This tax season, thousands of trusts with ownership interests in corporations and pass-through entities may unknowingly be subject to a new 3.8% surtax on net investment income. As a result of the Patient Protection and Affordable Care Act (commonly referred to as “Obamacare”), trusts are now subject to a 3.8% tax on the lesser of the trust’s undistributed net investment income or adjusted gross income over $11,950. A trust, however, can avoid this surtax if the trust materially participates in the activity that generates the investment income. The courts and the IRS, however, have yet to agree on how a trust materially participates in an activity, creating uncertainty as to which trusts are subject to the new surtax.
For instance, in Mattie K. Carter Trust v. United States, a federal district court held that a trust’s material participation in a cattle farm is measured by the involvement of all of the trust’s fiduciaries, employees, and agents in the activity. In so holding, the court explicitly rejected the IRS’s position that material participation should be measured only by the trustee’s involvement in the activity. Instead, the court allowed the trustee’s day-to-day management of the cattle farm and the beneficiaries’ employment by the cattle farm to count toward the trust’s material participation in the activity.
Conversely, the IRS, in various Technical Advice Memoranda, has explicitly rejected the holding in Carter Trust, ruling that a trust does not materially participate in an activity unless its trustees participate in their role as fiduciaries to the trust. Thus, if the president of the business also serves as a trustee to a trust holding stock in the business, the president’s day-to-day management of the business will not be counted towards the trust’s material participation in the business.
The uncertainty as to how a trust materially participates in an activity is unlikely to be clarified before 2013 returns are filed. While the Treasury Department has acknowledged the need for guidance on the issue, it has not indicated any upcoming publication dates for this guidance. In the meantime, a trustee concerned about the 3.8% surtax should consider ways to avoid it. One possibility is to take steps to increase the trustee’s involvement in the business held by the trust. Alternatively, if the trust beneficiary is not subject to the surtax on an individual basis and the trust terms permit, the trustee may want to distribute the net investment income to the beneficiary.