurred outside of the taxing jurisdiction. Id.
at 225, 823 A.2d at 131. After reviewing the case law from the U.S. Supreme
Court on external consistency, the Pennsylvania Supreme Court held that the
Football Club had shown, by clear and cogent evidence, that the imposition of the
PBT on 100% of the media receipts, when the Football Club’s games were telecast
from venues outside of Philadelphia, “was inherently arbitrary and had no rational
18
relationship to the Football Club’s business activity that occurred in Philadelphia.”
Id. at 227, 823 A.2d at 132 (emphasis in original). Our Supreme Court explained
that, “[b]y imposing the BPT on 100% of the media receipts when only 50% of the
receipts were generated from games played in and broadcast from Philadelphia, the
City actually doubled the Football Club’s tax assessment on the media receipts,”
which the Supreme Court held was “plainly ‘out of all proportion’ to the Football
Club’s business activities in Philadelphia that generated the payment of media
receipts.” Id. at 227-28, 823 A.2d at 132 (quoting Hans Rees’ Sons, Inc. v. North
Carolina, 283 U.S. 123, 135 (1931)) (emphasis omitted).
The facts here present an even clearer case of external inconsistency than
those in Philadelphia Eagles. While the Football Club in Philadelphia Eagles
obtained some income from media receipts in the taxing jurisdiction, thereby
justifying the assessment of the PBT on a portion of the receipts, the City of
Philadelphia could not tax the Football Club’s entire income obtained from all of
the receipts without violating the Commerce Clause. Here, the parties stipulated
that, for TY 2007, the Trusts did not derive any income from Pennsylvania and did
not have any assets or interests in Pennsylvania. (Stip. ¶¶ 31-33, 39-40, 61-64, 70-
71.) They further stipulated that neither WTC nor the general trustees have any
presence in Pennsylvania and all of the Trusts’ books and records are maintained in
Delaware.16 (Stip. ¶¶ 22-30, 34, 58-65.) Notwithstanding the lack of Pennsylvania
income, assets, or presence, the Department sought to impose the PIT on all of the
16
We note that there was one “transaction” that occurred in Pennsylvania in 2007, which
was the discretionary distribution the MVM Trust made, (Stip. ¶¶ 68-69), on which the
discretionary beneficiary would have paid PIT on the distribution she received pursuant to
Sections 302 and 305 of the Tax Code, 72 P.S. §§ 7302, 7305.
19
Trusts’ income. We conclude, like the Supreme Court concluded in Philadelphia
Eagles, that the imposition of the PIT on all of the Trusts’ income is “plainly ‘out
of all proportion’ to the [Trusts’] business activities in [Pennsylvania] that
generated the payment of [the income].” Philadelphia Eagles, 573 Pa. at 228, 823
A.2d at 132 (quoting Hans Rees’ Sons, Inc., 283 U.S. at 135).
Thus, the imposition of the PIT on the Trusts’ income, when all of that
income was derived from sources outside of Pennsylvania, is “inherently arbitrary
and ha[s] no rational relationship to the [Trusts’] business activity that occurred in
[Pennsylvania].” Id. at 227, 823 A.2d at 132. Accordingly, the imposition of the
PIT here does not satisfy the fair apportionment prong of Complete Auto.
3. Fairly Related
Taxes are fairly related to the services a state provides where the taxpayer
benefits directly or indirectly from the state’s protections, opportunities, and
services. Erieview Cartage, Inc. v. Commonwealth, 654 A.2d 276, 279 (Pa.
Cmwlth. 1995). These services include: access to the state’s economic markets;
the benefits and protections of the state’s courts, laws and law enforcement; use of
the state’s roadways and bridges; and “police and fire protection, the benefit of a
trained work force, and ‘the advantages of a civilized society.’” Exxon
Corporation v. Wisconsin Department of Revenue, 447 U.S. 207, 228 (1980)
(quoting Japan Line, Ltd. v. County of Los Angeles, 441 U.S. 434, 445 (1979)).
See also Erieview Cartage, 654 A.2d at 279; Transcontinental Gas Pipe Line
Corporation v. Commonwealth, 620 A.2d 614, 620 (Pa. Cmwlth. 1993).
20
The Trusts argue that the imposition of the PIT to all of the Trusts’ income
does not bear a reasonable relationship to the benefits Pennsylvania confers upon
the Trusts. The Trusts assert that neither they nor their trustees benefit from any of
the services cited in Exxon Corporation or Erieview Cartage and, consequently, the
imposition of the PIT on all of the Trusts’ income does not satisfy the fairly related
prong of Complete Auto. The Commonwealth focuses on the benefits
Pennsylvania provided Settlor and refers to the discretionary beneficiaries to
support its contention that the imposition of the PIT to all of the Trusts’ income
does not violate this prong. It states that Pennsylvania provided all of the benefits
of a civilized society to Settlor and to the Trusts’ discretionary beneficiaries to live,
work and exist and that the Trusts exist to pay income to the discretionary
beneficiaries, who benefit from Pennsylvania’s societal and legal framework.
In Erieview Cartage, this Court held that the imposition of the corporate net
income tax was fairly related to the services Pennsylvania provided the taxpayer, a
trucking company incorporated in Delaware and headquartered in Ohio, but who
transported property through Pennsylvania, delivered property in Pennsylvania,
and picked up property in Pennsylvania for out-of-state delivery. Erieview
Cartage, 654 A.2d at 277, 279. This Court concluded that the taxpayer availed
itself not only of Pennsylvania’s roadways and bridges, but also to its economic
market. Id. at 279. Similarly, in Quality Markets, Inc. v. Commonwealth, 514
A.2d 228, 232-33 (Pa. Cmwlth. 1986), we held that the imposition of a corporate
net income tax was fairly related to the services the taxpayer, which had eight
stores located in the Pennsylvania, received in the form of a trained work force,
police, and fire protection.
21
In 2007, the Trusts had no physical presence in Pennsylvania, none of their
income was derived from Pennsylvania sources, none of their assets or interests
were located in Pennsylvania, and they were established under and were governed
by Delaware law. (Stip. ¶¶ 31-33, 39-40, 61-64, 70-71; NMM Trust Agreement at
11; MVM Trust Agreement at 11.) Hence, unlike the taxpayers in Erieview
Cartage and Quality Markets, the Trusts do not benefit from Pennsylvania’s
roadways, bridges, police, fire protection, economic markets, access to its trained
workforce, courts, and laws. We recognize that the Trusts’ discretionary
beneficiaries almost certainly benefit from Pennsylvania’s societal and legal
framework because they reside in Pennsylvania; however, they are not the taxpayer
in this matter and, importantly, as discretionary beneficiaries, they have no present
or future right to distributions from the Trusts. Moreover, pursuant to Sections 302
and 305 the Tax Code, 72 P.S. §§ 7302 and 7305, the beneficiaries will pay PIT on
any distributions they do receive from the Trusts, which are fairly related to the
benefits they receive from residing in Pennsylvania. Similarly, Settlor, who was
deceased in TY 2007, is not the taxpayer in this matter.
Thus, the Department’s imposition of the PIT on the Trusts’ entire income is
not reasonably related to the benefits Pennsylvania provides the Trusts. Therefore,
the Commonwealth’s imposition of the PIT here does not satisfy the fairly related
prong of Complete Auto.
V. Conclusion
For the foregoing reasons, we conclude that the imposition of the PIT on the
Trusts’ income for TY 2007 does not satisfy the test set forth by the U.S. Supreme
22
Court in Complete Auto and, therefore, violates the Commerce Clause of the U.S.
Constitution.17 Accordingly, we reverse the Board’s Orders.
________________________________
RENÉE COHN JUBELIRER, Judge
17
Because we conclude that the PIT imposed here violates the Commerce Clause, we
need not address whether it also violated the Due Process and Equal Protection Clauses of the
U.S. Constitution or the Uniformity Clause of the Pennsylvania Constitution.
IN THE COMMONWEALTH COURT OF PENNSYLVANIA
Robert L. McNeil, Jr. Trust for : Nancy M. McNeil, et al., : : Petitioner : : v. : No. 651 F.R. 2010 : Commonwealth of Pennsylvania, : : Respondent : Levine R L JRV MCN Levine, : a/k/a Robert L. McNeil, Jr. Trust : for Mary Victoria McNeil, et al., : : Petitioners : : v. : No. 173 F.R. 2011 : Commonwealth of Pennsylvania, : : Respondent :
O R D E R
NOW, May 24, 2013, the Orders of the Board of Finance and Revenue in the
above-captioned matter are hereby REVERSED. The Chief Clerk is directed to
enter judgment in favor of the Petitioners if exceptions are not filed within 30 days
pursuant to Pa. R.A.P. 1571(i).
________________________________
RENÉE COHN JUBELIRER, Judge
Increase to New York Estate Tax Exemption AmountBefore April 1, each resident of New York had a $1 million exemption from New York estate tax. From that point forward, the budget increases the exemption by approximately $1 million per year, to $5.25 million by 2019. Thereafter, the exemption will be indexed for inflation from 2010, and thus brought in line with the federal exemption beginning on January 1, 2019. The top New York estate tax rate remains 16%.
The benefit of this increased exemption, however, does not apply to estates that exceed the exemption amount by more than 5%. This means that the increase will benefit only those dying with taxable estates that do not exceed 105% of the New York exemption amount. Wealthy New Yorkers dying with estates above this amount will end up paying the same amount of tax they would have paid under the prior rules.
ExampleAssume a New Yorker passed away on April 2, 2014 with a taxable estate of $2,062,500. Since that amount equals New York’s exemption amount
at that time, no New York estate tax will be due. If
that same New Yorker passed away with a taxable
estate of $2.2 million (an amount 5% greater than
the New York exemption then), the tax would be
a full $114,800.
Inclusion of Certain Gifts Made Within Three Years of
Death in the New York Taxable Estate
For a person who dies as a resident of New York,
the budget requires that gifts made on or after April
1, 2014, and before January 1, 2019, be included
in the decedent’s taxable estate if he or she was a
resident of New York at the time of the gift and
died within three years of making the gift. Similar
rules apply to a non-resident decedent who, while
living in New York, made gifts of New York situs
property (i.e., real or tangible personal property
located in New York or intangible personal
property used in a business, trade, or profession
carried on in New York). Annual exclusion gifts
should be excluded from this provision.
Peter Slater, Fiduciary Counsel
On March 31, New York Governor Andrew Cuomo signed into law the New York State 2014-2015 Budget, which contains the following important changes to the taxation of New York estates, gifts, and the income of certain trusts:
• Increasing the New York estate tax exemption over the next few years, from $1 million to $5.25 million by 2019, and then effectively linking that exemption amount to the federal exemption thereafter;
• Including in a decedent’s New York taxable estate certain gifts made within three years of death;
• Changing the income tax treatment of “exempt New York resident trusts” and so-called “incomplete gift non-grantor trusts” (also known as DING or NING trusts); and
• Repealing the New York generation-skipping transfer (GST) tax.
April 28, 2014
Estate Planning UpdateChanges to the Taxation of New York Estates, Gifts, and the Income of Certain Trusts
Estate Planning Update: Changes to the Taxation of New York Estates, Gifts, and the Income of Certain Trusts
2
Income Tax Treatment of “Exempt New York Resident
Trusts” and so-called “Incomplete Gift Non-Grantor Trusts”
Exempt New York Resident Trusts
Trusts set up by New York residents (New York Resident Trusts) are generally subject to New York State income tax. However, this doesn’t apply to New York Resident Trusts that have no New York trustees, no New York tangible property or real estate, and no New York source income (Exempt New York Resident Trusts).
Under the new budget, distributions of accumulated income made after December 31, 2014 to New York resident beneficiaries of Exempt New York Resident Trusts will be taxable to the New York recipient. Accumulated income for these purposes will not include income that is accumulated either a) before January 1, 2014 or b) before the beneficiary first became a New York resident. Capital gains are not typically considered income for these purposes. These provisions also apply to the New York City personal income tax.
Incomplete Gift Non-Grantor Trusts
An “Incomplete Gift Non-Grantor Trust” is a trust typically formed in a state with no state income tax, such as Delaware or Nevada, for the benefit of the grantor and possibly other persons. As the name implies, the trust is structured so that a transfer of assets into the trust is not considered a completed gift by the grantor and thus does not trigger gift tax when made. The trust is also structured to be a separate taxpayer for income tax purposes, a so-called “non-grantor trust.” Such trusts are typically used to avoid state income tax.
Under the budget, such trusts created by New York residents are deemed to be “grantor trusts” for New York purposes. This means any income received by the trust is deemed to flow through to the grantor and be subject to New York State income tax by the grantor. This provision is effective for income earned on or after January 1, 2014, but does not apply to trusts liquidated before June 1, 2014. These provisions also apply to the New York City personal income tax.
Repeal of the GST Tax
The budget repealed New York’s generation-skipping transfer tax for estates of those dying on or after April 1, 2014. The New York GST tax had applied to taxable distributions and taxable terminations from a trust to a skip person (i.e., a person two generations or more removed from the trust’s grantor) if the trust included New York property.
Planning Tips• Reduce taxable estates so they don’t exceed the New
York exemption by more than 5%. Wealthy married couples may be able to retain the benefit of the increased New York exemption amount by reducing the taxable estate of the first spouse to die so that it does not exceed the New York exemption amount by more than 5%. For example, assume a decedent spouse leaves all of his assets to his surviving spouse except for an amount equal to the New York exemption amount, which instead goes into a trust for the benefit of his spouse and children. Because the outright bequest to the surviving spouse reduces the decedent spouse’s taxable estate by virtue of the marital deduction, the net taxable estate would not exceed the New York exemption amount by more than 5%. Therefore, the beneficiaries can benefit from the increased New York exemption amount, with assets transferred into the trust free of New York estate tax.
• Postpone certain distributions. Since New York only taxes net accumulated income at the time of its receipt by New York resident beneficiaries, trustees of exempt resident trusts should consider postponing distributions of accumulated income to New York resident beneficiaries into future years to defer the tax on such distributions.
• Consider liquidating “Incomplete Gift Non-Grantor
Trusts” before June. Trustees of “incomplete gift non-grantor trusts” should consider liquidating such trusts before June 1, 2014 to avoid the complication of having the trust be considered a grantor trust for New York purposes and a non-grantor trust for federal purposes.
Estate Planning Update: Changes to the Taxation of New York Estates, Gifts, and the Income of Certain Trusts
Recent Insights
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• Revisit your current estate plan. If you have a New York taxable estate that is likely to exceed the increased New York exclusion amount, consider revisiting your current estate plan to review the impact of these reforms on your plan.
If you have any questions or concerns about how the new law might affect you or your family, please feel free to contact your Bessemer Trust Client Advisor.
This material is for your general information. This material does not constitute tax advice or take into account the particular investment objectives, financial situation, or needs of individual clients. It has been prepared based on information that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed are current as of the date noted and are subject to change without notice.
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Founded in 1907, Bessemer Trust is a privately owned wealth and investment management firm that focuses
exclusively on ultra-high-net-worth families and their foundations and endowments. We oversee $96 billion
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New Proposed Regulations Under §67(e); Expenses of Trusts and Estates That Are Subject to the “2% Floor” on Deductions (September 7, 2011) Proposed §67(e) Regulations Updated in Light of Knight Supreme Court Case; Investment Advisory Fees of Trusts/Estates Generally Are Subject to 2% Floor; Unbundling of Trustee Fees, Attorneys Fees and Accountant Fees Required; Comments Requested For Approaches to Reasonably Allocate Bundled Fees
September 2011 Steve R. Akers Bessemer Trust 300 Crescent Court, Suite 800 Dallas, Texas 75201 214-981-9407 [email protected] www.bessemer.com Copyright © Bessemer Trust Company, N.A. All rights reserved.
This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current opinions only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.
Bessemer Trust 1
Synopsis
Under §67(a), miscellaneous itemized deductions generally may be deducted only to the extent they exceed two percent of adjusted gross income. Section 67(e)(1) provides an exception for costs of estates or trusts that “would not have been incurred if the property were not held in such estate or trust.” The Supreme Court in Knight v. Commissioner interpreted §67(e)(1) to apply to expenses that are not commonly or customarily incurred by individuals. The proposed regulations regarding the application of §67(e) that were published before Knight was decided have been withdrawn (as requested by many commentators) and new proposed regulations have been issued that reflect the Supreme Court’s decision. Unfortunately, the proposed regulations offer little in the way of workable and easy-to-apply safe harbors. Highlights of the new proposed regulations include the following.
• The allocation of costs of a trust or estate that are subject to the two-percent floor is based not on whether the costs are “unique” to trusts or estates (as in the prior proposed regulations), but whether the costs “commonly or customarily would be incurred by a hypothetical individual holding the same property.”
• In making the “commonly or customarily incurred” determination, the type of product or service actually rendered controls rather than the description of the cost.
• “Commonly or customarily” incurred expenses that are subject to the two-percent floor include costs in defense of a claim against the estate that are unrelated to the existence, validity, or administration of the estate or trust.
• “Ownership costs” that apply to any owner of a property (such as condominium fees, real estate taxes, insurance premiums, etc. [other examples are listed]) are subject to the two-percent floor.
• A safe harbor is provided for tax return preparation costs. Costs of preparing estate and GST tax returns, fiduciary income tax returns, and the decedent’s final income tax return are not subject to the two-percent floor. Costs of preparing all other returns are subject to the two-percent floor.
• Investment advisory fees for trusts or estates are generally subject to the two-percent floor except for additional fees (above what is normally charged to individuals) that are attributable to “an unusual investment objective” or “the need for a specialized balancing of the interests of various parties.” However, if an investment advisor charges an extra fee to a trust or estate because of the need to balance the varying interests of current beneficiaries and remaindermen, those extra charges are subject to the two-percent floor.
• Bundled fees (such as a trustee or executor commissions, attorneys’ fees, or accountants’ fees) must be allocated between costs that are subject to the two-percent floor and those that are not.
• A safe harbor is provided in making the allocation of bundled fees. If a bundled fee is not computed on an hourly basis, only the portion of the fee that is attributable to investment advice is subject to the two-percent floor. All of the balance of the bundled fee is not subject to the two-percent floor (This exception may be overly broad as applied to attorneys’ and accountants’ fees.)
• If the recipient of the bundled fee pays a third party or assesses separate fees for purposes that would be subject to the two-percent floor, that portion of the bundled fee will be subject to the 2% floor.
• Any reasonable method may be used to allocate the bundled fees. The Preamble to the proposed regulations provides that detailed time records are not necessarily required, and the IRS requests comments for the types of methods for making a reasonable allocation, including possible factors and related substantiation that will be needed. The IRS is particularly interested in comments regarding reasonable allocation methods for determining the portion of a bundled fee that is attributable to investment advice — other than numerical (such as trusts below a certain dollar
Bessemer Trust 2
value) or percentage (such as 50% of the trustee’s fee) safe harbors, which the IRS suggests that it will not use.
Brief Background
Under §67(a) miscellaneous itemized deductions may be deducted only to the extent that they exceed 2% of adjusted gross income. Under §67(e) the same rules apply to estates and trusts, except that “the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate” are allowed in full.
In Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2nd Cir. 2006)(opinion written by Judge Sotomayor), the court held that trust investment advisory fees are subject to the 2% floor, with the unusual reasoning that the exception for trusts and estates applies only to costs that individuals “are incapable of incurring,” giving as examples, trustee fees, judicial accountings, and fiduciary income tax returns.
The IRS issued proposed regulations on July 27, 2007, about one month after the Supreme Court accepted certiorari to review Rudkin. The proposed regulations did two major things. First, they took the position that only costs that are “unique” to trusts or estates qualify for the exception (based on the “incapable of incurring” reasoning of Rudkin). Second, the proposed regulations quite surprisingly took the position that there would have to be an “unbundling” of trustee or executor fees, attorney fees or accountant fees that related only partly to activities that were unique to trusts or estates. (This position was so surprising because the Second, Fourth and Sixth Circuit Courts of Appeal had stated that trustee fees are deductible, without any suggestion that a portion of them would be nondeductible. Rudkin Testamentary Trust (2nd Cir.); Scott v. United States, 328 F.3d 132 (4th Cir. 2003); William J. O'Neill Jr. Irrevocable Trust v. Commissioner, 994 F.2d 302 (6th Cir. 1993), nonacq., 1994-2 C.B. 1. Even Rudkin, on which the proposed regulations were based, gave “trustee fees” as an example of costs that individuals are “incapable of incurring.”)
The U.S. Supreme Court affirmed the Rudkin result, under the case name Knight v. Commissioner, 522 U.S. 181 (2008). Knight held that trust investment advisory fees are generally subject to the 2% floor, but did not agree with the Second Circuit’s test. (Indeed, the Justices seemed to have fun at oral argument puzzling over how a court could reason that “would” means “could.”) The Court adopted the “unusual or uncommon” test used by the Fourth and Federal Circuits and concludes generally that “§67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur.” (emphasis added) In applying this general test to investment advisory fees, the Court observed that a trust’s investment advisory fees are often incurred to comply with the prudent investor standard, which is a standard based on “what a prudent investor with the same investment objectives handling his own affairs would do — i.e., a prudent individual investor.” In light of that “it is quite difficult to say that investment advisory fees ‘would not have been incurred’ — that is, that it would be unusual or uncommon for such fees to have been incurred — if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs.” [Observation: That seems a real reach. While the taxpayer’s attorneys were unable to locate statistical data on how many individuals hire investment advisors. It is likely that very few individuals do, on a percentage basis. Relatively few individuals hire investment advisors — as opposed to investing through mutual funds or with a commission-based broker (where the expenses are netted against income and are not subject to the §67 limitations in any event.)] In light of the Court’s reasoning, it does not seem possible for trusts to argue that individuals in the same financial situation as the trust would not commonly hire an investment advisor.
Bessemer Trust 3
The Court did acknowledge several exceptions. First, there may be an exception for some limited special circumstances. The Court recognized, as the government conceded, that “some trust-related investment advisory fees may be fully deductible ‘if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.’” (emphasis added). In addition, the court observed that
“a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.” (emphasis added).
The Court noted that the trust involved in that case had not asserted that its investment objective or its requisite balancing of competing interests was distinctive, so held that the trust’s investment advisory fees were subject to the 2% floor.
Second, the Court impliedly recognized that the IRS could provide regulatory guidance in stating “that the inquiry into what is common may not be as easy in other cases, particularly given the absence of regulatory guidance.” Advisors have hoped that regulations would provide workable practical guidance as to when investment advisory fees of trusts or estates are not subject to §67.
The Supreme Court did not discuss the unbundling requirement that had been suggested by the IRS in the proposed regulations, either in oral argument or in the Knight opinion. A concern with subjecting trustee fees or corporate trustees to the unbundling requirement is that many times there is very little difference between trustee fees and investment management fees that are charged by financial institutions, so most trustee fees might arguably be nondeductible — which seems contrary to the dictum in three circuit level cases (and no case has suggested to the contrary). This is quite unfortunate because most families do not use investment advisors (as compared to using mutual funds or commission-based brokers) but any family needing a professional trustee to make sure that all of the fiduciary duties of trustees in protecting the interests of all beneficiaries are met will have to pay a trustee fee. As a practical matter, the trustee fee is incurred only because the assets are in trust. Furthermore, a significant portion of the fee paid to professional trustees represents time spent in communicating with beneficiaries and handling the many wide-ranging administrative and fiduciary duties of trustees. To the extent that corporate trustees charge about the same for investment management fees as for trustee fees means that they in effect are undercharging for the investment advice to trusts. This is widely understood, and planners have hoped that the IRS would take a “real world” approach of generally recognizing that trustee fees are, by their nature, expenses that would not have been incurred if the property were not held in trust. In light of the difficulty of unbundling fees, planners have hoped that the IRS will be sensitive to adopting an approach that is workable and practical in the real world.
Following the issuance of the Knight case, the IRS requested comments in Notice 2008-32 regarding the position that regulations should take regarding §67(e). The IRS has received a number of comments, many taking the position that trustee fees should not be subject to the two-percent floor because of the many duties, responsibilities and services of trustees that are not required for investment management clients. Various comments provided long lists of the services required of trustees that are not required of investment managers. To the extent that trustee fees are not recognized as presumptively being fully deductible, some commentators suggested various safe harbors, such as the value of assets under management (a $3.5 million safe harbor would remove 95% of trusts from the 2% rule), or for trusts having multiple beneficiaries. Another suggestion is that in unbundling trustee fees, a certain percentage of the trustee fee (for example, 50%) might be considered fully deductible under §67(e). (This would not reduce the amount of the lost deduction in most cases [because the investment advisory fees may be considerably larger than 2% of AGI], but the entire portion of the fee that is exempted from the 2% rule would be removed as a tax preference item for AMT purposes, and the AMT implications of being a type
Bessemer Trust 4
of expense that is subject to the 2% rule are often much more important than the direct loss of deduction equal to 2% of AGI.)
The IRS received a number of comments and there were initial informal indications that the IRS might merely review those comments and then issue final regulations. Fortunately, the IRS chose to issue another round of proposed regulations and request additional comments and to hold an additional hearing in light of its approach in the newly issued proposed regulations. However, the newly issued proposed regulations do not adopt simple easy-to-apply safe harbors, but continue the approach of requiring unbundling of fees based on the “type of product or service” rendered to the trust and request more comments regarding reasonable methods of unbundling fees “other than numerical or percentage safe harbors.”
Preamble to Proposed Regulation
1. Background. Following the issuance of the Knight case, the IRS issued Notice 2008-32 to provide interim guidance providing that fiduciary fees would not have to be unbundled for any taxable years before 2008 and requesting comments “with regard to possible factors on which to base safe harbors.” Notices 2008-116 and 2010-32 provided that unbundling fiduciary fees is not required for 2009 and 2010 taxable years, and Notice 2011-37 extended the period to taxable years that begin before final regulations are issued. In response to many comments recommending that the proposed regulations be withdrawn and the new proposed regulations be issued to allow public comment, the IRS is withdrawing the prior proposed regulations and is issuing new proposed regulations.
2. Knight and Its Exception For Unusual Investment Objective or Specialized Balancing of Interests. The history of the Knight case is reviewed and the newly proposed regulations “reflect the reasoning and holding in Knight and provide guidance relating to the limited portion of the cost of investment advice that is not subject to the two-precent floor.” The IRS adopts a narrow view toward the exception in Knight for “the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer” where there is an unusual investment objective or a specialized balancing of interests of various parties.
“Thus, where the costs charged to the trust do not exceed the costs charged to an individual investor, the cost attributable to taking into account the varying interests of current beneficiaries and remaindermen is included in the usual investment advisory fees and is not the type of cost that is excluded from the two-percent floor under this narrow exception. Individual investors commonly have investment objectives that may require a balance between investing for income and investing for growth and/or a specialized approach for particular assets.”
Rather than provide any kind of safe harbor for the trustee’s special duties in balancing the interests all beneficiaries, the IRS seems to suggest that such activities do not qualify for any exception, and the IRS requests comments on the “types of incremental charges” that may be incurred by trusts and estates for these purposes as well as a “specific description and rationale” for any such charges.
3. Administrative Complexity. The Preamble acknowledges the many comments that implored the IRS to provide administratively workable guidelines and safe harbors in light of the legislative intent of §67(e):
“Many of the comments received in response to Notice 2008-32 highlighted the legislative intent of the provision imposing the two-percent floor for miscellaneous itemized deductions. The commentators noted that the intent was to simplify recordkeeping, reduce
Bessemer Trust 5
taxpayer errors, ease administrative burdens for the IRS, and reduce taxpayer errors in distinguishing between nondeductible personal expenditures and deductible miscellaneous itemized deductions. The IRS and the Treasury Department recognize the administrative difficulty of determining whether every type of cost incurred by a trust or estate is the type of cost that would be incurred commonly or customarily by individuals owning the same property.”
All of that sounds like the IRS is pointing toward providing useful and workable safe harbors to simply the application of §67(e). Despite the fact that the proposed regulation provides only one easy-to-apply safe harbor (regarding tax return preparation expenses), the IRS concludes that its proposed regulations “provide simplified rules for the application of section 67(e).”
4. Authority to Require Unbundling. Some commentators questioned the authority of the IRS to require unbundling of fiduciary commissions. Interestingly, the IRS used the Supreme Court’s exception meant to favor taxpayers by allowing full deductibility of investment advisory fees in some circumstances as a rationale to support the requirement to unbundle all fiduciary fees. Many comments objected to unbundling because of the cost and administrative difficulty of doing so, perhaps requiring expensive software to track and measure the value of the various types of services provided. The IRS response is that the proposed regulations address reducing the administrative burden because they “limit the costs that are subject to allocations” under §67(e) and allow “any reasonable method to perform such allocations.” [Observation: The limitations of costs subject to the §67 allocation in the proposed regulations are (i) that return preparation expenses for certain tax returns are excepted and (ii) for unbundled fees not computed on an hourly basis, the portion of the fee that is not attributable to investment advice is not subject to the two-percent floor [although there are exceptions to even that]. Of course, that sidesteps the difficult issue — which is determining the portion of the bundled fee that is attributable to investment advice, and no kind of safe harbor is offered for that critical issue.]
5. Methods For Making Reasonable Allocation. The IRS requests comments on the “types of methods for making a reasonable allocation, including possible factors … and … related substantiation that will be needed…” (emphasis added). The IRS is specifically “interested in methods for reasonably estimating the portion of a bundled fee that is attributable to investment advice.” For methods based in whole or in part on time devoted to investment advice, suggestions are requested “for alternatives to contemporaneous time records for specific activities that could be used to substantiate the reasonableness of the allocation.” [Observation: This is one bit of good news coming from the newly proposed regulations — that the IRS will not require time records for all trustee activities.]
6. Rejection of Easy-To-Apply Numerical or Percentage Safe Harbors. The IRS received a number of comments suggesting safe harbors for trusts below a certain value or for a percentage of the fiduciary’s fee. The IRS rejects such easy-to-apply safe harbors because (i) some trustees would not use them and (ii) they would increase complexity by requiring anti-abuse rules.
“The IRS and Treasury Department have considered comments regarding possible numerical or percentage safe harbors in response to Notice 2008-32. Commentators noted that, in many cases, fiduciaries could not rely on safe harbors because their fiduciary duties would require them to make a more accurate estimate so as to not harm the trust or their beneficiaries. In addition, safe harbors could increase complexity by requiring complicated anti-abuse rules. Therefore, comments are requested on methods other than numerical or percentage safe harbors.”
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[Query, what complicated anti-abuse rules would be required for a simple safe harbor treating 50% of the fiduciary fee as being within the §67(e) exception, perhaps other than for payments the trustee makes out of the bundled fee to other providers for services that are “commonly” incurred by individuals?]
7. Effective Date. The Preamble reiterates the timing under Notice 2011-37, that unbundling fiduciary fees is not required for taxable years beginning before the date of the issuance of final regulations.
8. Public Hearing. A public hearing regarding the proposed regulations is scheduled for December 19, 2011.
Proposed Regulation §1.67-4
1. In General, §1.67-4(a). The Knight test is summarized. A miscellaneous itemized deduction incurred by an estate or non-grantor trust that “commonly or customarily would be incurred by a hypothetical individual holding the same property” does not qualify for the §67(e) exception for trusts and estates.
2. “Commonly” or “Customarily” Incurred, §1.67-4(b).
a. In General, §1.67-4(b)(1). In applying the “commonly or customarily … incurred by a hypothetical individual” test, the type of product or service rendered controls “rather than the description of the cost of that product or service.” (emphasis added). An awkwardly worded confusing type of cost that is included is an expense that “do[es] not depend upon the identity of the payor (in particular, whether the payor is an individual or instead is an estate or trust).” [What does that mean???] Fortunately, an example is given of what the IRS has in mind: “costs incurred in defense of a claim against the estate, the decedent, or the non-grantor trust that are unrelated to the existence, validity, or administration of the estate or trust.” [Even that example could be confusing. As a part of “administering” a trust or estate, the fiduciary has a duty to defend the estate or trust against unfounded claims in order to protect the trust estate. Presumably, the regulation is contemplating a narrower concept of the “administration” of the trust or estate.]
b. Ownership Costs, §1.67-4(b)(2). Ownership costs are subject to the 2% rule. They are costs incurred “simply by reason of being the owner of the property.” Examples are “condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs deemed to be passed through to and reportable by a partner.”
c. Tax Preparation Fees, §1.67-4(b)(3). This is one area in which the proposed regulations adopt an easy-to-apply rule and safe harbor. The preparation fees for certain types of returns are not subject to the two-percent floor and the preparation fees for all other returns are.
(1) Returns Not Subject to 2% Floor. “All estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax returns are not subject to the two-percent floor.” [This is a taxpayer-friendly rule. Individuals also file generation-skipping transfer tax returns, at least to report direct skips and allocate GST exemptions (and an estate might file a generation-skipping transfer tax return to report a direct skip or to allocate GST exemptions to assets passing to trusts). Presumably, the IRS will recognize a decedent’s final income tax return as not being subject to the two-percent floor because there are
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some special elections that apply on the decedent’s final return, whether or not the estate actually is involved in any of those elections.] [The regulations refer to the “decedent’s final individual income tax returns — plural. Presumably that should instead refer to the final return, singular.]
(2) Returns Subject to 2% Floor. Other types of income tax returns are subject to the two-percent floor.
d. Investment Advisory Fees, §1.67-4(b)(4). The proposed regulation restates the general rule and exception provided in Knight. The general rule is that fees for investment advice “(including any related services that would be provided to any individual investor as part of an investment advisory fee)” are subject to the two-percent floor. An incremental cost (i) in excess of what is normally charged to individuals, (ii) that is added solely because the advice is to an estate or trust, and (iii) “that is attributable to an unusual investment objective or the need for a specialized balancing of the interests of the various parties” is not subject to the two-percent floor.
The regulation clarifies that any additional charge imposed because of the “usual balancing of the various interests of current beneficiaries and remaindermen” does not qualify for the exception. This seems like an unnecessarily harsh limitation. This seems to says that if an investment advisor charges an extra fee for a trust or estate, beyond what is charged to individuals, because of the need to balance the varying interests of the current beneficiaries and remaindermen under trust law principles, that is somehow still not viewed as an expense “which would not have been incurred if the property were not held in such trust or estate” (using the words of §67(e)).
The closest that the Preamble comes to offering a rationale to justify this strict position is the following sentence:
“Individual investors commonly have investment objectives that may require a balance between investing for income and investing for growth and/or a specialized approach for particular assets.”
The Supreme Court did not explicitly require that an extra expense charged by an investment advisor to accommodate the specialized balancing of the interests of current beneficiaries and remaindermen required by trust law principles (but not required for individuals) would be subject to the two-percent floor. Review again what the Supreme Court said in Knight:
“It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.” (emphasis added).
That statement was prefaced with “moreover.” It was an additional observation after its immediately prior observation about additional advisor fees that are imposed only on fiduciary accounts and that the investment advisor did not treat the trust any differently than individual accounts:
“As the Solicitor General concedes, some trust-related investment advisory fees may be fully deductible ‘if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.’ Brief for Respondent
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25. There is nothing in the record, however, to suggest that Warfield charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives, because of the Trustee’s fiduciary obligations.”
That seems to leave the possibility for allowing full deductibility of advisor fees to the extent they represent services in light of a trust’s different objectives than an individual because of the trustee’s fiduciary obligations.
Even if the Knight opinion can be read as saying, in the absence of regulatory guidance, that extra advisory fees (that would not be paid by individuals) for balancing the interests of current beneficiaries and remaindermen are subject to the 2% limitation, that does not mean that the IRS must adopt that suggestion in writing regulations to provide regulatory guidance. Indeed, the Supreme Court acknowledged “that the inquiry into what is common” may not be easy in all cases and seemed to invite workable regulatory guidance.
This limitation regarding extra expenses charged for balancing the interests of current beneficiaries and remaindermen applies to investment advisory fees. The proposed regulations do not repeat this limitation in its discussion of bundled fees. Trustees devote a significant amount of attention to assuring that the interests of all trust beneficiaries are balanced and that all are treated fairly. For example, dealing with the difficult issues of allocating receipts and expenses between income and principal is necessary in order to treat all of the beneficiaries fairly. Attention devoted to carefully assessing distribution decisions is largely necessitated by the need to assure that the varying interests of all beneficiaries are treated fairly. Hopefully, the IRS does not intend to apply this unfortunate limitation that it imposes on investment advisory fees to the issues of unbundling trustee fees.
3. Bundled Fees, §1.67-4(c).
a. In General, §1.67-4(c)(1). A “single fee, commission, or other expense (such as a fiduciary’s commission, attorney’s fee, or accountant’s fee)” must be allocated between those costs subject to the two-percent floor and those that are not. There is an exception for costs that are a “de minimus amount.” Observe that the bundled fee issue applies not just to trustee fees but also to attorney’s fees and accountants’ fees.
b. Several Specific Allocation Rules, §1.67-4(c)(2). This is labeled as an “Exception,” but in some ways the exception literally seems to override the general allocation rule stated above. An “exception” is obviously intended to override the general rule, but perhaps the stated exception was not intended for all purposes (as discussed immediately below).
Only Portion of Fee That Is Attributable to Investment Advice Is Subject to 2% Floor. If the bundled fee is not computed on an hourly basis, the portion of the fee that is not attributable to investment advice is not subject to the two-percent floor. (Presumably, this general statement applies only to fiduciary fees. Attorneys and accountants often do not provide any investment advice at all. But this “exception” literally says that if attorneys’ fees or accountants’ fees are not charged on an hourly basis, the full amount of the fee is deductible, regardless of the purposes of the attorney or accountant services, as long as none of the services relate to investment advice.)
Payments Made From Bundled Fee to Third Parties. If the fiduciary, attorney, or accountant who receives a single fee pays a third party for services that would have been
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subject to the two-percent floor if paid directly by the trust, that amount of the bundled fee is subject to the two-percent floor.
Separately Assessed Fee. If the fiduciary, attorney or accountant assesses a separate fee or expense, in addition to the basic bundled fee, for services that are commonly or customarily incurred by an individual, that separate fee is subject to the two-percent floor. The regulations give an example of a corporate trustee that charges an additional fee for leasing and managing the trust’s rental real estate. That separate management fee would be subject to the two-percent floor.
c. Reasonable Method for Making Allocation. ”Any reasonable method” can be used to make the allocation of the portion of the bundled fee attributable to costs subject to the two-percent floor and those that are not. This specifically applies to determining the portion of the bundled fee that is allocable to investment advice.
The ability to use “any reasonable method” does not apply to determine the portion of the bundled fee paid to third parties for expenses subject to the two-percent floor or to a separately assessed expense for a purpose that is customarily incurred by an individual. The reason given by the regulations is that “those payments and expenses are readily identifiable without any discretion on the part of the fiduciary or return preparer.” However, that seems to beg the question. What if the payment to a third party or separately assessed expense is partly for a purpose that would be subject to the two-percent floor and partly for a purpose that is not? What is the trust to do for determining the portion of such third party payment or separately assessed fee attributable to a purpose subject to the two-percent floor if it cannot use a “reasonable method” to do so? Presumably the regulations will be interpreted to a allow a “reasonable method” to be used to determine that allocation, but once the portion attributable to the two-percent floor portion is determined, that full amount will be subject to the two-percent floor.
4. Effective Date. The regulations apply to taxable years beginning on or after the date the regulations as published as final regulations.
Don W. CRISP, Trustee of the Caroline Hunt Trust Estate, Plaintiff, v. The UNITED STATES, Defendant.
United States Court of Federal Claims.
34 Fed.Cl. 112
No. 92-870T.
Sept. 7, 1995.
Buford P. Berry, Dallas, Texas, for plaintiff. Barbara B. Ferguson and William R. Mureiko, of counsel.
Arthur C. Hoene, with whom were Assistant Attorney General Loretta C. Argrett, Mildred L. Seidman, Chief, and William K. Drew, Senior Trial Attorney, Washington, D.C., for defendant.
OPINION
ANDEWELT, Judge.
I.
In this tax refund action, plaintiff, Don W. Crisp, trustee of the Caroline Hunt Trust Estate (the Trust or Trust Estate), seeks a refund of $2,993,572.81 1 for income taxes the Trust allegedly overpaid for the tax year ending June 30, 1987, and the shortened tax period ending December 31, 1987. 2
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1 Plaintiff's original claim for refund included an additional $16,988 for alleged overpayments involving the calculation of depletion on certain assets owned by the Trust Estate. During the course of this litigation, however, the Supreme Court resolved the depletion issue in a manner adverse to plaintiff. See United States v. Hill , 506 U.S. 546, 113 S.Ct. 941, 122 L.Ed.2d 330 (1993).
2 Plaintiff shortened the fiscal tax year beginning July 1, 1987, to December 31, 1987, in compliance with the Tax Reform Act of 1986, Pub.L.No. 99-514, Title XIV, ╖ 1403, 100 Stat. 2713 (codified at I.R.C. ╖ 645(a)), which required all trusts to conform their tax years to the calendar year beginning after December 31, 1986.
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In 1935, Caroline Hunt's parents, H.L. and Lyda Hunt, established the Trust Estate through an "Articles of Agreement and Declaration of Trust" (the Trust Agreement). The
Trust Agreement provides that the trustee may, at his or her discretion, make periodic payments to Caroline Hunt during her lifetime and then, for the next 21 years after her death, make periodic payments to Caroline Hunt's heirs. At the end of the 21√year period following Caroline Hunt's death, the Trust Agreement obliges the trustee to dissolve the Trust and disburse the assets to Caroline Hunt's heirs.
I.R.C. ╖ 641 obliges trusts to pay taxes on trust income. When calculating taxable trust income for any given tax year, I.R.C. ╖ 661 permits a deduction from trust income of all distributions made to trust beneficiaries during that tax year up to the amount of the trust's distributable net income (DNI). 3 I.R.C. ╖ 643(a) sets forth the method for calculating a trust's DNI.
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3 I.R.C. ╖ 661(a) provides, in pertinent part, as follows:
(a) Deduction.≈In any taxable year there shall be allowed as a deduction in computing the taxable income of an estate or trust . . . the sum of≈
(1) any amount of income for such taxable year required to be distributed currently (including any amount required to be distributed which may be paid out of income or corpus to the extent such amount is paid out of income for such taxable year); and
(2) any other amounts properly paid or credited or required to be distributed for such taxable year;
but such deduction shall not exceed the distributable net income of the estate or trust.
(Emphasis added.)
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For the two tax periods in issue here, the Trust distributed to Caroline Hunt $4.5 million and $1.6 million, respectively. Pursuant to I.R.C. ╖ 661, the Trust deducted from its income the full amounts distributed to Caroline Hunt because the Trust's DNI for these periods, as calculated by the trustee, exceeded the amounts distributed. In calculating the Trust's DNI for these two periods, the trustee included within the DNI all capital gains credited to the Trust's capital account by ZH Associates (ZH), a limited partnership in which the Trust is a limited partner.
After conducting an audit, the Internal Revenue Service (IRS) concluded that the trustee had improperly included the ZH capital gains in the Trust's DNI. When the IRS recalculated the Trust's DNI to exclude these capital gains, the DNI for the respective tax periods fell to $2,665,300 and $600,√252. Because the Trust's distributions to Caroline Hunt exceeded the recalculated DNI, and because I.R.C. ╖ 661 provides that any deduction from trust income "shall not exceed the [DNI]," the IRS recalculated the
Trust's tax burden to include, as taxable income, the amount of the Trust's distributions to Caroline Hunt that exceeded the reduced DNI. As a result, the Trust owed taxes, penalties, and interest in the amounts of $2,895,496 and $98,076, respectively.
Plaintiff paid the taxes, penalties, and interest calculated by the IRS, and thereafter filed the instant suit to secure a refund. This action is presently before the court on the parties' cross-motions for summary judgment on the issue of whether the trustee properly included in the Trust's DNI the ZH capital gains credited to the Trust. There are no material issues of fact in dispute. For the reasons set forth below, plaintiff's motion for summary judgment is granted and defendant's cross-motion is denied.
II.
The Trust Estate and Robert E. Zoellner (Zoellner) formed ZH pursuant to the New Jersey Uniform Limited Partnership Act and through a January 1, 1982, "Agreement of Limited Partnership" (the Partnership Agreement). The Partnership Agreement designated the Trust as the sole limited partner and Zoellner as the general partner. The Partnership Agreement was later amended to substitute Zoellner Management Company, Inc., of which Zoellner is president, as the general partner.
The Partnership Agreement describes ZH's business as follows:
The purposes of the Partnership are to engage in trading for its own account, including to deal in arbitrage, hedge arbitrage, option arbitrage, international securities arbitrage (but not currency or commodities arbitrage) and hedge trading and securities trading in connection therewith and otherwise to deal in securities being traded in connection therewith. . . .
ZH engaged primarily in "deal arbitrage" which involves the purchase of securities sought in cash tender offers, exchange offers, or mergers and then the tendering of those securities for cash or new securities. 4 ZH also engaged in option arbitrage and hedge trading. Option arbitrage seeks, inter alia , to capture profits derived from the disparity between the open-market share price of a particular stock and the market price for options to purchase or sell that same stock. Hedge trading involves, inter alia , establishing securities positions in one industry and offsetting those positions by taking long or short positions in securities of another industry. ZH received some cash dividends as a consequence of owning securities, but ZH's primary focus was to buy and sell securities in an attempt to profit from the sudden swings in market value that resulted from the numerous mergers and acquisitions which were prevalent in the 1980s.
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4 Shares of a company subject to a tender offer typically sell at a discount to the amount of the tender offer. This discount, inter alia , reflects the uncertainty that the deal will consummate and the offeror will actually purchase the shares at the tender price. Deal arbitrage attempts to capture, as profit, the value of that discount by purchasing securities
subject to a tender offer, and if the deal consummates, tendering the shares at the full price offered.
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Pursuant to the Partnership Agreement, Zoellner, the original general partner, contributed $1 million to ZH and the Trust, the sole limited partner, contributed $5 million. The Partnership Agreement directed the allocation of ZH's profits and losses as follows: of the net profits shall be credited to the capital account of the limited partner and to the capital account of the general partner, and of the net losses shall be debited from the capital account of the limited partner and from the capital account of the general partner. The Partnership Agreement gave the general partner the exclusive authority to manage and control the operations of ZH, including the execution of investment decisions. 5 The general partner could, at his discretion, distribute profits to the two individual partners when the partners' combined capital accounts exceeded the initial $6 million combined contribution. Each partner had the right, upon 180 days' notice to the other partner, to demand dissolution of the partnership and distribution of the capital accounts, subject to the payment of partnership expenses and contingencies related to dissolution.
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5 Article IV of the Partnership Agreement, entitled "Management," provides, in pertinent part:
Section 4.1. General Powers of General Partner . The General Partner shall have exclusive management and control of the business of the Partnership and shall have the authority, in accordance with the terms and conditions of this Agreement, to make and execute investment decisions and take such action related thereto as he may deem necessary or advisable for the best interests, benefit and advantage of the Partnership. The Limited Partner shall not take part in the control of the business of the Partnership in any way.
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III.
Congress created DNI specifically to deal with the taxation of estates and trusts and their beneficiaries. See Treas.Reg. ╖ 1.643(a)-0. I.R.C. ╖ 661(a) employs DNI to determine the proportions of the income tax burden borne by the trust or estate and by its beneficiaries. I.R.C. ╖ 643(a) defines DNI as follows:
(a) Distributable net income.≈[T]he term "distributable net income" means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications. . . .
The listed modifications include deductions for distributions, personal exemption, capital gains and losses, extraordinary dividends and taxable stock dividends, tax-exempt interest, and income of a foreign trust. With respect to capital gains and losses, I.R.C. ╖ 643(a)(3) requires a trustee, when calculating DNI, to exclude capital gains from trust income under the following circumstances:
Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes of section 642(c) [which relates to charities].
The legislative history of the Internal Revenue Code explains Congress' rationale for including capital gains in DNI except when the gains are allocated to corpus and not paid, credited, or required to be distributed. The pertinent House Report states:
Subsection (a) defines the term "distributable net income" to mean the taxable income of the estate or trust with certain modifications. This concept of [DNI] serves the general purposes of limiting the additional deductions allowed to estates and trusts (under sections 651 and 661) for amounts paid, credited, or required to be distributed to beneficiaries and also of determining how much of an amount distributed or required to be distributed to a beneficiary will be taxed to him. In effect, the concept of [DNI] gives statutory expression to the principle underlying the taxation of estates and trusts, that is, that these separate taxable entities are only conduits through which income flows to the beneficiaries except where income is accumulated by the estate or trust for future distribution.
* ════ * ════ * ════ * ════ * ════ *
To the extent that gains from the sale or exchange of capital assets must be allocated to corpus and are not (A) paid or credited to any beneficiary during the taxable year or (B) paid, permanently set aside or to be used for the purposes specified in section 642(c) (charitable deduction), they are excluded from the computation of [DNI]. The effect of this modification is to tax capital gains to the estate or trust where the gains must be added to principal. However, where the gains, though allocable to corpus, are actually distributed to beneficiaries during the taxable year≈for example, in the year of termination of the trust≈then the gains are included in the computation of [DNI].
H.R.Rep. No. 1337, 83rd Cong., 2d Sess., at 194√95 (1954), reprinted in 1954 U.S.C.C.A.N. 4025, 4333. Thus, unlike a corporate structure which can be subject to double taxation, with the corporation first paying tax on its income and then the shareholder paying a second tax when it receives a cash dividend distribution from the corporation, Congress anticipated that when a trust is involved, capital gains distributed to trust beneficiaries in the year earned would be taxed only once, as income to the beneficiaries. The definition of DNI in I.R.C. ╖ 643(a) and its use in I.R.C. ╖ 661 as a ceiling on the deductibility of distributions permit a trust to function as a conduit in that
the statutes allow the trust to deduct from trust income capital gains distributed to its beneficiaries during the tax period in which the gains were earned.
Treas.Reg. ╖ 1.643(a) implements I.R.C. ╖ 643(a) and defines DNI as "the taxable income (as defined in section 63) of the estate or trust, computed with the modifications set forth in ╖╖ 1.643(a)-1 through 1.643(a)-7." Regarding capital gains, Treas.Reg. ╖ 1.643(a)-3 provides:
(a) [G]ains from the sale or exchange of capital assets are ordinarily excluded from [DNI], and are not ordinarily considered as paid, credited, or required to be distributed to any beneficiary unless they are:
(1) Allocated to income under the terms of the governing instrument or local law by the fiduciary on its books or by notice to the beneficiary, [or]
(2) Allocated to corpus and actually distributed to beneficiaries during the taxable year. . .
The two alternative allocations to which the regulation refers≈income and corpus (alternatively referred to as principal)≈are the two possible allocations of funds within a trust. The term "income" as used in Treas. Reg. ╖ 1.643(a) refers to "the amount of income of an estate or trust for the taxable year determined under the terms of its governing instrument and applicable local law." Treas.Reg. ╖ 1.643(b)-1. Hence, under Treas.Reg. ╖ 1.643(a)-3, capital gains are includable in DNI if they are either (1) allocated to income or (2) allocated to corpus and actually distributed to the beneficiary during the tax year.
In the instant case, plaintiff contends that he properly applied Treas.Reg. ╖ 1.643(a) when he included in the Trust's DNI the ZH capital gains because the Trust's auditor had allocated these gains to income rather than to corpus. In response, defendant acknowledges that plaintiff's auditor allocated the ZH capital gains to income, but contends that this allocation was erroneous, i.e ., that the Trust Agreement (the trust instrument) and the applicable local law (Texas state law) required instead that the trustee allocate the capital gains to corpus. Defendant appreciates that under Treas.Reg. ╖ 1.643(a)-3 corpus that is properly distributed to the beneficiary in the tax year is includable in DNI. Defendant argues correctly, however, that because the instant trust instrument specifically precludes any distribution of corpus to the beneficiary, the ZH capital gains cannot be classified as distributed corpus includable in DNI under Treas.Reg. ╖ 1.643(a)-3. Thus, the crucial issue on summary judgment under the controlling statute and regulation is whether the trustee had authority to distribute to Caroline Hunt the capital gains earned by ZH and credited to the Trust. If the trustee had such authority, then the ZH capital gains were not corpus and the trustee properly allocated the gains to income and properly included the gains in the Trust's DNI.
As quoted above, Treas.Reg. ╖ 1.643(a)-3(a)(1) provides that gains from the sale or exchange of capital assets are includable in DNI if the gains are "[a]llocated to income under the terms of the governing instrument or local law by the fiduciary on its books. . .
." In the instant case, Texas state law is the applicable local law, and the Texas Trust Code provides that, to the extent a trust dictates such an allocation, a trustee shall allocate receipts between income and principal according to the provisions of the trust instrument. 6 Therefore, both Treas. Reg. ╖ 1.643(a)-3(a)(1) and the applicable local law point this court initially to the Trust Agreement. If the Trust Agreement dictates the allocation of the ZH capital gains to income, or alternatively to corpus, then that allocation would be determinative. If the Trust Agreement fails to allocate the gains to either income or corpus, then the court must consult the other applicable provisions of Texas state law.
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6 Section 113.101 of the Texas Trust Code provides:
(a) A trustee shall administer the trust with due regard for the interests of income beneficiaries and remaindermen with respect to the allocation of receipts and expenditures by crediting a receipt or charging an expenditure to income or principal or partly to each:
(1) in accordance with the terms of the trust instrument;
(2) in the absence of any contrary terms of the trust instrument, in accordance with this subtitle; or
(3) if neither of the preceding rules of administration is applicable, in accordance with what is reasonable and equitable in view of the interests of those entitled to income and to principal.
(b) If the trust instrument gives the trustee discretion in crediting a receipt or charging an expenditure to income or principal or partly to each, no inference arises from the fact that the trustee makes an allocation contrary to this subtitle.
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IV.
The Trust Agreement contains a series of introductory clauses, a series of articles that establish the powers and rights of the trustee (Article I), the advisory board (Article II), and the beneficiary (Article III), and then an article that contains miscellaneous provisions (Article IV). Article I, Section 4(b), expressly precludes distribution of corpus. ("[T]he corpus of [the] Trust Estate shall never be diminished through a distribution to the Beneficiary.") 7 Although the trustee may not distribute corpus, the trustee may, at his or her discretion, distribute "net profits" or "net earnings," two terms the Trust Agreement appears to use synonymously. Article IV, Section 4, referring to the trustee's distribution of net profits, provides:
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7 Article III, Section 1, when defining the rights of the beneficiary, reiterates the settlors' intent to preclude distribution of corpus during the life of the beneficiary as follows: "The beneficiary shall have no right to the corpus of the Trust property. . . ."
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The Beneficiary may receive from time to time during the life of this trust, such portions of the net profits accruing from time to time to this Trust Estate, as the Trustee, acting with the advice and consent of the Advisory Board, may see fit to pay over and deliver to the Beneficiary. Net profits shall be determined by the annual audits as provided for herein, and the Trustee shall never in any event pay to the Beneficiary, during any one calendar year, any sum in excess of the Net Profits for the preceding calendar year. No duty is imposed upon the Trustee to make such distribution of net profits, but the power is conferred upon him, acting with the advice and consent of the Advisory Board, so to do, and in exercising this discretion said Trustee and Advisory Board shall give full consideration to the interest of both the Beneficiary and this Trust Estate.
Article III, Section 1, referring to the trustee's distribution of net earnings, provides: "The beneficiary shall have no right to the corpus of the Trust property . . . and the Beneficiary shall have no right with respect to [the] Trust other than to receive distribution of net earnings awarded her by the Trustee with consent of the Advisory Board, as is elsewhere herein provided. . . ."
Because the trustee may never distribute corpus but may distribute net profits and net earnings, the Trust Agreement necessarily treats net profits and net earnings as distinct from corpus. Treas.Reg. ╖ 1.643(a)-3, however, employs only two classifications≈trust corpus and trust income. Therefore, to the extent that the Trust Agreement allocates the ZH capital gains to net profits or net earnings, in applying the regulation, the allocation will be treated as an allocation to income. Hence, the court must determine whether the Trust Agreement dictates the allocation of ZH capital gains to either net profits or net earnings or rather to corpus. As explained above, if the Trust Agreement dictates a particular allocation, then that allocation would control.
V.
The Trust Agreement does not define the terms "net profits" and "net earnings." In the absence of such definitions, the settlors' intent in 1935 would seem best unveiled by consulting contemporaneous law dictionaries. See Fox v. Thoreson , 398 S.W.2d 88, 92 (Tex. 1966) ("language used by the parties should be given its plain grammatical meaning unless it definitely appears that the intention of the parties would thereby be defeated"); see also Transamerica Ins. Co. v. Frost Nat'l Bank , 501 S.W.2d 418, 423 (Tex.Civ.App., Beaumont 1973), writ refd n.r.e . (1974). Black's Law Dictionary (3d ed. 1933) presents two similar definitions of net profits.
NET PROFITS. This term does not mean what is made over the losses, expenses, and interest on the amount invested. It includes the gain that accrues on the investment, after deducting simply the losses and expenses of the business.
Id . at 1239.
Net profits
Theoretically all profits are "net." But as the expression "gross profits" is sometimes used to describe the mere excess of present value over former value, or of returns from sales over prime cost, the phrase "net profits" is appropriate to describe the gain which remains after the further deduction of all expenses, charges, costs, allowance for depreciation, etc.
Id . at 1440 (citation omitted). 8
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8 The 1933 edition of Black's defines profit, as follows:
The advance in the price of goods sold beyond the cost of purchase. The gain made by the sale of produce or manufacturers, after deducting the value of the labor, materials, rents, and all expenses, together with the interest of the capital employed.
The excess of receipts over expenditures; that is, net earnings.
The receipts of a business, deducting current expenses; it is equivalent to net receipts.
An excess of the value of returns over the value of advances. The same as net profits.
Id . at 1439√40 (citations omitted).
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The 1933 edition of Black's defines net earnings, as follows:
The gross earnings of a business or company are the total receipts before deducting expenditures. Net earnings are the excess of the gross earnings over the expenditures defrayed in producing them, and aside from and exclusive of capital laid out in constructing and equipping the works or plant.
Id . at 635.
Although the dictionary definitions do not specifically refer to partnerships or, more specifically, to the treatment of partnership profits credited to a limited partner, the definitions are broad enough to encompass such profits. Upon forming the ZH limited partnership, the Trust, in an apparent effort to profit from Zoellner's stock trading
expertise, essentially became a passive investor in a business run by Zoellner. The Trust and Zoellner created ZH by combining Zoellner's assets with the Trust's assets. The Partnership Agreement gave Zoellner full control over the operations of ZH, including the selection of assets to be purchased and sold. In this setting, the profits earned by ZH and credited to the Trust essentially constitute profits earned by the Trust on an investment in a limited partnership. Such profits fit within the pertinent dictionary definitions of net profits and net earnings in that they are appropriately characterized as "gain[s] that accrue[d] on [an] investment" ( id . at 1239), as the "excess of present [Trust] value over former value" ( id . at 1440), and as the "excess of the gross [Trust] earnings over . . . expenditures" ( id . at 635). Although the Internal Revenue Code's classification of such profits as capital gains rather than ordinary income may affect the ultimate rate of taxation of these profits, such a classification does not affect the allocation of these profits to either net profits or net earnings or alternatively to corpus. Instead, the Trust Agreement and Texas state law control that allocation.
Hence, the terms "net profits" and "net earnings," as employed by the Trust Agreement and as defined in the contemporaneous law dictionaries, encompass the profits earned by ZH and credited to the Trust, regardless of whether the Internal Revenue Code classifies these profits as ordinary income or as capital gains.
VI.
Defendant argues that the ZH profits credited to the Trust could not properly be classified as net profits or net earnings because these profits fit squarely within the definition of corpus provided in the Trust Agreement. Upon review, however, the Trust Agreement contains no provision that directs the trustee to treat as corpus profits such as those credited to the Trust from the ZH limited partnership. 9
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9 The court recognizes that certain profits that fit within the dictionary definitions of net profits and net earnings may also fit within the Trust Agreement's definition of corpus. For example, if the Trust exchanged corpus for a capital asset, and the capital asset subsequently increased in value and the trustee sold that asset, the provisions of the Trust Agreement relating exclusively to corpus would seem to classify as corpus the entire proceeds from the sale of the asset, including the profit. For such profits that fit within the definitions of net profits and net earnings and also the definition of corpus, the court would have to determine which classification is appropriate based on a reading of the Trust Agreement, the current law, and the law applicable in 1935. Because, as explained below, profits credited to a trust by a joint venture such as ZH do not fit within the Trust Agreement's definition of corpus, there is no basis within the Trust Agreement for not classifying the ZH profits according to the contemporaneous dictionary definitions of the terms the settlors chose to employ. In this regard, limited partnerships were apparently a commonly recognized method of conducting business in Texas in 1935 when H.L. and Lyda Hunt signed the Trust Agreement. In 1846, the State of Texas adopted a limited partnership act, "An Act for the Regulation of Limited Partnerships," 1st Leg., Laws of
Tex. 1585 (May 12, 1846), which remained essentially unchanged until 1955. Given the legal recognition of limited partnerships, if the settlors had intended the terms "net profits" and "net earnings" to have meanings different from those defined in the contemporaneous dictionaries and therefore for profits from limited partnerships to be treated as corpus rather than as net profits, then the settlors seemingly would have so provided in the Trust Agreement.
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The Trust Agreement delineates the metes and bounds of the corpus of the Trust Estate in a paragraph preceding Article I, which provides:
WHEREAS , it is contemplated that said Trustee of said Caroline Hunt Trust Estate, with the consent of the Advisory Board, may , from time to time, hereafter acquire additional property, through gift, devise, purchase or exchange , real, personal or mixed, of divers and sundry kinds, all of which, together with said 1800 shares of the capital stock of Hunt Production Company already acquired by said Trustee for said Beneficiary, is intended to create the corpus of a Trust Estate for the use and Benefit of said Caroline Hunt, and the legal title to all of which said property shall be in said Trustee and his successors, with and for the purposes herein stated, and any and all of said property of whatsoever kind or character, whether real, personal or mixed, together with the accretions thereto, income thereon, or proceeds thereof, shall be by said Trustee held in a trust capacity as herein defined;
(Emphasis added.) Upon analysis, this definition of corpus does not encompass profits from the Trust's share of a limited partnership such as ZH.
Under New Jersey state law, which controls the operation of ZH, a limited partnership interest constitutes personal property. N.J.Stat.Ann. ╖ 42:2A-12. Because the Partnership Agreement required the Trust to invest $5 million to secure its limited partnership interest in ZH, the trustee can fairly be said to have "acquire[d this] additional property [ i.e ., the limited partnership] through . . . purchase or exchange." The Trust's limited partnership interest in ZH, therefore, fits within the Trust Agreement's definition of corpus. Such a conclusion, however, does not support the further conclusion that profits derived from the Trust's interest in ZH also fit within the Trust Agreement's definition of corpus.
The ZH profits credited to the Trust resulted from ZH's acquisition and sale of stocks and stock options (hereinafter securities or stocks). These securities do not themselves qualify as corpus under the above-quoted Trust Agreement definition because the Trust did not "acquire" the securities, but rather ZH, a distinct legal entity, acquired the securities. 10
Article I, Section 4, of the Trust Agreement states requirements for investments by the Trust and provides:
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10 Defendant argues that a partnership is not a separate taxpayer under I.R.C. ╖╖ 701 and 702 and, therefore, a partnership is no more than a conduit through which tax items flow to its partners. There is no dispute, however, that ZH functions as a conduit for tax purposes. Rather, the crucial issue is whether the profits credited by ZH, a distinct legal entity, to the Trust's capital account are allocable by the Trust to income or to principal. I.R.C. ╖╖ 701 and 702 offer no instruction as to allocation between income and principal.
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All investments shall be made and the legal title to all property shall be held, and all property managed, controlled, and disposed of, absolutely by [the] trustee and his successors under this [Trust Agreement], with the advice and consent of the Advisory Board. . . .
Herein, the trustee had the requisite title to and control over the Trust's limited partnership interest in ZH in that the trustee could unilaterally exercise all the rights of a limited partner. The trustee, however, did not have title to or control over the securities purchased by ZH. Rather, as described above, the general partner of ZH solely controlled the operation of the partnership and the purchase and sale of securities. Hence, the securities owned by ZH could not be classified as an investment of the Trust or property of the Trust under Article I, Section 4, of the Trust Agreement and thus cannot be classified as an investment "acquired" by the Trust. This interpretation of the Trust's interest in the ZH assets is consistent with applicable New Jersey state law, which provides that a limited partner does not itself own, possess, or have legal title to the specific assets of the partnership. N.J.Stat.Ann. ╖ 42:1√25; see also Fortugno v. Hudson Manure Co ., 51 N.J.Super. 482, 144 A.2d 207 (1958); Mazzuchelli v. Silberberg , 29 N.J. 15, 148 A.2d 8, 11 (1959). 11 Thus, although the Trust "acquired" its limited partnership interest in ZH, the Trust did not "acquire" the securities owned by the partnership and, hence, those securities are not classifiable as corpus. Because the securities themselves are not corpus, it would follow that the ZH profits credited to the Trust based on the sale of those securities likewise would not be classifiable as corpus in that they are not property "acquire[d] . . . through gift, devise, purchase or exchange." 12
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11 The common law in effect at the time the settlors established the Trust was consistent with this notion that a limited partner does not possess title to partnership property. See, e.g., Appeal of Merchants' Fund Ass'n , 136 Pa. 43, 20 A. 527, 528 (1890) ("[the limited partner] had no title to the land bought by the trustees for the company, as a tenant in common or otherwise, and could neither convey nor encumber it.")
12 Defendant cites Texas Trust Code ╖ 113.104(c)(3), which provides that capital gains received by a trust from its investment in a regulated investment company or mutual fund constitute corpus even though the trust does not hold title to the underlying securities. This provision, however, does not support defendant's position because ZH does not
qualify as either a regulated investment company or a mutual fund. See 15 U.S.C. ╖ 80a√3(c)(1) (a company "whose outstanding securities . . . are beneficially owned by not more than one hundred persons" is not an investment company within the meaning of this statute).
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The paragraph preceding Article I of the Trust Agreement that defines corpus includes the provision that "[trust] property, . . . accretions thereto, income thereon, or proceeds thereof, shall be . . . held in a trust capacity." Because the profits ZH credited to the Trust derived from the Trust's limited partnership interest in ZH, the profits potentially could be characterized as either "income" from the limited partnership or "proceeds" thereof. Thus, the Trust Agreement seemingly obliged the trustee to hold the ZH profits credited to the Trust "in a trust capacity," at least once ZH had distributed those profits to the trustee. Such an obligation to hold distributions in a trust capacity, however, does not also dictate the allocation of such proceeds to corpus. For example, income is one of the listed assets that must be "held in a trust capacity" and defendant has not contended, nor could it reasonably contend, that all income is allocable to corpus. Thus, rather than dictating the allocation of a particular receipt to corpus, the phrase "held in a trust capacity" merely requires the trustee to exercise control over the covered assets. The phrase indicates nothing about whether the trustee must allocate the proceeds to corpus, which the trustee is prohibited from distributing to the beneficiary, or alternatively to net profit or net earnings, which the trustee generally may, but need not, distribute.
To support its position that the ZH profits constitute corpus, defendant also relies upon Article I, Section 4(b), of the Trust Agreement which states:
Likewise, with the advice and consent of said Advisory Board as herein provided, to sell and convey or otherwise use and deal in or dispose of, on such terms as he shall see fit, any part or all of said Trust properties and income therefrom, provided, however, that all considerations paid for all or any part of said Trust Estate shall be the property of said Trust Estate and provided further that the corpus of said Trust Estate shall never be diminished through a distribution to the Beneficiary under said Trust, and the moneys, funds or other properties arising from the sale or other disposition of said properties by said Trustee shall be held and re-invested for the benefit of said Trust Estate.
This provision, however, does not aid defendant. Article I describes the trustee's powers and responsibilities and not the metes and bounds of the corpus of the Trust Estate. Corpus is defined in a paragraph that precedes Article I of the Trust Agreement. In any event, classifying certain funds as part of the Trust Estate or as property of the Trust Estate does not also mean that those funds are necessarily part of corpus. The phrase "Trust Estate" is not synonymous with the term "corpus" because undistributed net profits and net earnings, which clearly are not corpus in the year earned, constitute part of the Trust Estate. Additionally, for the reasons stated above, the securities that produced the receipts at issue were purchased by and were the property of ZH, not the Trust Estate. The proceeds from the partnership's sale of these securities, therefore, would not
constitute "considerations paid for all or any part of [the] Trust Estate" or "moneys, funds or other properties arising from the sale or other disposition of [Trust] properties by [the] Trustee." 13
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13 Contrary to defendant's contention, the mandate that moneys arising from the disposition of Trust properties "be held and re-invested for the benefit of [the] Trust Estate" does not mean that such moneys necessarily constitute corpus. As described above, because the trustee must also "hold" income for the benefit of the Trust, and income of the Trust unquestionably is not corpus, the mandate that the trustee "hold" moneys for the benefit of the Trust does not dictate that the moneys be held as corpus. Likewise, the additional obligation that the trustee reinvest the moneys does not necessarily mean that the moneys constitute corpus. For example, Article I, Section 10, of the Trust Agreement provides that the trustee must determine the net profits available for distribution based on annual audits. Thus, funds earned by the Trust shortly after an annual audit, including income in the form of interest or dividends, would not be eligible for distribution until the next audit or up to one full year later. It seems reasonable to expect, and Article I, Section 4(b), seems to dictate, that the trustee would reinvest any such funds for the period of time between receipt of those funds and their distribution after the next annual audit. An obligation to reinvest therefore does not convert receipts to corpus.
Additionally, the obligation to reinvest appears to address a legal issue concerning passive trusts and the Statute of Uses that was significant in 1935 when the settlors drafted the Trust Agreement. Today, all trusts are generally assumed to be active. During the nineteenth and early twentieth centuries, however, courts sometimes concluded that a trust became passive when the trustee no longer had any active duties to perform, and that pursuant to the Statute of Uses, the passive trust "executed" and legal title to trust property vested in the beneficiary. See Griggs v. Jefferson Bank & Trust Co ., 57 S.W.2d 390, 391 (Tex.Civ.App., Texarkana 1933); Brown v. Harris , 7 Tex.Civ.App. 664, 27 S.W. 45 (1894); Tex.Trust Code ╖ 112.032; 1 A. Scott & W. Fratcher, The Law of Trusts ╖ 69.2 (4th ed.1987). Herein, the requirement in Article I, Section 4(b), of the Trust Agreement that the trustee "[hold] and re-invest" the proceeds from a sale of Trust property imposes active duties on the trustee which would avoid the operation of the Statute of Uses and thus would defeat any argument that the Trust should execute. See Gentemann v. Dyer , 140 S.W.2d 75, 78 (Mo.Ct.App.1940) ("selling" real property and "reinvesting the proceeds" are active duties that avoid the operation of the Statute of Uses).
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For the foregoing reasons, the ZH capital gains credited to the Trust fit squarely within the applicable definitions of distributable net profits and net earnings and do not fit squarely within the Trust Agreement's definition of undistributable corpus. Because the Trust Agreement authorized the trustee to distribute the ZH capital gains to Caroline
Hunt, for the reasons explained above and on the facts of the instant case, the profits are properly allocable to income and thus includable in DNI under I.R.C. ╖ 643(a)(3) and Treas.Reg. ╖ 1.643(a)√3(a)(1).
VII.
If the Trust had directly acquired the securities that produced the profits in issue, rather than purchasing an interest in a partnership which in turn acquired the securities, then the securities would constitute corpus, and apparently so too would any profits that resulted from the sale of those securities. Defendant argues that given this result, this court's interpretation of net profits and net earnings as encompassing the capital gains in issue would unreasonably give the trustee the power to convert undistributable corpus into distributable net profits simply by interposing a partnership between the trustee and the underlying securities. Rather than this result being unreasonable, however, it would appear that the settlors of the Trust intended to grant the trustee such power.
First, as described above, the court's interpretation flows directly from the ordinary meaning of the words chosen by the settlors in drafting the Trust Agreement. Unless the Trust Agreement demonstrates a contrary intent, the best way to give effect to the settlors' intent is to interpret the settlors' words consistent with their ordinary meaning. Fox v. Thoreson , 398 S.W.2d at 92.
Second, at the time the settlors created the Trust, the common law permitted a trustee to choose among various business structures to direct receipts from an investment either to income beneficiaries or to remaindermen. For example, if the trustee invested corpus directly in securities, any increase in the market value of the securities would also constitute corpus. On the other hand, if the trustee invested in securities indirectly by purchasing shares of a corporation that purchased the securities, distributions of profits from the corporation in the form of cash dividends ordinarily would be classifiable as income rather than corpus. Restatement of Trusts ╖ 236 (1935); see also , Tex.Trust Code ╖╖ 113.102(a)(3) and 113.104(a)(1). Given this result, it is not apparent why, assuming the trustee chose to invest a portion of the Trust assets in a business such as ZH so as to produce distributable income, the settlors would have restricted the trustee to the use of a corporate structure, which would result in double taxation, rather than authorizing the use of a limited partnership structure, which would allow for single taxation. In addition, in 1935, case law supported a trustee using a limited partnership structure in order to have receipts from an investment, in the form of capital gains, classifiable as income distributable to income beneficiaries. Appeal of Merchants' Fund Ass'n , 136 Pa. 43, 20 A. 527, 528√29 (Pa. 1890), involved facts similar to those involved in the instant case. In Merchants , a trust owned a limited partnership interest in a business that bought and sold land. The issue presented therein was whether capital gains earned by the partnership and credited to the trust could be distributed to the income beneficiary. The court concluded that they could. Thus, in 1935, the settlors of the Trust should have recognized that by choosing different business structures, the trustee, in effect, could vary the allocation of receipts from an investment between distributable income and corpus. Given this state of the law, had the settlors intended to preclude the trustee from investing in a business that
would result in capital gains being treated as distributable income, the settlors reasonably would be expected to have demonstrated such an intent in the wording of the Trust Agreement.
Third, and related to the second point, perhaps the most convincing evidence in the Trust Agreement that the settlors did not intend to force the trustee to treat as corpus all profits classified as capital gains is the very broad degree of discretion the settlors allowed the trustee and advisory board. In theory, a trustee can direct individual investments of trust assets either toward growing corpus, income, or some combination of the two. Article I, Section 4(c), of the Trust Agreement essentially permits the trustee, with the advisory board's approval, to invest Trust assets in any way the trustee and advisory board deem appropriate so long as the investments are in the interest of the Trust Estate. 14 Thus, the Trust Agreement does not require the trustee to invest a specified minimum portion of Trust assets in investments that would tend to grow corpus or alternatively in investments that would tend to grow net profits. In addition, even when investments produce distributable net profits, the trustee has the discretion as to whether to distribute those profits. Given this very broad discretion granted to the trustee and advisory board with respect to investing and distributing trust assets, it would seem incongruous for the settlors to have restricted the trustee and advisory board from taking advantage of the benefits of a limited partnership arrangement for Trust investments directed at producing net profits. In other words, given the broad discretion granted the trustee and advisory board, if the trustee and advisory board decided to invest $5 million so as to produce net profits for possible distribution to Caroline Hunt, and also determined that the most efficient way to maximize these net profits was to invest in a limited partnership such as ZH, then it is not apparent why the settlors would have precluded such an option.
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14 After listing a lengthy series of possible investments, Article I, Section 4(c), contains the following broad authorization:
[I]n general [the] Trustee, [with the] consent of the Advisory Board . . . shall have full power in all matters not hereinabove specified to deal with and use the Trust properties and moneys and the income, proceeds, profits and revenues arising therefrom, and to manage and conduct the Trust hereby created in any manner that the said Trustee and said Advisory Board should see fit, and to execute and make all such agreements, deeds, mortgages, releases, lease contracts and instruments of all kinds, and to do such other things as may be proper for any of said purposes above named, and to do anything else properly incident thereto that to the said Trustee and said Advisory Board may seem reasonable and to the best interest of said Trust Estate . . . .
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VIII.
Defendant contends that the settlors' primary intent was to accumulate property, particularly capital gains, for the eventual benefit of the remaindermen and that allowing distribution of capital gains to Caroline Hunt would frustrate this intent. The absence of a mandate in the Trust Agreement requiring the trustee and advisory board to invest a minimum proportion of the Trust assets in investments that would tend to grow corpus, however, belies any such intent. Indeed, on balance, the wording of the Trust Agreement and the surrounding facts support the conclusion that the settlors' primary concern was to accumulate net profits for possible distribution to Caroline Hunt rather than to accumulate corpus for the remaindermen. On the first page of the Trust Agreement, H.L. and Lyda Hunt state that they are the parents of Caroline Hunt and that "it is [their] desire and purpose . . . to create an irrevocable trust, known as the Caroline Hunt Trust Estate, for the use and benefit of Caroline Hunt." Caroline Hunt was 12 years old when her parents created the Trust and her parents could not have possibly known at that time who would succeed Caroline Hunt. The Trust Agreement does not mention successors to Caroline Hunt until Article III, Section 3, positioned on the second to last page of the 10√page Trust Agreement, which states:
At the time of the death of the Beneficiary, her equitable interest in said Trust Estate, unless disposed of otherwise by said Beneficiary, shall pass to and vest in her heirs in accordance with the laws of descent and distribution then in force, applicable to the equitable interest of such Beneficiary in said Trust Estate. (The term "Beneficiary" applies not only to Caroline Hunt but to all her successors to beneficial interests under this trust.)
The court appreciates that a prohibition on the distribution of corpus tends to ensure that assets will remain in the Trust upon Caroline Hunt's death. In light of Caroline Hunt's youth at the time the settlors created the Trust, however, this prohibition seems at least as likely to promote Caroline Hunt's interests. A prohibition on the distribution of corpus would help to ensure that the corpus of the Trust Estate would be preserved over many years so that Caroline Hunt could receive profits earned on remaining corpus throughout her lifetime, i.e ., that distributions would not completely dissipate the Trust Estate prior to Caroline Hunt's death. 15
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15 Article IV, Section 4, of the Trust Agreement also limits the distribution of assets to the beneficiary. It provides that "the Trustee shall never in any event pay to the Beneficiary, during any one calendar year, any sum in excess of Net Profits for the preceding calendar year." This provision likewise potentially benefits Caroline Hunt in that it tends to maintain in the Trust, under the control of the trustee, net profits that are available for distribution to Caroline Hunt at a future time.
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IX.
The grant of summary judgment is appropriate when there is an absence of a genuine issue of material fact and the moving party is entitled to judgment as a matter of law. RCFC 56. In the instant case, there is no dispute as to any material issue of fact. For the reasons set forth above, the court concludes that the Trust's auditor correctly classified the ZH capital gains credited to the Trust as net profits potentially distributable to Caroline Hunt. Because these gains constitute net profits, for the reasons explained above, the trustee properly allocated the profits to income and included the profits in the calculation of the Trust's DNI. Thus, plaintiff is entitled to summary judgment.
Even if the court had concluded that the Trust Agreement was ambiguous with respect to the allocation of the ZH profits between corpus and income, plaintiff still would be entitled to summary judgment on an alternative ground. If the terms of a trust instrument do not direct the allocation of a receipt to either income or principal, Subchapter D of the Texas Trust Code controls. Thereunder, if the provisions of the Texas Trust Code defining income and principal, Tex.Trust Code ╖ 113.102, fail to provide direction, then the trustee must make the allocation "in accordance with what is reasonable and equitable in view of the interests of those entitled to income and to principal." Tex.Trust Code ╖ 113.101(a). 16
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16 Tex.Trust Code ╖ 113.101(a) directs a trustee to allocate between principal and income as follows:
[B]y crediting a receipt or charging an expenditure to income or principal or partly to each:
(1) in accordance with the terms of the trust instrument;
(2) in the absence of any contrary terms of the trust instrument, in accordance with this subtitle; or
(3) if neither of the preceding rules of administration is applicable, in accordance with what is reasonable and equitable in view of the interests of those entitled to income and to principal.
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In the instant case, the Texas Trust Code definitions of income and principal do not direct the allocation of the ZH capital gains either to income or to corpus. The Texas Trust Code defines income as "the return derived from the use of principal including . . . ," and then provides eight examples. Tex.Trust Code ╖ 113.102(a). None of the examples addresses profits credited to a trust from a limited partnership. The Texas Trust Code lacks a similar generic definition of principal and relies exclusively upon ten examples
("Principal includes . . ."). Tex. Trust Code ╖ 113.102(b). Again, none of the examples addresses profits of a limited partnership credited to a trust. 17 Example eight of Section 113.102(b) broadly defines principal as "profit resulting from any change in the form of principal." As explained generally above, however, the ZH profits credited to the Trust did not result from any change in the form of principal. The Trust's limited partnership interest in ZH was part of the principal of the Trust but the Trust's interest in ZH did not change in form during the tax periods in issue. 18 The securities purchased and sold by ZH were not Trust investments and thus cannot be classified as principal of the Trust Estate.
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17 Both parties argue by analogy that the instant circumstances are similar to allocations directly addressed by the Texas Trust Code. For example, plaintiff, relying on Section 113.102(a)(3), argues that a limited partnership is like a corporation and therefore capital gains from ZH should be considered income because receipts from the ZH partnership are like receipts from a corporation. But ZH is a limited partnership, not a corporation, and therefore Section 113.102(a)(3) does not apply. Plaintiff also relies upon Sections 113.102(a)(5) and 113.106 which provide that net profits from an ongoing business that was started by the settlor of a trust shall be treated as income. Here, the settlors did not start ZH, and thus, Sections 113.102(a)(5) and 113.106 do not apply. Defendant, relying on Section 113.104(c)(3), argues that ZH is like a regulated investment company and therefore ZH capital gains are principal because Texas law allocates the capital gains from a regulated investment company to principal. ZH, however, does not qualify as a regulated investment company because as stated in note 12 above, the definition of a regulated investment company requires in excess of 100 shareholders. 15 U.S.C. ╖ 80a√3(c)(1).
18 Plaintiff appended to its reply to defendant's supplemental brief an affidavit from E. James Gamble, who was appointed Co-Reporter by the National Conference of Commissioners on Uniform State Laws for the revision of the Uniform Principal and Income Act. In his affidavit, Gamble states his opinion that the Uniform Principal and Income Act of 1962 and the provisions of the Texas Trust Code that derive from that Act do not contain a rule which governs the allocation of the ZH profits to either principal or income. Defendant responded by moving to strike Gamble's affidavit. The court, however, has relied upon the plain meaning of the wording of the Trust Agreement and the Texas Trust Code and not the contents of the Gamble affidavit. Defendant's motion to strike is therefore denied as moot.
Material Participation by Trusts, Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014)
April, 2014
Trust With Individual Trustees Can Qualify for “Real Estate Professional Exception;” Activities of Trustees As Employees of Wholly Owned LLC Managing Real Estate Are Considered in Determining If Trust Materially Participates in Real Estate Rental Business
Steve R. Akers Senior Fiduciary Counsel — Southwest Region, Bessemer Trust 300 Crescent Court, Suite 800 Dallas, TX 75201 214-981-9407 [email protected] www.bessemer.com
www.bessemer.com/advisor i
TABLE OF CONTENTS
Brief Synopsis .................................................................................................................... 1
Basic Facts ........................................................................................................................ 1
Holdings ............................................................................................................................ 2
Analysis ............................................................................................................................ 2
Observations ...................................................................................................................... 4
Copyright © 2014 Bessemer Trust Company, N.A. All rights reserved.
Important Information Regarding This Summary This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.
www.bessemer.com/advisor 1
BRIEF SYNOPSIS
The Frank Aragona Trust qualified for the “real estate professional exception” under §469(c)(7), and the trust materially participated in real estate rental business. Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014) (Judge Morrison).
The trust qualified for the real estate professional exception so that rental losses were not disallowed as passive activities for purposes of the passive activity loss rules of §469. The IRS raised and the court addressed two major issues. First, the court rejected the IRS’s contention that a trust can never qualify for the real estate professional exception even though the regulations refer to personal services “performed by an individual.” The court concluded that if the trustees are individuals, their work can be considered “work performed by an individual” and that a trust is capable of performing personal services and therefore can satisfy the §469(c)(7) exception.
Second, the court ruled that the trust materially participated in the real estate business, which is one of the requirements to satisfy the §469(c)(7) real estate professional exception. Three of the six co-trustees were full time employees of a trust-wholly owned LLC that managed the rental properties. The court concluded that the activities of the trustees, including their activities as employees of the LLC, are considered in determining material participation. The court reasoned that their activities as employees counted because (1) Michigan statutory law requires trustees to administer the trust solely in the interests of the beneficiaries, and (2) a Michigan case makes clear that trustees are not relieved of their duties of loyalty by conducting activities thorough a separate entity controlled by the trust. Also, the court rejected the IRS argument that two of the co-trustees owned minority interests in some of the entities that conducted the rental operations and that some of their activities were attributable to their personal portions of the businesses. The court gave several reasons, including that their interests as individual owners were generally compatible with the trust’s goals for the jointly held enterprises to succeed.
BASIC FACTS
The Frank Aragona Trust owned real estate rental properties and also owned interests in wholly owned entities and owned majority interests in other entities that conducted rental real estate activities. The trust was the sole owner of an LLC that managed the real estate properties (it was treated as a disregarded entity for income tax purposes). (The trust also owned majority and minority interests in entities that conducted real estate holding and development activities. Those entities that held and developed real estate were not involved in the issues in this case.)
The trust benefited the grantor’s five children, who shared equally in the trust income.
The grantor was the initial trustee. Following his death, there were six co-trustees-- his five children and one independent person. One of the children served as the “executive trustee” and “the trustees formally delegated their powers to the executive trustee (in order to facilitate daily business operations),” but “the trustees acted as a management board for the trust and made all major decisions regarding the trust’s property.”
Three of the children were full time employees of an LLC that operated the properties.
The LLC employed “several people” in addition to the three children, “including a controller, leasing agents, maintenance workers, accounts payable clerks, and accounts receivable clerks.”
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The five children were paid $72,000 per year as a trustee fee. Those with limited involvement in the business were paid the same trustee fee as those who were full time employees of the LLC. The independent trustee (an attorney) was paid $14,400 per year.
The trust claimed losses from the rental operations in 2005 and 2006, which contributed to net operating losses that the trust carried back to its 2003 and 2004 years. The issue is whether those rental losses are deductible by the trust or whether they should be treated as passive activity losses that are not currently deductible.
HOLDINGS
1. Real Estate Professional Exception. A trust can qualify for the “real estate professional” exception under §469(c)(7) so that rental losses are not disallowed as passive activities for purposes of the passive activity loss rules of §469. If the trustees are individuals, their work can be considered “work performed by an individual” (as required by a regulation), so a trust is capable of performing personal services and therefore can satisfy the §469(c)(7) exception.
2. Material Participation by Trust. The trust materially participated in the real estate business, which is one of the requirements to satisfy the §469(c)(7) real estate professional exception. The activities of three of the co-trustees as employees were considered in determining whether the trust materially participated in the business. Activities by two- co-trustees who also owned minority interests in some of the rental entities were not apportioned between the trust and their personal portions of the businesses.
ANALYSIS
1. Rental Losses Are Passive Unless the Real Estate Professional Exception Applies. Any rental activity is considered a passive activity, §469(c)(2), unless what has been termed the “real estate professional exception” under §469(c)(7) applies.
The exception in §469(c)(7) has two tests. First, more than one-half of the “personal services” performed in trades or businesses by the taxpayer during the taxable year are performed in real property businesses in which the taxpayer materially participates. §469(c)(7)(B)(i). Second, the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. §469(c)(7)(B)(ii). [Observe that both of these tests require material participation by the taxpayer, just to meet the real estate professional exception, aside from the general material participation requirement under §469(c)(1)(B). But presumably the same standards would apply for the general material participation requirement as for the material participation requirement that is part of the real estate professional exception.]
2. Trusts Can Satisfy the Real Estate Professional Exception. The IRS argued that a trust can never meet the real estate professional exception. [This is consistent with the IRS’s position in CCA 201244017.] The regulations describe “personal services” as that term is used in the first of the two tests for the real estate professional exception as meaning “any work performed by an individual in connection with a trade or business.” Reg. §1.469-9(b)(4). The IRS argues, based on its regulations, that a trust is not an individual so cannot possibly meet the requirements of the real estate professional exception. The court rejects
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this argument. While comments in the House Report and Conference Committee Report for §469(c)(7) state that the provision applies to “individuals and closely held C corporations,” the Reports do not say that the exception applies only to individuals and closely held C corporations. Congress could have excluded trusts if had meant to do so; other exceptions in the passive loss rules apply only to “any natural person,” but the §469(c)(7) exception does not have that limitation.
The court reasons that if the trustees are individuals, they can meet this regulatory requirement:
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 performing personal services and therefore can satisfy the section 469(c)(7) exception.
3. Little Authority Regarding Material Participation by Trust. Section 469(h) states that material participation requires “regular, continuous, and substantial” involvement in the operations of the business. Regulations address how individuals or corporations meet the material participation requirement, but there is no statute or regulation addressing how a trust materially participates. There is one line in the legislative history about trust material participation. S. Rept. No 99-313, at 735 (1986), 1986-3 C.B. 1, 735 states that a trust “is treated as materially participating in an activity … if an executor or fiduciary, in his capacity as such, is so participating.”
4. Activities of Non-Trustee Employees. One case has addressed material participation by a trust. It held that the activities of non-trustee employees can be considered in determining whether a trust materially participated in a ranching activity. Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003).
The Aragona Trust court specifically noted that it was not faced with deciding whether the activities of non-trustee agents or employees should be disregarded. (Footnote 15).
5. Activities of Trustees as Employees Are Counted. The IRS argued that the activities of the three co-trustees as full-time employees of the LLC should not be considered because (1) they performed their activities as employees, and (2) it is impossible to disaggregate the activities they performed as employees and as trustees. [This is consistent with the IRS’s reasoning in TAM 201317010.]
The court concluded that the activities of the trustees, including their activities as employees, should be considered in determining whether the trust materially participated in real estate operations. The court reasoned that state law requires trustees to look out solely for the interests of trust beneficiaries, and that trustees are not relieved of their duties of loyalty by conducting activities through an entity wholly owned by the trust.
The trustees were required by Michigan statutory law to administer the trust solely in the interests of the
trust beneficiaries, because trustees have a duty to act as a prudent person would in dealing with the
properly 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)
(construing Mich. Comp. Laws sec. 700.813 (1979), a statute in effect from 1979 to 2000 that was a
similarly-worded predecessor to Mich. Comp. Laws sec. 700.7302).
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Trustees are not relieved of their duties of loyalty to beneficiaries by conducting 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 themselves 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 materially participated in its real-estate operations.
6. Activities of Trustees Who Also Co-Own Interests in the Business Are Counted. The IRS argued that some trustees owned minority interests in some of the real estate activities and some of their activities were attributable to their personal portions of the businesses. The court rejected this argument, giving four reasons for considering the activities of the co-trustees who co-owned minority interests in the same business entities. (1) Their combined interests were not a majority interest. (2) Their combined interest was never more than the trust’s interest in the entities. (3) Their interests as owners were compatible with the trust’s goals for the success of the joint enterprise. (4) They were involved in managing day-to-day operations of the businesses.
7. Multiple Fiduciaries. If there are multiple fiduciaries, how many of them must be involved in the business in order for the trust to materially participate? [Technical Advice Memorandum 200733023 provides that merely labeling a person involved in the business as a “special trustee” will not suffice. The determining factor is whether the special trustee had powers that could be exercised solely without the approval of another trustee. If so, material participation of the special trustee would suffice. This raises the concern by extension of whether a majority of the multiple fiduciaries must be involved in the business.] The Aragona Trust court did not address how to determine material participation by a trust that has multiple trustees. However, in Aragona Trust, three of the six co-trustees (not a majority) were full-time employees of the LLC that operated the real estate business. Therefore, Aragona Trust suggests that having a majority of co-trustees involved in the business is not required in order for the trust to materially participate.
OBSERVATIONS
1. Case of Huge Importance; Increasing Significance Because of 3.8% Tax on Net Investment Income. There has been only one other case (Carter Trust, a federal district court case) addressing how a trust materially participates in a business. This is the first case exhibiting how the Tax Court will address the issue—and it is a “regular” Tax Court case, not just a memorandum opinion.
The issue in Aragona Trust was whether the trust could deduct business losses under §469. Whether a trust materially participates in a business is increasingly important because non-passive business income is not subject to the 3.8% tax on net investment income (NII). The issue has far more importance than when the only issue was the ability to deduct losses under §469. Many trusts own interests in businesses that result in hundreds of thousands if not millions of dollars of business income per year. Whether that trust income is subject to the additional 3.8% tax can be quite significant. Furthermore, Richard Dees (Chicago) points out that the regulations under §1411 take the position that the characterization of trust income as NII is made at the trust level, and distributing income
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to a beneficiary who is actively involved in a business does not convert the income from being NII at the trust level to being non-NII at the beneficiary level. Reg. §1.1411-3(e)(3)(ii). (For grantor trusts, the participation in the business of the grantor deemed-owner of the trust is determinative.)
2. “Regular” Tax Court Opinion. This is a “regular” Tax Court opinion, not a memorandum opinion of one judge. Taxpayers faced with similar situations know they can challenge the IRS in the Tax Court, rather than in a district court, and know the Tax Court’s position.
3. Possibility of IRS Guidance Project. There is little guidance regarding how a trust or estate “materially participates” in a trade or business, under either the §469 or §1411 regulations. The §1411 final regulations declined to provide any guidance regarding this issue, despite the fact that it is now of much greater importance than for just the passive activity loss rules. The Preamble to the final regulations points out that “the issue of material participation of estates and trusts is currently under study by the Treasury Department and the IRS and may be addressed in a separate guidance project issued under section 469 at a later date.” The IRS requested comments, including “recommendations on the scope of any such guidance and on specific approaches to the issue.”
While Aragona Trust provides very important viewpoints of the Tax Court, various issues remain for which the IRS could provide helpful guidance (for example, whether material participation by a decedent would be “tacked” to the estate or perhaps to a testamentary trust for some period of time).
4. Overview of IRS Growing Attacks on Trust Material Participation. Regulations addressing passive activity rules for trusts and estates have never been written. The IRS position is that the trustee must be involved directly in the operations of the business on a “regular, continuous, and substantial” basis. The IRS points to the legislative history of §469, which states very simply:
Special rules apply in the case of taxable entities that are subject to the passive loss rule. An estate or trust is treated as materially participating in an activity if an executor or fiduciary, in his capacity as such, is so participating. S. Rep. No. 99-313, at 735.
The IRS lost the only prior reported case that has addressed material participation by trusts. (The Mattie K. Carter Trust case is discussed below.) Since then, the IRS has issued several informal ruling positions, generally taking a strict approach toward trust material participation.
Letter Ruling 200733023 disagreed with the Carter Trust decision and said that activities of “Special Trustees” would not be considered in determining the trust’s material participation if they did not have the authority to commit the trust to any course of action without approval of the trustees.
Letter Ruling 201029014 was taxpayer friendly in recognizing that a trust could materially participate in the activities of a multi-tiered subsidiary through the activities of its trustee even though the trustee had no direct authority to act with respect to the business in its capacity as trustee (because of the remote relationship of the trust to the subsidiary).
Technical Advice Memorandum 201317010 takes a very hard-nosed approach, refusing to recognize the activities of a co-trustee who was also the president of a subsidiary of an S
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corporation in which the trust owned an interest, reasoning in part that the activities were largely in the individual’s capacity as employee and not as trustee. The Aragona Trust case in particular seems to undermine the IRS’s strict approach in that TAM.
This prior case and these prior rulings are discussed in more detail below. Query whether, following its loss in Aragona Trust, the IRS will change its harsh attacks on seemingly every effort by a trust to materially participate in a business.
5. Specific Facts of Aragona Trust Involved Wholly Owned Management Entity. The court’s reasoning in Aragona Trust was related to the specific facts of the case. The court reasoned that state law requires trustees to look out solely for the interests of trust beneficiaries, and that trustees are not relieved of their duties of loyalty by conducting activities through an entity wholly owned by the trust (citing In re Estate of Butterfield, which refers to trustees who are directors of a corporation controlled by the trust). The court’s reasoning is understandable in light of the fact that it specifically addressed the fact scenario presented by the Aragona Trust. The court gave no indication that it would necessarily limit its reasoning to that situation. Indeed, the first rationale (that the trustee must look out solely for the interests of trust beneficiaries) seems to acknowledge that any activities of a trustee must be consistent with the trustee’s duties to the beneficiaries.
6. Can Trustee Ever “Take Off Its Hat” As Trustee? Some commentators have described this issue in terms of whether a trustee can ever “take off its hat” as a fiduciary. Under this approach, all activities of a trustee should be considered in determining material participation by the trust.
A review of the existing tax guidance supports considering all of a trustee’s actions in a trust-owned business in whatever capacity the trustee acts in determining whether the trust materially participates. The non-tax authorities support this conclusion too: the trustee is unable to completely remove her trustee “hat” when donning a different “hat” in a different capacity in the business. Where a trustee also acts in a potentially managerial role (e.g., for an entity the equity interests of which are trust assets), the trustee’s fiduciary duties extend to her managerial activities. A trustee cannot disregard her fiduciary obligations to the beneficiaries when acting in another capacity, for example, as an employee or director, in a business owned by the trust. Because the trust will be a shareholder, the fiduciary duties a trustee owes the beneficiaries will not conflict with the fiduciary duties a director owes the shareholders. If they do, however, the director/trustee will have to recuse herself. Thus, all of the actions undertaken by an individual trustee with respect to any activity owned directly or indirectly by the trust are subject to her fiduciary obligations to the trust beneficiaries and, therefore, relevant to determine whether the trust materially participates under Code sections 469 and 1411. Richard Dees, 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax, Part 1, TAX NOTES 683, at 688-700 (Aug. 12, 2013) (Question 10) and Richard Dees, 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax, Part 2, TAX NOTES 785 (Aug. 19, 2013).
In support of his analysis, Mr. Dees cites (and quotes) the Restatement (Third) of Trusts §78, Bogert on Trusts and Trustees §543 (Dec. 2012), and In re Schulman, 165 A.D.2d 499, 502 (N.Y. App. Div. 3d Dep’t 1991).
7. Activities of Non-Trustee Agents of Trust Constituted Trust Material Participation, Mattie K. Carter Trust v. U.S. A 2003 federal district court was the first to address in a reported case what activities can qualify as material participation under the passive loss rules for trusts and estates. The Mattie K. Carter Trust v. U.S., 256 F. Supp.2d 536 (N.D. Tex. 2003). In the Carter Trust case, the trust operated active ranch operations, and the trustee hired a ranch manager (who was not a trustee). The IRS maintained that was not material
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participation for the trust because the trustee individually did not materially participate. The taxpayer maintained that, analogous to a closely held C corporation (see footnote 3 of the opinion), it could only participate in an activity through its fiduciaries, agents, and employees and that the activities of employees and agents of the trust should be included. The District Court sided with the taxpayer, concluding that material participation should be determined by reference to all persons who conducted the business on the trust’s behalf, including employees as well as the trustee. Participation is tested by the activities of the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of the trust. Section 469 states that “a taxpayer” is treated as materially participating in a business if “its” activities in pursuit of that business are regular, continuous, and substantial. I.R.C. § 469(h)(1). The court reasoned that measuring the trust’s participation by reference only to the trustee “finds no support within the plain meaning of the statue. Such a contention is arbitrary, subverts common sense, and attempts to create ambiguity where there is none.” The court observed that no regulations are on point, but “the absence of regulations and case law does not manufacture statutory ambiguity.” The court acknowledged that it had studied the “snippet of legislative history IRS supplied” (including the Senate Finance Committee Report) as well as a footnote in the Joint Committee on Taxation’s General Explanation of the Tax Reform Act of 1986, at 242 n.33, but the opinion concludes that “the court only resorts to legislative history were the statutory language is unclear, … which, … is not the case here.”
Aragona Trust in footnote 15 said that it was not faced with and did not address whether activities by non-trustee employees are considered in determining a trust’s material participation.
8. Technical Advice Memorandum 200733023; Rejection of Carter Trust Reasoning, Treatment of Special Trustee. The IRS disagreed with Carter Trust in Technical Advice Memorandum 200733023, concluding that notwithstanding the Carter Trust decision, the sole means for a trust to establish material participation is by its fiduciaries being involved in the operations, relying primarily on the legislative history that made specific reference to “an executor or fiduciary, in his capacity as such” clause. The ruling also reasoned that because a business will generally involve employees or agents, a contrary approach would result in a trust invariably being treated as materially participating in the trade or business activity, rendering the requirements of §469(h)(1) superfluous.
TAM 200733023 also addresses the effect of having Special Trustees with responsibility for the business. The ruling concluded under the facts of that situation, the Special Trustees were not fiduciaries for purposes of §469, because they gave recommendations but they were not able to commit the trust to any course of action or control trust property without the Trustees’ express consent. The Trustees retained final decision-making authority over all facets of the business. The ruling reasoned that if advisors, consultants, or general employees could be classified as fiduciaries simply by labeling them so, the §469 material participation requirement for trustees would be meaningless. Furthermore, the ruling concluded that even if the Special Trustees were considered fiduciaries, many of their activities would not count in determining the trust’s involvement in the business, because time spent negotiating the sale of the trust’s interest in the company and resolving a tax dispute with another partner was not time spent managing or operating the business.
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9. PLR 201029014; No Strict Application of “In Such Capacity” Clause in Legislative History. Private Letter Ruling 201029014 reiterates the general IRS position that a trust materially participates in business activities only if the trustee is involved in the operations of the entity’s activities on a regular, continuous, and substantial basis. It did not mention the Carter Trust case, but it cited the Senate Report’s “in such capacity” language. The issue was whether a trust could materially participate in the business of a subsidiary (Sub 2) of a subsidiary (Sub 1) owned by a partnership in which the trust owned an interest. In light of the trust’s remote relationship with Sub 2, a strict application of the “in such capacity” clause in the legislative history would seemingly have prevented the trustee from being able to materially participate, because any actions of the trustee in the business of Sub 2 would have been taken in some capacity other than as trustee. In PLR 201029014, the IRS did not apply this strict approach, but agreed with the taxpayer that the trustee could materially participate in Sub 2 through the trustee’s regular, continuous and substantial involvement in the operations of Sub 2.
10. TAM 201317010; IRS’s Most Recent Strict Attack—Activities of Co-Trustee Who Was President of Business Not Counted in Determining Trust’s Material Participation. If a trust owns an interest in an active trade or business operation, a planning consideration will be whether to name some individual who is actively involved in the business as a co-trustee. However, the IRS questioned that strategy in Technical Advice Memorandum 201317010 (released April 26, 2013). The trust in that TAM had owned stock in an S corporation. The trust had a trustee and a “Special Trustee.” The trustee “did not participate in the day-to-day operations of the relevant activities” of the company. The individual who was the Special Trustee was also the president of a qualified Subchapter S subsidiary of the S corporation. The trust instrument limited the Special Trustee’s authority in selling or voting the S corporation stock. The IRS concluded that the trust did not materially participate in the activities of the company for purposes of the §469 passive loss rules. The ruling highlights two issues: (1) the Special Trustee’s authority was limited to voting and selling the S corporation stock; and (2) the Special Trustee’s activities as president were not in the role as fiduciary. As to the first issue, the ruling concluded that time spent serving as Special Trustee voting the stock of the company or considering sales of stock would count for purposes of determining the trust’s material participation in the business, but the “time spent performing those specific functions does not rise to the level of being ‘regular, continuous, and substantial.’” As to the second issue, the ruling stated in its recitation of facts that the individual serving as president and Special Trustee “is unable to differentiate time spent” as president, as Special Trustee, and as a shareholder. The ruling reasoned that under §469 the owner of a business may not look to the activities of the owner’s employees to satisfy the material participation requirement, or else an owner would invariably be treated as materially participating because most businesses involve employees or agents. The ruling concluded that the work of the individual serving as Special Trustee and president “was as an employee of Company Y and not in A’s role as a fiduciary” of the trust and therefore “does not count for purposes of determining whether [the trust] materially participated in the trade of business activities” of the company.
TAM 201317010 creates a significant distinction in the treatment of individuals vs. trusts with respect to the “employee” issue. For individual taxpayers, their activities as employees of a business will be considered for purposes of determining their material participation in the business. For trust taxpayers, the IRS position is that the activities of a trustee as an
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employee of the business cannot be considered to determine the trust’s material participation in the business.
Aragona Trust goes a long way toward rejecting the IRS’s strict position in TAM 201317010. The IRS’s arguments in Aragona Trust were very similar to its reasoning in TAM 201317010 for not considering the activities by the LLC employees/trustees in the business operations:
[The IRS] 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.
The court’s rejection of the IRS’s position direct rejection of this reasoning calls into question the basic tenets of the TAM. Furthermore, the court rejected the same type of reasoning with respect to its refusal to consider separately the activities attributable to the trust portion and the individual portion of the business by the trustees who also owned personal interests in the business.
Query whether the distinction of serving as employee of the wholly owned LLC in Aragona Trust vs. serving as employee of the corporation in the TAM is significant?
11. Comments of ABA Tax Section Recommend Recognizing All Activities of Trustees in Determining Trust Material Participation. Comments to the proposed regulations under §1411 by the American Bar Association Tax Section submitted on April 5, 2013 recommend that the IRS issue new proposed regulations regarding material participation for a trust or estate for purposes of §1411. The Tax Section Comments propose that such regulations recognize material participation by an estate or trust under any of three tests, one of which is that “[t]he fiduciary participates in the activity on a regular, continuous, and substantial basis, either directly or through employees or contractors whose services are directly related to the conduct of the activity.” In addition to recognizing actions through employees or contractors, material participation of a trust could be based on direct participation of the fiduciary, and in that context, the Tax Section Comments reason that
any time spent working on the activity should be considered towards meeting the material participation requirements regardless of whether the fiduciary is working on the activity as a fiduciary or in another role, for instance as an officer or an individual investor. If there are multiple fiduciaries, time spent by the fiduciaries could be aggregated for purposes of determining material participation.
12. Multiple Trustees. There is no guidance regarding what activities of multiple co-trustees are needed to satisfy the material participation requirement. Must all co-trustees materially participate? A majority? Any one co-trustee? Aragona Trust does not address this issue expressly, but on the facts of the case, material participation by each of three out of six co-trustees (not a majority) was sufficient. At a minimum this suggests that material participation by a majority of co-trustees is not required.
Can the activities of the co-trustees be aggregated? For example, if the 500 hour test that applies to individuals is applied to the activities of trustees, would the trust materially participate if the co-trustees in the aggregate devoted 500 hours to the business? This issue was not presented in Aragona Trust because each of three co-trustees met the 500 hour test (because they each worked “full time” for the LLC).
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13. Outstanding Resource. For a detailed discussion of the application of the non-passive trade or business income exception from the §1411 tax to trusts, see Richard Dees, 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax, Part 1, TAX NOTES 683, at 688-700 (Aug. 12, 2013) and Richard Dees, 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax, Part 2, TAX NOTES 785 (Aug. 19, 2013). Another excellent resource including planning strategies with respect to the trust material participation issue is Steve Gorin, Structuring Ownership of Privately-Owned Business: Tax and Estate Planning Implications (2014) (a 500+ page article addressing a variety of tax and estate planning issues for businesses available from the author at [email protected]).
142 T.C. No. 9
UNITED STATES TAX COURT
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 engagedin other real-estate activities. T’s rental real-estate activities would beconsidered per se passive activities under I.R.C. sec. 469(c)(2) unlessT qualified for the exception found in I.R.C. sec. 469(c)(7). Thisexception is applicable if more than one-half of the personal servicesperformed in trades or businesses by the taxpayer are performed inreal-property trades or businesses in which the taxpayer materiallyparticipates and if the taxpayer performs more than 750 hours ofservices during the year in real-property trades or businesses in whichthe 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 withinthe meaning of I.R.C. sec. 469(c)(7). Services performed byindividual trustees on behalf of the trust may be considered personalservices performed by the trust.
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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”), determining the following deficiencies in federal income tax and the
following penalties:
Year Deficiency
Accuracy-relatedpenalty
sec. 6662(a)
2003 $86,289.00 $17,257.80
2004 421,292.00 84,258.40
2005 -0- -0-
2006 84,540.00 16,908.00
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The trust filed a petition as permitted by section 6213(a). We have jurisdiction to1
redetermine the deficiencies and penalties under section 6214(a). After
concessions, the two issues remaining for decision are: 2
(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 resolution of the first issue.
FINDINGS OF FACT
Some facts have been stipulated by the parties. The stipulated 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
Even though the petition was filed by Paul V. Aragona, the executive1
trustee, for ease of reference we refer to the trust as having filed the petition. Inany event we do not mean to suggest whether the petitioner in this case is thetrustee or the trust. See sec. 7482(b)(1)(A) (providing that default appellate venuefor deficiency cases is the circuit in which is located the legal residence of thepetitioner). We do not reach that particular question.
All references to sections are to the Internal Revenue Code of 1986, as ineffect for the years at issue.
The IRS conceded that the trust is not liable for any accuracy-related2
penalties for the 2003, 2004, and 2006 tax years. (The notice of deficiency did notdetermine a penalty for 2005.)
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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. The other3
five trustees were Frank Aragona’s five children, including Paul V. Aragona, the
executive trustee. Although the trustees formally delegated their powers to the4
executive trustee (in order to facilitate daily business operations), 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 children--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 disregarded entity for federal income tax
The trust instrument gives the independent trustee the power to distribute3
the principal of the trust under limited circumstances.
When the petition was filed, Paul V. Aragona was a resident of Michigan. 4
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purposes. Holiday Enterprises, LLC, managed most of the trust’s rental real-estate
properties. It employed several people in addition to 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:
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Name of trustee RoleAnnual trustee
fee
Salvatore S. Aragona Full-time dentist; limited involvement in trust’s business $72,000
Paul V. Aragona Executive trustee; full-time employee of Holiday Enterprises, LLC 72,000
Anthony F. Aragona Disabled; limited involvement in trust’s business 72,000a
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
The $72,000 annual trustee fee for Anthony F. Aragona was reported as aa
distribution 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
- 7 -
Anthony F. Aragona). The losses reported as being 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, a determination that increased the5
passive-activity losses for 2005 and 2006. The increase in the passive-activity6
The notice of deficiency stated that “[t]he rental losses incurred are deemed5
passive”.
A passive-activity loss is the amount by which aggregate losses from all the6
(continued...)
- 8 -
losses resulted in a decrease in the allowable deductions from gross income for
each of those years, which decreased the net-operating-loss carrybacks to the7
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 reclassified 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 1041instead of $302,400.00 and $302,400.00 shown as a rental expense
(...continued)6
taxpayer’s passive activities for the year exceed the aggregate income from all thetaxpayer’s passive activities for the year. Sec. 469(d)(1). The trust’s losses fromits rental real-estate activities exceeded its income from the activities. Therefore,characterizing the trust’s rental real-estate activities as passive resulted in a netincrease in the trust’s passive-activity loss for each year.
The existence of a passive-activity loss for the year results in the7
disallowance of current deductions in the amount of the passive-activity loss forthe year. Sec. 1.469-1T(a)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5701(Feb. 25, 1988).
- 9 -
deduction on the Schedule E for taxable years 2005 and 2006,respectively.
The adjustment was made to the rental loss claimed by HolidayEnterprises to disallow the trustee fees as an “other” expense and theexpense was moved to Line 12 on the face of the return where theyare 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. Commissioner, 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. Section 469(a)(1) provides that a
taxpayer’s passive-activity loss is disallowed for the year if the taxpayer is
- 10 -
“described in” section 469(a)(2). The following taxpayers are “described in”8
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 from all the taxpayer’s passive activities for the year exceeds the
aggregate income from all the taxpayer’s passive activities 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 section 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
A loss from an activity disallowed under sec. 469(a) is treated as a8
deduction allocable to such activity for the next tax year. Sec. 469(b).
The following reason was given for the amendment:9
The passive loss rules limit deductions and credits from passive(continued...)
- 11 -
Section 469(c)(7)(B) consists of two tests. The first test is met if more than one-
half of the “personal services” performed 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
(...continued)9
trade or business activities. Deductions attributable to passiveactivities, to the extent they exceed income from passive activities,generally may not be deducted against other income, such as wages,portfolio income, or business income that is not derived from apassive activity. * * *
* * * * * *
The committee considers it unfair that a person who performspersonal services in a real estate trade or business in which hematerially participates may not offset losses from rental real estateactivities against income from nonrental real estate activities oragainst other types of income such as portfolio investment income. * * *
H. R. Rept. No. 103-111, at 612-613 (1993), 1993-3 C.B. 1, 188-189.
Sec. 469(c)(7)(B) provides in part:10
This paragraph shall apply to a taxpayer for a taxable year if--
(continued...)
- 12 -
Section 469(c)(7)(D)(i) provides a special rule for determining 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 ofsubparagraph (B) shall be treated as met for any taxable year if morethan 50 percent of the gross receipts of such corporation for suchtaxable year are derived from real property trades or businesses inwhich the corporation materially participates.
Thus, the determination of whether a closely held C corporation 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.
(...continued)10
(i) more than one-half of the personal services performed intrades or businesses by the taxpayer during such taxable year areperformed in real property trades or businesses in which the taxpayermaterially participates, and
(ii) such taxpayer performs more than 750 hours of servicesduring the taxable year in real property trades or businesses in whichthe taxpayer materially participates.
- 13 -
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) exception is found in
section 1.469-9, Income Tax Regs. This regulation 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 paragraph (c) provision referred to in the quotation above) provides:
“(1) In general.--A qualifying taxpayer must meet the requirements of section
469(c)(7)(B).” Thus, to be a “qualifying taxpayer” within the meaning of the
regulation a taxpayer 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 individual in connection
- 14 -
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 corporation meets the
requirements of paragraph (c)(1) of this section 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 materially 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.
- 15 -
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), 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 Committee 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 taxpayer performs in a trade or business are in real property
trades or businesses in which he materially participates.” Id. (The bill adopted by
- 16 -
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 taxpayer 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 further stated that a closely held C corporation meets the
requirements of the exception “if more than 50 percent of its gross receipts for the
- 17 -
taxable year are derived from real property 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 amodification. Under the conference agreement, an individualtaxpayer meets the eligibility requirements if (1) more than half of thepersonal services the taxpayer performs in trades or businesses duringthe taxable year are performed in real property trades or businesses inwhich the taxpayer materially participates, and (2) such taxpayerperforms more than 750 hours of services during the taxable year inreal property trades or businesses in which the taxpayer materiallyparticipates. * * *
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
- 18 -
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 performing personal services and therefore can
satisfy the section 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 the phrase “natural person” but
instead used the word “taxpayer” 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:
- 19 -
(1) the word “individual” in the regulation should be interpreted 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 taxpayers 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 Committee 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 individuals 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 individual falls
within the section 469(c)(7) exception by meeting the two tests. But this does not
mean that other types of taxpayers cannot fall within the exception.
- 20 -
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-property 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 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 substantial. 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), Temporary
Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988). Section 469(h)(4) provides
a method for determining whether certain types of corporations have met the11
The IRS does not take the position that the trust should be treated as a11
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).
- 21 -
tests for material 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 guidance. 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 participating in an activity * * * if an executor
A number of commentators have argued that there is a need for a12
regulation that resolves questions regarding material participation of trusts andgenerally coordinates the passive-activity-loss rules of sec. 469 with the rules ontaxation of trusts in subch. J. See, e.g., 1 Byrle K. Abbin, David K. Carlson, andMark L. Vorsatz, Income Taxation of Fiduciaries and Beneficiaries, sec. 801, at8003 to 8004 (2012 ed.) (“Section 469 does not easily comport with subchapter J. To date no regulatory explanation has been forthcoming * * * [on questionsincluding] where and how material participation is measured[.]”); M. CarrFerguson, James J. Freeland, and Mark L. Ascher, Federal Income Taxation ofEstates, 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 IWere King)”, 58 Tax L. Rev. 191 (2005).
- 22 -
or fiduciary, in his capacity as such, is so participating.” The Senate committee
report also stated 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. Additionally, the IRS would have14
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.
The Senate committee report stated:13
The fact that a taxpayer utilizes employees or contract servicesto perform daily functions in running the business does not preventsuch taxpayer from qualifying as materially participating. However,the activities of such agents are not attributed to the taxpayer, and thetaxpayer must still personally perform sufficient services to establishmaterial participation.
S. Rept. No. 99-313, at 735 (1986), 1986-3 C.B. (Vol. 3) 1, 735.
The IRS disagrees with Carter Trust v. United States, 256 F. Supp. 2d 536,14
541 (N.D. Tex. 2003), which held that the activities of the trust’s non-trusteeemployees (and of the trustee) are considered in determining whether the trustmaterially participated in ranching activity.
- 23 -
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 dentist, 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, the activities of the trustees--including their activities as employees15
of Holiday Enterprises, 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 administer the trust solely in the interests of
the trust beneficiaries, 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) (construing
Mich. Comp. Laws sec. 700.813 (1979), a statute in effect from 1979 to 2000 that
We need not and do not decide whether the activities of the trust’s non-15
trustee employees should be disregarded.
- 24 -
was a similarly-worded predecessor to Mich. Comp. Laws sec. 700.7302).
Trustees are not relieved of their duties of loyalty to beneficiaries by conducting
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 themselves 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 materially 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
We need not consider the effect of sec. 469(c)(7)(D)(ii), which provides16
that for purposes of sec. 469(c)(7)(B) personal services performed as an employeeare generally not treated as performed in real-property trades or businesses. Thisrule has no application to the resolution of this case because, 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-propertytrades or businesses. Thus, we need not, and do not, determine how many hours ofpersonal 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.
- 25 -
operations full time. The trust’s real-estate operations were substantial. The trust
had practically no other types of operations. 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 operated real-estate holding and real-estate
development projects and because they had minority interests in some of the
entities 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 portions 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 combined 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 combined 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 operations of the
trust’s various real-estate businesses.
- 26 -
We hold that the trust materially participated in real-property 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 arguments to the two
arguments discussed above, namely (1) that trusts are categorically barred from
qualifying under the section 469(c)(7) exception, and (2) that the trust did not
materially 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 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
- 27 -
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 activities 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
In determining whether a taxpayer who qualifies for the sec. 469(c)(7)17
exception has materially participated in a rental real-estate activity, each interest inrental real estate is treated as a separate rental real-estate activity unless thetaxpayer has made an election under section 469(c)(7)(A). If the taxpayer hasmade such an election, then all interests in rental real estate are treated as a singlerental real-estate activity. Sec. 469(c)(7)(A). Before the years at issue, the trustmade an election under sec. 469(c)(7)(A)--an election that was binding forsubsequent tax years, absent changed circumstances--to treat all of its interests inrental real estate as a single activity.
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deductions other than passive-activity-loss deductions (and allowed the full
deduction of $302,400). The treatment of the $302,400 in trustee fees as18
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. The trust appears19
to disagree with the assumption in the notice of deficiency: the trust apparently
A passive-activity loss is generally defined as the amount, if any, by which18
the passive-activity deductions for the year exceed the passive-activity grossincome for the tax year. Sec. 1.469-2T(b)(1), Temporary Income Tax Regs., 53Fed. Reg. 5711 (Feb. 25, 1988). Passive-activity gross income is generally allitems of gross income from a passive activity. Sec. 1.469-2T(c), TemporaryIncome Tax Regs., supra. A passive-activity deduction is generally defined as adeduction arising in connection with the conduct of a passive activity. Sec. 1.469-2T(d)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5716 (Feb. 25, 1988).
In its brief, the IRS frames the issue of proper characterization of the19
trustee fees as: “Whether petitioner should have reported trustee fee expenses onthe front of its U.S. Income Tax Return for Estates and Trusts, Form 1041, or onthe 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 reference to the notice of deficiency’sassumption that the trustee fees are not the expenses of the trust’s rental real-estateactivity.
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contends that the trustee fees were the expenses of the trust’s rental real-estate
activities. 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.
In its reply brief, the trust argues that the trustee fees are “properly20
included in the determination of the Trust’s losses from its real estate activities.” Strictly speaking, however, the computations in the notice of deficiency assumedthat the trustee fees were not the expenses of the trust’s rental real-estate activities.
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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.
To reflect the foregoing,
Decision will be entered
under Tax Ct. R. Pract. & Proc. 155.
Refreshing Expiring Distribution Carryovers of Private Foundations
QUESTION
Can a private foundation make an election to treat a qualifying distribution as made out of corpus, in order to refresh an expiring excess distribution carryover under Code section 4942?
ANSWER
A private foundation cannot refresh the life of an excess qualifying distribution carryover beyond the five-year period set forth in section 4942(i) by making an election to treat a current-year qualifying distribution as made out of corpus. It has been brought to the attention of the IRS that some private foundations may be attempting to refresh or renew or prolong their expiring excess qualifying distribution carryovers under Code section 4942(i) beyond the five-year limit in this manner, which is not permitted under the regulations. The following discussion is intended to supplement the instructions to Part XIII of Form 990-PF.
BACKGROUND
Code section 4942 effectively requires a private foundation (other than an operating foundation) to make qualifying distributions at least equal to its distributable amount for the tax year. An excise tax is imposed on the shortfall (referred to as undistributed income).
Section 4942(h) treats qualifying distributions as made:
• First, out of the undistributed income for the prior tax year; • Second, out of undistributed income for the current tax year (unless the
foundation elects to treat all or a part as made out of corpus); and • Third, out of corpus.
Thus, if a foundation has no undistributed income for the prior tax year, it may elect to treat all of its qualifying distributions as made out of corpus.
A foundation may make an election to treat qualifying distributions as made out of corpus for several reasons. The foundation may have undistributed income for one or more tax years preceding the prior tax year and thus need to correct deficient distributions for such year(s). The foundation may want to qualify as a pass-through foundation under Code section 170(b)(1)(F)(ii), or may want a donor foundation to receive credit for a qualifying distribution to it, as set forth in section 4942(g)(1)(A)(i) or (ii) and (g)(3) (contributions to private non-operating foundations or to certain controlled organizations).
A private foundation has excess qualifying distributions for a particular tax year if the foundation’s distributable amount for the year is less than the combination of its
qualifying distributions made out of undistributed income for the year and out of corpus with respect to the year. Amounts distributed out of corpus as required for pass-through contributions under section 170(b)(1)(F)(ii) or 4942(g)(3), or to correct deficient distributions in prior years are not considered in this calculation, however. Regulations section 53.4942(a)-3(e)(2). Thus, in no case can the carryover generated in the particular tax year exceed the qualifying distributions for the year less the distributable amount for the year.
An excess of qualifying distributions may be carried forward for up to five years. Section 4942(i)(2).
DISCUSSION
The problem at issue is explained in the following examples.
Example 1. X Foundation has an unused excess qualifying distribution carryover of $100,000 from a prior year (5 years ago) that will expire if it is not used in its current tax year. For its current tax year, X Foundation has a distributable amount of $100,000 and qualifying distributions also of $100,000. X Foundation has no undistributed income from prior tax years, and does not elect to distribute any part of its qualifying distributions in satisfaction of sections 170(b)(1)(F)(ii) or 4942(g)(3). Because its qualifying distributions for the year do not exceed its distributable amount for the year, X Foundation has no excess distribution carryover for its current tax year, and its $100,000 carryover from 5 years ago must expire. X Foundation cannot generate an excess distribution carryover for its current tax year by electing to treat the $100,000 qualifying distribution for the current year (or any part of it) as made out of corpus and applying the $100,000 carryover from the prior year (or any part of it) in satisfaction of its distributable amount for the current year.
Example 2. Same facts as in Example 1, except that instead of a $100,000 carryover from 5 years ago, X Foundation has unused excess qualifying distribution carryovers of $20,000 for each of the five prior years. Again, X Foundation has no excess distribution carryover for its current tax year, so in this case its $20,000 carryover from 5 years ago must expire. X Foundation cannot generate an excess distribution carryover for its current tax year by electing to treat the $100,000 qualifying distribution for the current year (or any part of it) as made out of corpus and applying the $20,000 carryovers from each of the five prior years (or any part of them) in satisfaction of its distributable amount for the current year.
http://www.irs.gov/Charities-&-Non-Profits/Private-Foundations/Refreshing-Expiring-Distribution-Carryovers-of-Private-Foundations
Page Last Reviewed or Updated: 30-Apr-2013
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Resource Guide
“2013 Trust Nexus Survey: Analysis of Key Factors Driving State Taxation of Trusts” http://www.bna.com/uploadedFiles/Content/PDFs/2013%20Trust%20Nexus%20Special%20Report%20Complete.pdf “The Good, the Bad & the Ugly of Trusts Investing in Partnerships” by David Nave http://papers.ssrn.com/sol3/papers.cfm?abstract_id=923081
Sections 305.4 and 305.5 from Income Taxation of Fiduciaries and Beneficiaries by Byrle M. Abbin http://tinyurl.com/kj44s7z
Why Some Taxpayers Benefit from Not Claiming Deductions” by Joseph D. Beams and W. Eugene Seago http://tax.cchgroup.com/onlinestore/sample-issues/TAXES-issue2.pdf
“Private Foundations: Many Routine Investment Activities are Neither Subject to the Section 4940 Excise Tax Nor to UBIT” by Richard R. Upton http://www.pbwt.com/files/Publication/65c8a2ef-7ad3-49b2-bb9d-9b7d188f8432/Presentation/PublicationAttachment/96f051aa-1291-4a9d-9c53-9d5982e318d4/Upton1.pdf
“Including Capital Gains in Trust or Estate Distributions After ATRA” by Frederick Sembler. Available for purchase at http://wealthmanagement.com/estate-planning/including-capital-gains-trust-or-estate-distributions-after-atra-0 PPC’s 1041 Deskbook. Available for purchase at http://store.tax.thomsonreuters.com/accounting/Tax/PPCs-1041-Deskbook/p/100200169 “20 Questions (and 20 Answers!) On the New 3.8 Percent Tax” by Richard L. Dees http://tinyurl.com/kxl5hkv
