May a Trust Avoid the 3.8% Income Tax Surcharge?

The 3.8% income tax surcharge (the “Surcharge”) is a new concern faced by trustee. The current investment environment poses challenges to invest in a manner that will produce enough income to satisfy beneficiaries. Trustees of trusts that own business assets may avoid the surcharge if the income earned from the business is deemed active rather than passive in nature. The determination of income as active or passive is difficult for several reasons. The rules, called the passive los rules, require material participation on the part of the trustee in order to characterize the trust’s income as active. These rules were enacted to put a stop to the tax shelter industry and are intentionally restrictive.  There are few cases and little in the way of guidance on what actions constitute material participation on the part of the trustee. A Trustee is faced with a dilemma. Does the trustee take the safe route and pay the extra tax? In the alternative, does the trustee attempt to structure his actions so that participation is material, regular and continuous.

A recent IRS ruling applied the passive loss rules to two trusts that owned an S corporation. The S corporation was the sole owner of a qualified subchapter S subsidiary (QSub) corporation, which was the operating company. The same person was trustee of both trusts and another person was the special trustee and president of the QSub. The taxpayer argued that the management decisions and personal supervision of the business by the special trustee should be attributed to the trusts thereby making the income active rather than passive and escaping the imposition of the Surcharge.

The ruling analyzed the activities of the special trustee to assess whether they were regular, continuous and substantial. The ruling held that simply voting shares of stock did not constitute material participation and therefore the income was passive and subject to the Surcharge. The ruling focuses on the fact that the special trustee was limited in his authority by the terms of the trust and therefore special trustee could not have materially participated.  Stated another way, he was acting as an officer and not as trustee.

This issue of material participation will arise more frequently as trust laws in more states are amended to permit the use of special trustees to administer businesses and other special assets. Previously trust companies were reluctant to administer special assets because trustees were limited by a more restrictive standard. A special trustee may administer a business as a prudent businessperson would do without liability to the trustee.