IRS Finds that Trusts did not Materially Participate in S Corporation Activities
Timothy M. Nichols
A recently released Technical Advice Memorandum highlights one of the many ambiguities regarding the passive activity rules. Given the imposition of the new 3.8% on many types of “passive” income, now is a good time for taxpayers to reevaluate the impact of the passive activity rules on their activities.
Technical Advice Memorandum 201317010
Starting in 2013, a new 3.8% tax is imposed on higher income taxpayers’ net investment income. Net investment income includes income from “passive” trade or business activities. Whether an activity is “passive” is generally determined under the complex passive activity rules. If a taxpayer does not “materially participate” in a trade or business activity the taxpayer’s income or loss from that activity is likely passive.
An unsettled issue under the passive activity rules is how material participation is determined for trusts and estates. In a recent technical advice memorandum (“TAM”) the Internal Revenue Service reiterated its position that a trust materially participates in an activity only if a fiduciary materially participates in the activity in a fiduciary capacity.
In TAM 201317010, the IRS chief counsel’s office considered two trusts that owned stock in an S corporation. The sole trustee of the trusts was not substantially involved in the S corporation’s activities. However, the trusts also named a second individual, the president of the S corporation, as special trustee with authority over the voting, sale and retention of the S corporation’s stock held by the trusts.
The passive activity rules define materials participation as participation on a regular, continuous and substantial basis. See 26 USC 469(h). However, the treasury department has not yet issued regulations interpreting this requirement for trusts and estates. Therefore, the TAM looked to the legislative history of the provision, which indicates that “an estate or trust is treated as materially participating in an activity… if an executor or fiduciary, in his capacity as such, is so participating.” S. Rep. No. 99-313, at 735. In light of this legislative history, the IRS determined that the president’s involvement in the S corporation as president was not counted for purposes of determining whether the trusts materially participated in the S corporation’s activities.
The IRS’ position is this TAM is contrary to the one court case to consider this issue. In Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Texas 2003), the activities of the trust's fiduciaries, employees and agents were all considered to determine whether the trust materially participated in an activity.
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