Beginning this year, individuals, estates and trusts will be subject to a Medicare contribution tax equal to 3.8% of the trust’s undistributed net investment income for the tax year, complicating the administration of estates and trusts. (IRC § 1411) As a result of the enactment of the new tax, every trust that owns an interest in a trade or business must now determine whether or not the trust materially participates in that trade or business in order to determine whether the trust’s undistributed income may be subject to the tax.
Net investment income is income from passive activities. Whether an activity constitutes a passive activity is determined in accordance with IRC § 469, which sets forth the law with regard to passive activity losses and credits. A “passive activity” is a trade or business activity in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in a trade or business activity only if the taxpayer is involved in the operations of the trade or business on a regular, continuous and substantial basis. One way a taxpayer may be deemed to materially participate in a trade or business activity is if the taxpayer participated in that trade or business for more than 500 hours during the tax year.
Although the passive activity and material participation rules may appear straightforward when applied to individuals, there continues to be much uncertainty as to how those rules will apply to trusts. In particular, in the trust context it remains unclear who must materially participate in the trade or business from which the trust derives income in order for the trust to avoid paying the 3.8% tax. Is it the trustee? The agents and employees of the trustee? The beneficiaries?
A Technical Advice Memorandum issued by the Internal Revenue Service in January of this year is in conflict with previously most-cited law in this area. In TAM 201317010, the IRS specifically rejects the position of the Federal District Court for the Northern District of Texas in Mattie K. Carter Trust v. U.S., which held that the determination of whether a trust has materially participated in a trade or business is made by looking to the activities of the trustee and the trustee’s employees and agents. In contrast, in TAM 201317010, the IRS takes the position that only the trustee’s participation in the activities of the trade or business in his or her capacity as trustee will be counted in determining whether the trust has materially participated in the trade or business within the meaning of IRC § 469.
In the TAM, two trusts were created which mainly owned interests in Company X, an S corporation. Both trusts shared the same sole trustee, who did not participate in the day-to-day operations of the business, and each had a “Special Trustee” whose only role was to make decisions regarding the sale, retention and voting of stock in Company X. The Special Trustee owned shares of Company X and also served as president of Company Y, a qualified Subchapter S subsidiary of Company X.
The taxpayers argued that all of the Special Trustee’s time spent participating in the activities of Company Y, not merely his time spent related to his role as Special Trustee, should be counted in determining whether the trust materially participated in the business. The IRS, however, rejected that position and refused to count the Special Trustee’s time spent working as the president of Company Y as material participation by the trusts. The IRS reasoned that because the trust instruments limited the Special Trustee’s authority to certain specified activities, the Special Trustee served as the president of Company Y as an employee of the company and not in his capacity as the Special Trustee. The IRS did take into account the Special Trustee’s time spent voting the shares of Company X and determining whether to retain or sell those shares, but took the position that such activities did “not rise to the level of being ‘regular, continuous, and substantial’ within the meaning of § 469” and as such did not constitute material participation in the business. Therefore, the IRS ruled that the trusts did not materially participate in the business.
The position taken by the IRS in this TAM in finding that the Special Trustee would have had to perform his duties in his role as Trustee and not merely as an employee of the company in order for those activities to be counted toward material participation may make it virtually impossible for any trust to be considered to be materially participating in an S corporation or other business, subjecting most, if not all, such trusts to the 3.8% tax. It seems unlikely that such a result was intended by Congress. This issue is far from resolved and more pressing than ever with the enactment of the new 3.8% tax. Therefore, we expect and hope to see more guidance on the matter from the IRS and the courts in the future.
Finally, it is important to note that this TAM and the unresolved issues it raises do not apply to trusts that are “grantor trusts,” which are trusts treated for income tax purposes as being owned by the individual settlor or grantor of the trust. In the case of a grantor trust, the material participation test is applied to the individual settlor or grantor to determine whether the trust’s net income is derived from passive activities and is therefore subject to the 3.8% tax.