Trusts and material participation: the IRS is just making it up.

April 30th, 2013 by Joe Kristan

20130430-1The Obamacare “Net Investment Income” tax hammers trusts.  The new 3.8% tax affects trusts with taxable income as low as xxx in 2013.  In contrast, it only affects single individuals with Adjusted Gross Income of at least $200,000, and joint filers starting at AGI of $250,000.

“Passive income” is one item subject to the tax.  This means most rental income and business income from pass-through entities, unless the trustee “materially participates” in the business.

The new tax piggybacks off of the old “passive loss” rules for determining whether income is passive.  If a taxpayer has business income or loss, it is passive unless the taxpayer “materially participates” in an activity.   When losses are “passive,” they are only deductible when there is other passive income to offset it, or when the passive business is sold.

So how does a trust participate?  A trust can’t punch a time clock, after all.  The IRS says in newly-released  TAM 201317010 that a trustee’s participation counts as the trust’s participation — and then only if the trustee participates as a trustee.

The TAM involves trusts that own an interest in an S corporation.  The trusts each had a main trustee and a “special trustee” who also happened to be president of the S corporation.  A corporate president normally has no trouble materially participating in corporate business, but the IRS said that wasn’t good enough (my emphasis):

As Special Trustee, A lacked the power to commit Trust A and Trust B to any course of action or control trust property beyond selling or voting the stock of Company X or Company Y. The work performed by A was as an employee of Company Y and not in A‘s role as a fiduciary of Trust A or Trust B and, therefore, does not count for purposes of determining whether Trust A and Trust B materially participated in the trade or business activities of Company X and Company Y under § 469(h).

I think the IRS is wrong here.  They are just making up this requirement that the trustee participate “as a fiduciary.”  If somebody is both a trustee and a corporate employee, how are they to divide the time?  This IRS requirement should be rejected, but it poses a compliance problem until and unless it is overturned.  It creates uncertainty and makes it more difficult for trust businesses to avoid the 3.8% tax.

The TAM also rejects one district court case that allows trustees to count participation of the “employees and agents” as trust participation.  I believe the IRS is correct on that point.

More coverage from Peter Reilly:  Tough IRS Position Means More Trusts Will Get Hit With New ObamaCare 3.8% Tax.    He says “I really have a hard time seeing how you will ever be able to get a trust to be considered to be materially participating in an S
corporation, if this is the logic that is followed.”

A summary of material participation requirements is below the fold.


The regulations say you achieve “material participation” in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other “100 hour” activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a “facts and circumstances” test, but don’t count on it.

A special rule apples to real estate. If you are not a “real estate professional,” losses are normally passive no matter what, unless you provide “extraordinary” personal services.

If you are a “real estate” professional,” you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours – not less than 750 hours annually – in “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade.”


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