Frank Aragona Trust v. Commissioner

By Baker Newman Noyes December 3, 2014

Trustee material participation to avoid the 3.8% net investment income tax

The Net Investment Income Tax is imposed on investment income over certain thresholds. In a number of earlier articles, Baker Newman Noyes has addressed various aspects of the Net Investment Income Tax. For that background, we suggest the following articles:

• Two New Taxes on High-Income Individuals
• Helping our Clients with Investment Portfolios Navigate the 3.8% Net Investment Income Tax
• 3.8% “Medicare Surtax” Encourages Us to Revisit an Old Friend – The 65-Day Rule
• Self-Rental Income is Not Subject to New 3.8% Investment Income Tax

Before the passage of the Net Investment Income Tax (NIIT), pass-through business income earned by trusts was likely reported as passive activity income without extensive consideration. The tax implications were minimal and there was no clear guidance treating such income as other than passive. Because of the NIIT, however, passive business income is now considered investment income, taxed at an additional 3.8%. Further, trusts reach the threshold for being subject to the NIIT very quickly — for 2014, investment income over $12,150 is subject to the NIIT tax.

In Aragona v. Commissioner, the Tax Court held that trusts may “materially participate” in pass-through businesses under Internal Revenue Code (IRC) §469 through the activities of their fiduciaries, thereby exempting the pass-through income from the NIIT. The Tax Court decided two points: (1) trusts can qualify as real estate professionals under §469(c)(7); and (2) the work performed by fiduciaries in connection with a trade or business of a trust will count towards the material participation requirement of §469. This is true even if the trustees’ activities come from serving as an employee of an affiliated entity. Furthermore, if there are multiple trustees, each does not have to participate. In this case, there were 6 trustees, but only 3 were involved with the business on a regular basis. Unfortunately, the Court did not rule upon two salient questions: (1) whether the actions of non-trustee employees can be used to satisfy the material participation standard; and (2) how much material participation is enough?

Prior guidance on the topic of a trust’s material participation includes Technical Advice Memoranda (not binding), private letter rulings (only applicable to the letter’s particular scenario), and two court cases. In the first court case, Mattie K. Carter Trust v. U.S. decided in 2003, a United States District Court ruled that a trust’s material participation should be determined by reference to all persons conducting business on behalf of the trust, such as employees of the trust, and not solely the fiduciary. Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (2003).

Several years after the Mattie Carter case, the Service issued a Private Letter Ruling reasserting the Service’s more hardline position. The Service stated that the only way for a trust to establish material participation was to have its fiduciary “involved in the operations of the activity on a regular, continuous, and substantial basis.” PLR 201029014. Likewise, in TAM 201317010, released in April of 2013, the Service reiterated that material participation can only be established by the trustees, in their capacity as fiduciaries, and not as employees of the trust, a related entity, or as individuals acting for their own interests.

So how to advise fiduciaries to avoid the NIIT on pass-through business income? Unfortunately, we still have more questions than answers. When drafting trust instruments for non-grantor trusts that may hold rental real estate or pass-through entity businesses, it is important to consider fiduciaries who will be involved in the trust’s business on a full-time basis. There is no magic number of fiduciaries satisfying the material participation requirements although 3 out of 6 full-time employees satisfied the Court in Aragona. We also do not know if or to what extent fiduciaries working in the business on a part-time basis would satisfy the requirement.

For trusts already established, it is important that the fiduciaries track their time and business involvement and keep accurate records of their work in the event that proof of their activities is needed. Ideally, minutes of company meetings and documentation of business activity should be kept as evidence of the fiduciaries’ activities. Additionally, any extra evidence of material participation that could be attributed to the trust, for example, the work of non-trustee employees, attorneys and other business professionals on behalf of the trust should be documented to support the argument that participation includes work done for the trust in any capacity. The Aragona Court did not indicate that the work of non-fiduciary persons relating to the trust’s business could not be counted towards the material participation requirement. Therefore, it would be prudent to gather as much support for material participation, from both fiduciaries and non-fiduciaries working for the trust, as feasible.

Now that the NIIT is a permanent part of our tax world, we should be thinking about planning opportunities to mitigate the tax, especially for trusts that reach the threshold quickly. Although the Aragona Trust decision left many questions about material participation unanswered, it did determine a couple significant pieces of the material participation puzzle. First, trusts may be material participants under IRC §469 and thereby avoid the NIIT on pass-through business income. Second, material participation can be based on the actions of fiduciaries participating in the business. Where the facts and circumstances support material participation, advisors should encourage their clients to gather as much evidence as possible to evidence that position.

If you have any questions, please contact your BNN advisor at 1.800.244.7444.