In fact, many estate plans of business owners utilize trusts in some way.
Such ownership can raise interesting tax issues, such as when a trust is considered to “materially participate” in the business. This issue has existed for some time, but mainly applied to businesses that were generating losses, because material participation allows a shareholder to deduct losses passed through by the business.
The 3.8% Net Investment Income tax implemented in 2013 has made this issue important for many more businesses with trust ownership because the tax is not implemented on shareholders who are material participants in the business.
Although this tax has been effective for nearly two years, the IRS has not yet provided guidance on when this tax is imposed on trust and estate owners. Obviously, a trust does not participate in a business, much less “materially” participate.
The issue is what is the proper measure of the trust's activities in relation to the business?
There has been a history of disagreement between the IRS and taxpayers in this area. One of the few cases that addressed this issue focused on whether the trustee of the shareholder trust actually performed the services that were required to operate the business.
In that case, the trustee spent significant time supervising employees and making higher-level investment and other financial decisions.
The actual operations of the business (which was a ranch) were, however, mostly delegated to employees.
In its analysis of the trust's participation in the business, the IRS asserted that only the actions of the trustee were counted, whereas the trust asserted that the activities of everyone working on behalf of the trust should be counted.
Although the taxpayer won this case, the IRS issued additional guidance in subsequent years, providing that only the trustee's actions count toward satisfying the participation requirement.
In one ruling the IRS further restricted a trust's ability to meet the material participation test by providing that the business activity must be done by the trustee in the trustee's capacity as trustee and not some other capacity.
In other words, if the trustee was also the president of the business, the IRS did not count the time spent running the business toward the material participation test because the trustee's involvement in the business was as president, not as trustee.
The lack of clear guidelines in this area makes a recent tax court case very significant. In that case, the shareholder trust had several trustees who were the children of the trust's settlor.
The trust owned rental properties and owned other real estate activities.
The real estate operations were run through another related company that employed a number of employees, including three of the trustees.
The other trustees of the trust were not involved in the business.
The IRS argued that the trust could not qualify as active in the business.
First, the IRS reasoned that only individuals could satisfy the material participation test, indicating that a trust owner could never meet the material participation standard.
Second, it argued that even if the proper measure was the activities of the trustees, the participation by the trustees must be measured by their participation as trustees and not as employees of the separate company.
In this case, the IRS argued that because all of the participation by the trustees in the business was in their capacity as employees, this participation did not count toward meeting the material participation standard for the trust.
It was thought by most advisers that the IRS position was overreaching in its positions, and the tax court confirmed this, rejecting all of the IRS positions.
The tax court held that a trust could satisfy the material participation test through the activities of the trustees.
Most importantly, the court ruled that the activities of the trustees counted toward the material participation threshold, regardless of the capacity in which the activities were undertaken. The trustees' activities as employees of the related company, therefore, counted.
Although the court did not address whether the activities of non-trustee employees performing services on behalf of the trust counted toward material participation by the trust, this decision provides welcome clarity and a favorable precedent for many trust business owners with respect to both pass-through losses and the Net Investment Income tax.