As discussed in an earlier post, trusts and estates may be subject to a 3.8 percent tax on net investment income over certain threshold amounts. Net investment income may include trade or business income from passive activities — those in which the taxpayer does not “materially participate,” according to Section 469 of the code. So, the determination of whether a trust or trustee materially participates may decide whether the income is passive, and consequently, subject to the net investment income tax, or NIIT.
Under Section 469, material participation is defined as an activity in which the taxpayer participates on a “regular, continuous, and substantial basis.” For individuals, one of seven tests may be used to establish material participation (e.g. the 500-hour rule) to avoid passive income treatment. A separate exception also applies for real estate professionals (750 hours in real property trades or businesses).
Because grantor trusts are not treated as a separate entity for tax purposes, the IRS will look to the grantor (individual taxpayer) to determine material participation. However, no clear guidance exists regarding material participation by non-grantor trusts. Thus, because of the absence of regulations, taxpayers and practitioners must rely on the limited legal authorities available.
The IRS takes the position that trusts and estates are not treated as individuals under Section 469. Thus, the seven tests available to individuals do not apply to trusts and estates. The IRS also takes the position that the trustee must be involved directly in the operations of the business. Recent legal developments, however, have knocked the IRS back from this hard-nosed position. In Mattie K. Carter Trust v. U.S. (N.D. Tex. 2003), the Federal District Court concluded that material participation is determined by reference to all persons who conduct business on behalf of a trust, whether employees or fiduciaries. However, in TAM 200703023, the IRS rejected the court’s position in Carter Trust and adhered to the proposition that the IRS will look solely to the activities of the trustee and not the trustee’s agents or employees.
The IRS took similar positions in PLR 201029014 and TAM 201317010. However, in Frank Aragona Trust v. Commissioner (2014), the Tax Court provided welcome guidance that (1) a trust can qualify for the real estate professional exception, and (2) the activities of a trustee who is also an employee of a trust can be used to assess whether a trust materially participates in an activity.
With no clear guidance regarding material participation by trusts or estates, the IRS is considering regulations to address the issue. However, until additional guidance is provided, taxpayers and advisors must continue to rely on cases like Aragona Trust and the other authorities to determine material participation by trusts and whether such trade or business income may be non-passive, thereby avoiding imposition of NIIT.