Editor: Anthony S. Bakale, CPA, M. Tax.
Estates, Trusts & Gifts
Effective Jan. 1, 2013, Sec. 1411(a)(2) imposes a tax of 3.8% on estates and trusts on the lesser of their undistributed net investment income or the excess of their adjusted gross income over the dollar amount at which the highest tax bracket in Sec. 1(e) begins for the tax year (the amount for 2013 is $11,950, which is inflation-adjusted). Although Congress did not provide a rule specifying which trusts are subject to Sec. 1411, Prop. Regs. Sec. 1.1411-3 indicates that the 3.8% tax applies to most nongrantor trusts (REG-130507-11).
Sec. 1411(c)(1)(A) defines net investment income, in part, by reference to trades or businesses described in Sec. 1411(c)(2), which include passive activities (within the meaning of Sec. 469). Thus, one of the important exemptions from the 3.8% tax is for trade or business income derived from a business in which a taxpayer materially participates. (For an in-depth discussion of key issues for estates and trusts to consider regarding the new Medicare tax, see Nuckolls, et al., “Applying the New Net Investment Income Tax to Trusts and Estates,” 44 The Tax Adviser 316 (May 2013)).
Statutory Guidance on Trust Material Participation
Sec. 469(h)(1) provides that a taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Sec. 469(a)(2)(A) identifies trusts and estates as taxpayers to whom the passive activity rules apply. For individuals, the qualitative test of Sec. 469(h)(1) has largely been replaced by the more quantitative regulatory tests of Temp. Regs. Secs. 1.469-5T(a)(1)–(7). Although the Treasury Department reserved regulations addressing material participation to trusts, estates, and their beneficiaries almost 25 years ago (Temp. Regs. Sec. 1.469-5T(g) and Regs. Sec. 1.469-8), those regulations have never been issued. In the absence of explicit statutory or regulatory guidance on how a trust may establish material participation, the IRS has almost exclusively relied on the legislative history for Sec. 469, which provides that “an estate or trust is treated as materially participating in an activity . . . if an executor or fiduciary, in his capacity as such, is so participating” (S. Rep’t No. 99-313, 99th Cong., 2d Sess. at 735 (1985)).
Cases and Rulings
The only court opinion addressing how a trust establishes material participation for purposes of Sec. 469 is Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003). In Carter, the trust operated a 15,000-acre cattle ranch. The trustee spent a significant amount of time reviewing financial information and making financial decisions for the trust and the ranch. The day-to-day operations of the ranch were carried out by a full-time ranch manager and full- and part-time employees who performed essentially all of the activities for the ranch under the trustee’s supervision.
The IRS argued that the trust’s material participation should be determined solely by reference to the activities of the trustee, while the trust argued that since the trust (and not the trustee) was the taxpayer, the participation of the trust should be determined by assessing the activities of the trust through its fiduciaries, employees, and agents. The taxpayer noted that since the trust was a legal entity (as opposed to a natural person), its only way to participate was through the actions of its fiduciaries, agents, and employees. Finding that the statutory language of Sec. 469 clearly identifies a trust as a taxpayer to which Sec. 469 applies (Sec. 469(a)(2)(A)) and that a taxpayer is treated as materially participating in a business if its activities in pursuit of that business are regular, continuous, and substantial (Sec. 469(h)(1)), the court stated that “[c]ommon sense dictates that the participation of Carter Trust in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of Carter Trust.” The court did not feel bound by the language contained in the Senate report requiring participation by the trustee in his fiduciary capacity. Quoting Prudential Ins. Co. of Am. , 461 F.2d 208, 210–11 (5th Cir. 1972), the court noted that “[w]here the words and meaning of a statut e . . . are clear, there is no room for judicial consideration of Congressional intent.”
Although acknowledging the existence of Carter, the IRS rejected its rationale in Technical Advice Memorandum 200733023. In it, the trustee of a testamentary trust entered into a contract with a special trustee to provide administrative and operational functions. Under the contract, the first trustee retained all decision-making responsibilities, and the special trustee lacked the authority to legally bind the trust. The contract was intended to satisfy the material participation standard of Sec. 469(h)(1).
The special trustee maintained time logs, which indicated that the special trustee spent most of its work hours reviewing operating budgets, analyzing a tax dispute that arose among the partners, and preparing and analyzing other financial documents. In addition, the special trustee appears to have spent a considerable number of hours negotiating the sale of the trust’s interests in P, a limited liability company taxed as a partnership, to a newly admitted partner. Citing the special trustee’s lack of discretionary power to act on behalf of the trust, the IRS held that the special trustee was not a fiduciary of the trust and that its activities therefore did not count toward meeting the material participation requirement. Further, the IRS noted, that even if the special trustee were a fiduciary, a number of the hours in the time log were “investor hours” not spent managing or operating the business and thus would be disregarded.
In countering the Texas district court’s holdings in Carter, the IRS argued that the focus on a trustee’s activities for Sec. 469 purposes accords with the rationale underlying the passive loss regime. The IRS pointed out the fact that an individual may not count employees’ activities to satisfy the material participation requirements (S. Rep’t No. 99-313, at 735) and that to allow a trust to do so would not only be unfair to other types of business owners, but would also render part of the statute superfluous.
In July 2010, the IRS issued Letter Ruling 201029014, which again affirmed its position that a trust establishes material participation in a business based on the trustee’s involvement in the operations of the business activities on a regular, continuous, and substantial basis. In April 2013, the IRS released TAM 201317010, which also affirmed its position on trust material participation as well as its rejection of Carter . In TAM 201317010, A , one of the beneficiaries of two almost identical trusts, had also been appointed special trustee with the power to decide whether to sell or retain Company X (an S corporation) and Company Y ( X ’s qualified subchapter S subsidiary) stock owned by the trusts and to exercise the power to vote the stock. In addition to serving as special trustee of the trusts, A was president of Company Y (and as such was directly involved in Company Y ’s day-to-day operations) and owned the outstanding Company X stock not held by the trusts.
The taxpayers argued that because A’s roles of special trustee, individual shareholder, and president of Company Y were all interrelated, it was impossible to differentiate between A’s time in the different capacities for which A served; A was, in fact, fulfilling his obligations for these various capacities simultaneously, and thus his involvement in Company Y’s relevant activities should have been considered in determining whether the trusts materially participated. The IRS, however, held that only the time A spent fulfilling his duties as special trustee counted toward the material participation requirement for the trusts, and that his activities as special trustee were not regular, continuous, or substantial enough to meet the material participation standard. A’s time spent as president of Company Y was performed as an employee of the company, not in his role as trustee, and therefore did not count in determining the trusts’ material participation.
Although the unfavorable rulings in TAM 200733023 and TAM 201317010 are of concern to taxpayers because they represent the IRS Office of Chief Counsel’s decision to not follow Carter, the TAMs are binding only for the specific issue in the specific case for which the advice is issued. Thus, it would seem possible for taxpayers to challenge the rulings’ heavy reliance on the Senate report. It is worth noting that the Senate committee went to great lengths to describe the means by which an individual taxpayer might satisfy the material participation requirements and provided only two sentences addressing material participation by estates and trusts. Given the decision in Carter, until the IRS or the courts issue binding guidance in favor of the IRS, taxpayers should be able to determine material participation for trusts based on the rationale of Carter or another reasonable interpretation of the statute’s regular, continuous, and substantial test.
Alternatively, nongrantor trusts wishing to satisfy the IRS’s narrow interpretation of the material participation standard for trusts to avoid the imposition of the 3.8% Medicare surtax on the income from closely held business interests held by trusts should evaluate the following planning opportunities:
Ensure participation on a regular, continuous, and substantial basis by the trustee of the current trust: If the current trustee does not so participate, the taxpayer should evaluate whether to expand the current trustee’s involvement in the business or to appoint an additional or replacement trustee who is already providing regular, continuous, and substantial services to the business. If the person serving as fiduciary also performs services for the business entity in a capacity other than as a fiduciary (i.e., an employee), the taxpayer should evaluate whether the services that the person is to provide in each capacity should be clearly defined and, if so, the person should maintain a detailed record of his or her hours for each capacity separately, ensuring that significant services are performed as a fiduciary of the trust.
Transfer the stock to a different trust that will satisfy the material participation test for the business: This could be accomplished, for example, by selling the stock to a trust that is a grantor trust with respect to an individual that materially participates in the business (since the material participation of a grantor trust is determined by reference to the grantor). In most instances, the selling trust is required to recognize the gain on the sale of the stock; however, it may be possible to structure the sale as an installment sale to mitigate the tax consequences associated with the realization of gain.
Evaluate QSST election: In the case of an electing small business trust (ESBT), material participation is determined under the general rule of Sec. 469(h), presumably by reference to the fiduciary’s activities. In the case of a qualified subchapter S trust (QSST), however, Regs. Sec. 1.1361-1(j)(8) provides that, for a QSST’s share of allocable income and deductions, the QSST is treated as a grantor trust with respect to the QSST’s income beneficiary, and thus material participation generally is determined by looking at the beneficiary’s involvement.
Note: Treasury has requested comments as to whether the characterization of the gain on the sale of QSST stock should be determined by reference to the involvement of the QSST beneficiary or the fiduciary (see REG-130507-11).
Thus, in a case where the beneficiary materially participates in the business but the trustee does not, a QSST election may allow the trust to avoid the 3.8% surtax. The QSST election may also reduce ordinary income tax if the business income would be taxed at a lower marginal rate in the beneficiary’s hands. Although QSST and ESBT elections generally cannot be revoked without the commissioner’s consent, Regs. Sec. 1.1361-1(m)(7)(iii) provides that for an ESBT that wants to convert to a QSST, automatic consent is available to revoke the ESBT election as of the effective date of the QSST election when, among other requirements, the trust has not converted from an ESBT to a QSST within the 36-month period preceding the proposed effective date of the new election.
Before 2013, material participation generally was only an issue for trusts that had losses from operating a business. Following the large gifts that were made to trusts during 2012 when taxpayers thought taxes would go up significantly in 2013 and the implementation of the 3.8% tax on passive income, material participation is a substantial issue for any trust that holds a closely held business interest. If the IRS does not issue taxpayer-friendly guidance regarding material participation of trusts before the 2013 filing season, given that trusts could be subject to a $380,000 tax per $10,000,000 of operating income, it should be anticipated that taxpayers will litigate this matter and that binding judicial guidance will be forthcoming.
Anthony Bakale is with Cohen & Co. Ltd., Baker Tilly International, Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.