Inwood National Bank v. Fagin and Its Implications for Farmers and Small Business Owners

As individuals  plan for their legacy, the intersection of estate planning, business ownership, and elder law becomes increasingly critical, especially for farmers and small business owners who often rely on closely held business interests to sustain their families. A recent Texas Supreme Court decision, Inwood National Bank v. Fagin, No. 24-0055 (January 31, 2025), offers valuable insights into the complexities of transferring such interests into trusts, particularly when contractual restrictions and personal reconsiderations come into play. This case, while rooted in Texas law, has broad implications for Ohio and Missouri residents and others navigating similar challenges, especially those in agriculture or small enterprises.

Case OverviewThe Inwood National Bank v. Fagin case centered on Christy Fagin, who sought to transfer shares of Inwood Bancshares, Inc. (an S corporation) into a Qualified Subchapter S Trust (QSST) for her husband, Kyle, as part of estate planning. The shares were governed by a shareholder agreement requiring Inwood’s approval for transfers. The trust document listed the shares on Schedule A with the notation that Christy “intends” to transfer them upon Inwood’s approval. After initiating the process—prompted by the need to replace a lost share certificate—Christy reconsidered, realizing the transfer would make the shares Kyle’s separate property, irrevocable due to the QSST election. She withdrew her intent, never surrendering her replacement certificate, and Inwood did not countersign the necessary subscription agreement. Kyle sued Inwood for tortious interference, claiming the QSST owned the shares, but the Texas Supreme Court reversed the appeals court, ruling that the transfer was never complete due to the unfulfilled condition of Inwood’s approval.Legal AnalysisThe Court held that the transfer was subject to a condition precedent (Inwood’s approval), which was not satisfied despite the trust’s irrevocability. The conditional language on Schedule A distinguished this from an immediate gift, and the lack of bilateral performance (e.g., certificate surrender, countersignature) underscored that no enforceable contract existed. This decision aligns with prior cases like Smaldino v. Commissioner, which addressed transfer tax implications, but Inwood emphasizes the primacy of contractual conditions over trust intent when external approvals are required.Implications for Farmers and Small Business OwnersFor farmers and small business owners, this case highlights several key considerations:

• Transfer Restrictions in Business Agreements:  Many family farms and small businesses operate under shareholder agreements, LLC operating agreements, or buy-sell agreements that restrict equity transfers, often requiring management or co-owner approval. For instance, a farmer transferring farmland or equipment interests into an irrevocable trust to protect assets for Medicaid eligibility must navigate these restrictions. Evem a conveyance of business interests to a revocable trust must orient transfer considering these restrictions. Inwood clarifies that failure to secure approval renders the transfer incomplete, potentially leaving assets exposed to creditors or unintended heirs.

• Irrevocable Trust Challenges: Irrevocable trusts are popular for elder law planning to shield assets from nursing home costs, but Inwood underscores the risk if the grantor reconsiders mid-process. A farmer funding a trust with a 50% stake in a family LLC might change their mind upon realizing it reduces their control or income, as Christy did. The case suggests that until all conditions (e.g., co-owner consent) are met, the grantor can retract, but this delay could jeopardize Medicaid planning if within the 5-year look-back period (42 U.S.C. § 1396p).

• Revocable Trust Challenges:  Revocable trusts are often utilized by farmers and small business owners to orient their estate administration privately, outside of probate.  Trusts typically make challenge and contests more difficult by, among other things, including a "No-Contest" clause.  Failure, however, to properly assign, transfer, or convey business interests might open the trust estate estate to challenge or contest particulalrly, as is often the case, farming heirs are treated differently than non-farming heirs.  Non-farming heirs would not have to contest the trust, but the failure to properly convey business interests to the trust.

• Estate Planning Precision:  The decision emphasizes the need for precise drafting. Listing assets on a trust schedule with conditional language (e.g., “subject to approval”) protects against premature transfer claims, but farmers must ensure all parties, trustees, co-owners, and legal counsel, align on procedures. A small business owner transferring a machinery business interest might face disputes if the trust assumes ownership without formal transfer, as seen in Kyle’s failed claim.

• Marital and Succession Planning:  The Fagin’s marital discord post-transfer attempt mirrors issues common in family-run operations. A farmer transferring assets to a spouse’s trust might reconsider if it alters property division in a potential divorce. Inwood supports the grantor’s right to withdraw before completion, offering flexibility but requiring clear documentation to avoid litigation, as Kyle pursued.

• Elder Law and Medicaid Considerations:  
  For aging farmers or business owners seeking Medicaid, a disclaimer to redirect assets (e.g., to a child’s trust) could be affected by transfer restrictions. If approval is pending and the grantor retracts, as in Inwood, it may not trigger a penalty, but any subsequent transfer attempt within the look-back period could be scrutinized. Consulting an elder law attorney is crucial to document intent and timing.

Key Takeaways

• Contractual Compliance: Farmers and small business owners must strictly adhere to business agreement terms (e.g., approval processes) when funding trusts. Oral agreements or partial steps, as in Inwood, won’t suffice.
• Drafting Clarity: Trust schedules should explicitly note conditional transfers, avoiding assumptions of immediate ownership. This protects against disputes and ensures alignment with business governance.
• Flexibility and Risk: The ability to retract a transfer offers flexibility but risks delaying asset protection strategies, especially for Medicaid planning. Early coordination with co-owners and counsel is essential.
• Legal Guidance: Given the case’s emphasis on procedural rigor, engaging experienced estate and elder law attorneys is vital to navigate restrictions and protect generational wealth.

ConclusionInwood National Bank v. Fagin serves as a cautionary tale and a planning tool for farmers and small business owners. It reinforces that contractual conditions trump trust intent until fully executed, offering a safety net to reconsider but demanding meticulous execution. For Ohio and Missouri rresidents, where family farms and small businesses are cornerstones of rural economies, this ruling underscores the need for tailored estate plans that balance control, protection, and succession. Consult an attorney to align your trust funding with business agreements and elder law goals, ensuring your legacy thrives for future generations.

Good News for Trusts that Manage Real Estate

In the recent Frank Aragona Trust case, 142 T.C. No. 9 (2014), the US Tax Court reached a taxpayer favorable decision, one that benefits trusts that materially participate in real estate business activities.  For years, the IRS has steadfastly refused to allow trusts to deduct net operating losses related to real estate activities against other ordinary income unrelated to the real estate; based on the so-called “passive activity loss” limitations.  Now, it may be possible for such trusts to deduct the losses associated with the real estate against other profitable activities to reduce income taxes.

Frank Aragona formed a trust In 1979, naming himself as the grantor and trustee and with his five children as beneficiaries. Frank Aragona passed away in 1981 and he was succeeded as trustee by six trustees. One of the trustees was an independent trustee and Frank Aragona's children comprised the other five trustees. Two of the five children had very little involvement with the trust or the business of the trust. Three of the five children worked full time for a limited liability company (LLC) that was wholly owned by the trust. This LLC managed most of the trust's rental real estate properties. It employed several people in addition to Frank Aragona's children including a controller, leasing agents, maintenance workers, and accounting clerks. In addition to receiving a trustee fee, the three children who were employed by the wholly-owned limited liability also received wages from the limited liability company.

During 2005 and 2006, the Frank Aragona Trust incurred substantial losses from its rental real estate properties. The trust also reported gains from its other (non-rental) real estate activities. In the Tax Court, the IRS argued that the trust's rental real estate activities were passive because a trust is incapable of materially participating in rental real estate activities. Alternatively, the IRS argued that even if a trust could materially participate in rental real estate activities, in the Aragona case, the court should disregard the activities of the three trustees who also work for trust's wholly-owned LLC because these trustees performed their activities as employees of the LLC and not in their duties as trustees. The trust contended that it could materially participate in its rental real estate activities, and that the activities of the three trustees who were also employed by the wholly-owned limited liability company should not be disregarded.

The material participation exception applies when more than one-half of the personal services performed in trades or businesses by the taxpayer are performed in real-property trades or businesses where the taxpayer materially participates and performs more than 750 hours of services during the year in real-property trades or businesses in which the taxpayer materially participates.

More than ten years ago, in Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003), a Texas district court held that the material participation of a trust in ranch operations should be determined by reference to the persons and agents who conducted the ranch's business on the trust's behalf, including the trustee.  According to the court, in determining whether the trust materially participated in the real estate activities, the trust's non-trustee's fiduciaries, employees, and agents should be considered.

In the years since the Mattie K. Carter Trust case, the IRS has issued a series of rulings in which it disagreed with the holding of the case and stated that only a trustee could be considered in making the determination.  Further, according to the IRS, if the trustee is also an employee of the underlying business, a taxpayer could only consider the time spent by the trustee in his duties as a trustee, and not in his duties as an employee.

Prior to 2012, the issue did not garner much attention because it only affected those trusts involved in rental real estate activities whose operations incurred losses.  However, with the recent enactment of the 3.8% Net Investment Income Tax, this issue has become a hot-button issue among tax practitioners.  Material participation is important in the context of the 3.8% Medicare tax because under §1411, "net investment income" includes income from a "passive activity (within the meaning of section 469) with respect to the taxpayer." Therefore, all rental real estate activities conducted through a trust or estate will not have to be concerned with the material participation rules.

    

The Tax Court held that, “[a] trust is capable of performing personal services [because …] services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust.”  The Tax Court rejected the IRS’s argument that a trust is incapable of providing personal services, reasoning that, “[I]f 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.’”

    

Also, the Tax Court rejected the IRS’s argument the work of certain trustees as employees of an LLC that managed most of the Trust’s rental real estate properties – which was wholly owned by the Trust – should not count because such work was performed as employees and not as trustees.  The Tax Court counted the work of the trustees which they performed as employees of the Trust’s wholly owned LLC because, “trustees are not relieved of their duties of loyalty to beneficiaries by conducting activities through a corporation wholly owned by the trust.”

The Tax Court did not, however, “decide whether the activities of the trust’s nontrustee employees should be disregarded.”

Given that the IRS expressly disregards the work of non trustee employees towards the material participation test, what is certain is that trusts can count the work of their trustees (even if performed as employees of a corporation wholly owned by the same trust).  Work performed by trustees as employees of a corporation that is unrelated to the trust might not count.

The Frank Aragona Trust decision is good news for those ongoing trusts that actively manage real properties as a business and have income tax losses in such activities. It may now be possible for such losses to be deducted against other activities.  

While the case resolves some uncertainties it does not resolve all uncertainties, most importantly whether to include the activities of trust employees who are not themselves trustees towards satisfaction of the material participation requirement.

Sources: Estate Planning: Good news for trusts that manage real estate

               Tax Court Gives Taxpayer a Victory in Frank Aragona Trust Case -- But Doesn't Go All the Way