Trustee Material Participation More Prominent After Recent Rulings

Power shifts in trustee material participation

trustee material participationTaxpayer victories in Maggie K. Carter Trust v. U.S. and Frank Aragona Trust v. Commissioner  were hailed as opportunities for taxpayers to structure real estate ownership by trusts in a manner that would attribute management activity to the trustee.

The result of this trustee material participation was the 3.8% additional tax on Net Investment Income under §1411 (NII) being rendered inapplicable. The trust, through the activity of the trustee, was deemed to materially participate thereby converting passive income into active income and avoiding the 3.8% NII, also known as the Obama Tax.

Trustee material participation must be regular, continuous and substantial involvement in the operations of the company in order to avoid NII. In simplified form, it is direct involvement in regular management activity.

Constituents of the new trustee material participation

Subsequently, IRS issued Taxpayer Advisory Memorandum (TAM) 201317010, which stated that the activity of a special trustee could not be attributed to two trusts. The special trustee of two trusts was also a shareholder and president of the corporation in which the trusts owned stock. As special trustee, he was given the power to vote the stock owned by the trust. The corporation employed the special trustee as an individual, ostensibly to manage the affairs of the trust in the hope of securing material participation. There was a gap in the evidence that the individual was acting for the trusts and had actually performed work on their behalf. In these matters, the IRS distinguishes between investor work, such as oversight and voting on major decisions, and managing the daily affairs of the company.

Planning approaches have been developed to address IRS concerns. One solution is to have the real estate owned by a limited liability company (LLC) and retain the trust as manager. However, the trustee material participation would still be engaged in regular, continuous and substantial management of the enterprise. A second approach is for the trust to form an LLC that is wholly owned by the trust. The trust and trustee could contract to provide more than 100 hours of service (significant participation) that re-characterizes passive income as non-passive and avoid the 3.8% tax or to provide more than 500 hours to re-characterize all income and loss as non-passive.

A third approach, applicable to corporations, deals with the ability under state law to dispense with the Board of Directors and pass the duties to shareholders. Known as a “Close Corporation,” the law of the state of incorporation must be examined with regard as to what is needed to qualify. The third approach would have the shareholders, including the trust, run the business and serve as officers and participate in a regular, continuous and substantial way.

Other obstacles for trustee material participation

Although the above explanation may seem straight forward, there are other hurdles. Opening a bank account can be a slow and painful process at the retail level. Insurance coverage may also be an issue because the trustee may be a professional and it is a concern if he or she is acting outside the scope of coverage provided by errors and omissions policy. Title insurance is another issue and the availability of an imputation endorsement is important. Finally, make certain the tax preparer understands what you are doing in why so there are no surprises when the income tax returns are prepared.

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James F. McDonough, Jr. concentrates on wealth preservation and estate planning for high net worth individuals, closely held business matters and ownership succession, estate administration and income tax planning. He worked for three years for the public accounting firm, then known as Touche Ross, where he obtained his license as a Certified Public Accountant in 1983. In 1984, he was employed as a tax attorney by Union Camp Corporation where he engaged in planning for corporate income deferred compensation, qualified plan and tax-free exchanges. In 1986, Mr. McDonough was employed as Tax Manager for Monroe Systems For Business, Inc. Thereafter, he was employed as a tax attorney for five years where he engaged in corporate and estate tax planning and estate administration and litigation. For more information, please visit James McDonough's full biography at Scarinci Hollenbeck

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