On March 27, the Tax Court released its much anticipated decision in Frank Aragona Trust v. Commissioner. The court’s decision is extremely important to our clients with business interests held in trust.  Frank Aragona Trust answers the question of whether a trustee’s activities, in a non-fiduciary capacity (i.e. as an employee), of a business that is held in trust count for measuring material participation.  The Tax Court determined that the answer is “yes.”

We have previously discussed the importance of the concept of material participation and its effect on the application of the3.8% tax on a trust’s net investment income. Generally, if a taxpayer does not materially participate in the activities of a business, then the business income is subject to the 3.8% tax on net investment income.  In the context of a non-grantor trust, material participation of the trust is determined by the trustee’s activities in relation to the business.  Thus, income earned from a business held in trust will not be subject to the 3.8% tax on net investment income if the trustee materially participates in the business.

The IRS has previously taken the position that only the trustee’s activities in its role as Trustee will count towards measuring material participation, even if the trustee also works in the business. The court in Frank Aragona Trust disagreed with the IRS and held that a Trustee’s activities as an employee of a business should be considered in determining whether the trust materially participated in the business.

The following example illustrates the importance of the court’s decision.  Assume that Parents owned Family Business and after their death left Family Business in trust for the benefit of Daughter. Family Business distributes $1 million of income to the trust. Daughter is the trustee of the trust and also works daily in the business.  If only Daughter’s activities as Trustee count towards measuring material participation, then the undistributed business income retained by the trust will be subject to an additional 3.8% tax on net investment income.  However, if Daughter’s activities of working in Family Business on a daily basis count towards measuring material participation, then the trust will satisfy the material participation test and income distributed to the trust will not be subject to the 3.8% tax on net investment income.  The difference is potential tax savings of $37,538.