                             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 engaged
in other real-estate activities. T’s rental real-estate activities would be
considered per se passive activities under I.R.C. sec. 469(c)(2) unless
T qualified for the exception found in I.R.C. sec. 469(c)(7). This
exception is applicable if more 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 and if the taxpayer performs more than 750 hours of
services during the year in real-property trades or businesses in which
the taxpayer materially participates.

      Held: A trust can qualify for the I.R.C. sec. 469(c)(7)
exception. A trust is capable of performing personal services within
the meaning of I.R.C. sec. 469(c)(7). Services performed by
individual trustees on behalf of the trust may be considered personal
services performed by the trust.
                                    -2-

            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:

                                                         Accuracy-related
                                                             penalty
              Year                 Deficiency              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
                                         -3-

The trust filed a petition as permitted by section 6213(a).1 We have jurisdiction to

redetermine the deficiencies and penalties under section 6214(a). After

concessions,2 the two issues remaining for decision are:

      (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



      1
        Even though the petition was filed by Paul V. Aragona, the executive
trustee, for ease of reference we refer to the trust as having filed the petition. In
any event we do not mean to suggest whether the petitioner in this case is the
trustee or the trust. See sec. 7482(b)(1)(A) (providing that default appellate venue
for deficiency cases is the circuit in which is located the legal residence of the
petitioner). We do not reach that particular question.
       All references to sections are to the Internal Revenue Code of 1986, as in
effect for the years at issue.
      2
       The IRS conceded that the trust is not liable for any accuracy-related
penalties for the 2003, 2004, and 2006 tax years. (The notice of deficiency did not
determine a penalty for 2005.)
                                          -4-

of business was in Michigan when it filed the petition. In 1979 Frank Aragona

formed the trust with him as grantor and trustee and with his five children as

beneficiaries. According to the trust instrument, the five children share equally in

the income of the trust. Frank Aragona died in 1981. He was succeeded as trustee

by six trustees. One of the six trustees was an independent trustee.3 The other

five trustees were Frank Aragona’s five children, including Paul V. Aragona, the

executive trustee.4 Although the trustees formally delegated their powers to the

executive trustee (in order to facilitate daily business 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



      3
        The trust instrument gives the independent trustee the power to distribute
the principal of the trust under limited circumstances.
      4
          When the petition was filed, Paul V. Aragona was a resident of Michigan.
                                        -5-

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:
                                        -6-

                                                                   Annual trustee
     Name of trustee                        Role                       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

      a
        The $72,000 annual trustee fee for Anthony F. Aragona was reported as a
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,5 a determination that increased the

passive-activity losses for 2005 and 2006.6 The increase in the passive-activity


      5
       The notice of deficiency stated that “[t]he rental losses incurred are deemed
passive”.
      6
          A passive-activity loss is the amount by which aggregate losses from all the
                                                                        (continued...)
                                        -8-

losses resulted in a decrease in the allowable deductions from gross income for

each of those years,7 which decreased the net-operating-loss carrybacks to the

2003 and 2004 years. The notice of deficiency determined that for each of 2005

and 2006 the trust should be allowed a deduction of $302,400 for “Fiduciary fees”.

The notice of deficiency also determined that the trust’s Schedule E expenses,

which, as reported on the returns, included the $302,400 in trustee fees, should be

reduced by $302,400. Thus, the notice of deficiency 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 1041
      instead of $302,400.00 and $302,400.00 shown as a rental expense


      6
        (...continued)
taxpayer’s passive activities for the year exceed the aggregate income from all the
taxpayer’s passive activities for the year. Sec. 469(d)(1). The trust’s losses from
its rental real-estate activities exceeded its income from the activities. Therefore,
characterizing the trust’s rental real-estate activities as passive resulted in a net
increase in the trust’s passive-activity loss for each year.
      7
       The existence of a passive-activity loss for the year results in the
disallowance of current deductions in the amount of the passive-activity loss for
the year. Sec. 1.469-1T(a)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5701
(Feb. 25, 1988).
                                         -9-

      deduction on the Schedule E for taxable years 2005 and 2006,
      respectively.

      The adjustment was made to the rental loss claimed by Holiday
      Enterprises to disallow the trustee fees as an “other” expense and the
      expense was moved to Line 12 on the face of the return where they
      are required to be shown as “fiduciary fees”.

Computationally, the notice of deficiency did not include the $302,400 in the

amount of the trust’s passive-activity-loss deductions for each year.

                                      OPINION

      The petitioner generally bears the burden of proof (and therefore must prove

the relevant facts by the preponderance of the evidence) except when the

conditions of section 7491(a) are satisfied. Tax Ct. R. Pract. & Proc. 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933); Bronstein v. 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).8 The following taxpayers are “described in”

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

personal service corporations. A passive-activity loss is the amount by which the

aggregate losses 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


      8
       A loss from an activity disallowed under sec. 469(a) is treated as a
deduction allocable to such activity for the next tax year. Sec. 469(b).
      9
          The following reason was given for the amendment:

               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


      9
       (...continued)
      trade or business activities. Deductions attributable to passive
      activities, to the extent they exceed income from passive activities,
      generally may not be deducted against other income, such as wages,
      portfolio income, or business income that is not derived from a
      passive activity. * * *

      *               *            *               *       *             *

      The committee considers it unfair that a person who performs
      personal services in a real estate trade or business in which he
      materially participates may not offset losses from rental real estate
      activities against income from nonrental real estate activities or
      against 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.
      10
           Sec. 469(c)(7)(B) provides in part:

      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 of
      subparagraph (B) shall be treated as met for any taxable year if more
      than 50 percent of the gross receipts of such corporation for such
      taxable year are derived from real property trades or businesses in
      which the 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.

      10
        (...continued)
              (i) more than one-half of the personal services performed in
      trades or businesses by the taxpayer during such taxable year are
      performed in real property trades or businesses in which the taxpayer
      materially participates, and

             (ii) such taxpayer performs more than 750 hours of services
      during the taxable year in real property trades or businesses in which
      the taxpayer materially participates.
                                        - 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 a
      modification. Under the conference agreement, an individual
      taxpayer meets the eligibility requirements if (1) more than half of the
      personal services the taxpayer performs in trades or businesses during
      the taxable year are performed in real property trades or businesses in
      which the taxpayer materially participates, and (2) such taxpayer
      performs more than 750 hours of services during the taxable year in
      real property trades or businesses in which the taxpayer materially
      participates. * * *

Id.

             ii.    Analysis

      The IRS argues that a trust is incapable of performing “personal services”

because the regulation defines “personal services” to mean “any work performed

by an individual in connection with a trade or business”. Sec. 1.469-9(b)(4),

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

whereby trustees manage assets for the trust’s beneficiaries. 1 Restatement, Trusts

3d, sec. 2 (2003) (a trust “is a fiduciary relationship with respect to property, * * *

subjecting the person who holds title to the property to duties to deal with it for the

benefit of” others); see also sec. 301.7701-4(a), Proced. & Admin. Regs. (“In
                                        - 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 corporations11 have met the


      11
        The IRS does not take the position that the trust should be treated as a
corporation. See sec. 301.7701-4(b), Proced. & Admin. Regs. (business trusts,
defined as devices created by beneficiaries to carry on profit-making businesses,
are to be treated for federal tax law purposes as corporations or partnerships).
                                         - 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


      12
        A number of commentators have argued that there is a need for a
regulation that resolves questions regarding material participation of trusts and
generally coordinates the passive-activity-loss rules of sec. 469 with the rules on
taxation of trusts in subch. J. See, e.g., 1 Byrle K. Abbin, David K. Carlson, and
Mark L. Vorsatz, Income Taxation of Fiduciaries and Beneficiaries, sec. 801, at
8003 to 8004 (2012 ed.) (“Section 469 does not easily comport with subchapter J.
To date no regulatory explanation has been forthcoming * * * [on questions
including] where and how material participation is measured[.]”); M. Carr
Ferguson, James J. Freeland, and Mark L. Ascher, Federal Income Taxation of
Estates, Trusts, and Beneficiaries, para. 8.01, at 8-1 to 8-8 (3d ed. 2003); Leo L.
Schmolka, “Passive Activity Losses, Trusts, and Estates: The Regulations (If I
Were King)”, 58 Tax L. Rev. 191 (2005).
                                         - 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.14 Additionally, the IRS would have

us ignore the activities of the three trustees who are employees of Holiday

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

considered the activities of employees and not fiduciaries because (1) the trustees

performed their activities as employees of Holiday Enterprises, LLC, and (2) it is

impossible to disaggregate the activities they performed as employees of Holiday

Enterprises, LLC, and the activities they performed as trustees.


      13
           The Senate committee report stated:

             The fact that a taxpayer utilizes employees or contract services
      to perform daily functions in running the business does not prevent
      such taxpayer from qualifying as materially participating. However,
      the activities of such agents are not attributed to the taxpayer, and the
      taxpayer must still personally perform sufficient services to establish
      material participation.

S. Rept. No. 99-313, at 735 (1986), 1986-3 C.B. (Vol. 3) 1, 735.
      14
        The IRS disagrees with Carter Trust v. United States, 256 F. Supp. 2d 536,
541 (N.D. Tex. 2003), which held that the activities of the trust’s non-trustee
employees (and of the trustee) are considered in determining whether the trust
materially participated in ranching activity.
                                        - 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,15 the activities of the trustees--including their activities as employees

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


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


      16
         We need not consider the effect of sec. 469(c)(7)(D)(ii), which provides
that for purposes of sec. 469(c)(7)(B) personal services performed as an employee
are generally not treated as performed in real-property trades or businesses. This
rule 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-property
trades or businesses. Thus, we need not, and do not, determine how many hours of
personal services were performed by the trust in real-property trades or businesses.
We also note that the IRS does not cite sec. 469(c)(7)(D)(ii) in its brief.
                                          - 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


       17
         In determining whether a taxpayer who qualifies for the sec. 469(c)(7)
exception has materially participated in a rental real-estate activity, each interest in
rental real estate is treated as a separate rental real-estate activity unless the
taxpayer has made an election under section 469(c)(7)(A). If the taxpayer has
made such an election, then all interests in rental real estate are treated as a single
rental real-estate activity. Sec. 469(c)(7)(A). Before the years at issue, the trust
made an election under sec. 469(c)(7)(A)--an election that was binding for
subsequent tax years, absent changed circumstances--to treat all of its interests in
rental real estate as a single activity.
                                        - 28 -

deductions other than passive-activity-loss deductions (and allowed the full

deduction of $302,400).18 The treatment of the $302,400 in trustee fees as

deductions other than passive-activity-loss deductions assumes that the trustee

fees were not expenses of the trust’s rental real-estate activities. On brief, the IRS

appears to defend this assumption: it apparently contends that the trustee fees

were not the expenses of the trust’s rental real-estate activities.19 The trust appears

to disagree with the assumption in the notice of deficiency: the trust apparently




      18
        A passive-activity loss is generally defined as the amount, if any, by which
the passive-activity deductions for the year exceed the passive-activity gross
income for the tax year. Sec. 1.469-2T(b)(1), Temporary Income Tax Regs., 53
Fed. Reg. 5711 (Feb. 25, 1988). Passive-activity gross income is generally all
items of gross income from a passive activity. Sec. 1.469-2T(c), Temporary
Income Tax Regs., supra. A passive-activity deduction is generally defined as a
deduction arising in connection with the conduct of a passive activity. Sec. 1.469-
2T(d)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5716 (Feb. 25, 1988).
      19
         In its brief, the IRS frames the issue of proper characterization of the
trustee fees as: “Whether petitioner should have reported trustee fee expenses on
the front of its U.S. Income Tax Return for Estates and Trusts, Form 1041, or on
the Schedule E, for the 2005 and 2006 years.” It also frames the issue as:
“Trustee Fees Are An Expense Of The Trust and not [Holiday Enterprises, LLC].”
Both phrasings appear to be an obscure reference to the notice of deficiency’s
assumption that the trustee fees are not the expenses of the trust’s rental real-estate
activity.
                                           - 29 -

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.




       20
         In its reply brief, the trust argues that the trustee fees are “properly
included in the determination of the Trust’s losses from its real estate activities.”
Strictly speaking, however, the computations in the notice of deficiency assumed
that the trustee fees were not the expenses of the trust’s rental real-estate activities.
                                      - 30 -

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.
