SPECIAL REPORT. tax notes. 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax. By Richard L. Dees

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1 20 Questions (and 20 Answers!) On the New 3.8 Percent Tax By Richard L. Dees Richard L. Dees is a partner in the private client department in the Chicago office of McDermott Will & Emery. In this report, Dees discusses a broad range of issues related to the new 3.8 percent tax and its application to trusts and family Richard L. Dees businesses. Dees thanks the following colleagues at McDermott Will & Emery for their careful review, helpful comments, and knowledgeable suggestions: Thomas P. Ward, Gary C. Karch, Jeffrey C. Wagner, and Jeffrey K. Ekeberg. Any errors are those of the author. The policy prescriptions are his alone and do not necessarily reflect the opinions of his colleagues or McDermott Will & Emery. This article was originally published in Tax Notes in two parts on August 12, 2013, and August 19, Please cite to those versions. Copyright 2013 Richard L. Dees. All rights reserved. Table of Contents Introduction... 2 Question 1: Bottom Line: Can a Trust Avoid the 3.8 Percent Tax on the K-1 Business Income of A Family-Owned Business?... 2 Question 2: What Is the New 3.8 Percent Tax?... 2 Question 3: How Does the NII Tax Relate to The Hospital Insurance Medicare Tax?... 2 Question 4: What Net Income Is Subject to the NIITax?... 3 Question 5: How Is the NII Tax of a Trust Computed?... 4 Question 6: How Do You Determine Whether A Business Interest Is a Passive Activity?... 6 SPECIAL REPORT tax notes Question 7: Please Get to the Point Already: Can a Trust Materially Participate Under Section 469 (and Thus Section 1411)?... 7 Question 8: How Then Does a Trust Materially Participate Under Section 469 (and Section 1411)?... 9 Question 9: How Does the Senate Report s Statement That the Fiduciary Must Materially Participate in His Capacity as Such Affect How a Trust Materially Participates? Question 10: Can an Individual Take Off Her Trustee Hat When She Puts on the Hat Of an Employee, Manager, or Director of a Business the Trust Owns? Question 11: Who Is the Fiduciary of a Trust For Purposes of Determining Its Material Participation? Question 12: Because Existing Guidance Is Limited to Individual Trustees, How Does a Trust With a Corporate Trustee Materially Participate? Question 13: How Do the Special Rules For Trusts Owning S Corporation Stock Affect the Trust s Active Versus Passive Analysis? Question 14: What Are the Possible Negative Consequences of Treating a Trust Business As Active? Question 15: If a Trustee Determines Its Trust Should Materially Participate in a Business Investment, What Steps Might the Trustee Take? Question 16: Is That All There Is, My Friend, Is That All There Is? Question 17: Does the Hospital Insurance Medicare Tax Always Apply to Business Income That Escapes the NII Tax? Question 18: Did Congress Actually Have a Reason for Exempting Active Income From Both the NII Tax and the HI Tax, or Is This Just a Loophole? Question 19: Is the NII Tax Exemption for Active Business Income Another Example of Congress Showing Small Businesses Some Love? Question 20: How Should Congress and Treasury Fix Sections 469 and 1411 to Treat Family Businesses and Trusts Fairly? Conclusion TAX NOTES, August 12,

2 Introduction This report covers a broad range of issues concerning the new 3.8 percent tax and its application to trusts and family businesses. The question-andanswer format is designed to allow readers with different levels of experience, knowledge, and interest to focus on the matters of greatest importance to them. The answers to questions 2 through 6 explain the 3.8 percent tax. By the end of the answer to Question 6, you will know that Congress has exempted the income from an active trade or business 1 from the new 3.8 percent tax. The answers to questions 7 through 15 explain when a trust-owned business is active and exempt from the tax, rather than passive and subject to the tax (as noted above, this issue s part of the report only covers up through question 11). This report will not help a trustee disguise a passive investment as an active business investment to avoid the 3.8 percent tax. 2 Rather, it helps a trustee prevent an active family-owned business from being treated as passive, and therefore subject to the 3.8 percent tax, simply because its equity interests are owned in trust rather than outright. Although the new proposed regulations to section 1411 are discussed throughout this report, the answer to Question 16 focuses on their complexities and controversies, particularly regarding business income. That complexity contrasts with the simplicity of the statute. At the end of the answer to Question 16, you will ask yourself whether the net investment income (NII) tax is actually net. If you read section 1411, its legislative history, the proposed regulations and their lengthy preamble, 3 and the (not so short) answers to the first 16 questions, you still will not know why Congress exempted active trade or business income from the 3.8 percent tax. However, you learn why in the answers to questions 17 through 20. Tax policy 1 The businesses to which the 3.8 percent tax applies are sole proprietorships and passthrough entities, meaning the owners, rather than the entities, pay the tax on business income. Passthrough entities include S corporations and partnerships for federal income tax purposes (tax partnerships). Tax partnerships include general and limited partnerships, limited liability companies, and limited liability partnerships. Unless the context requires otherwise, the term partnership in this report refers to an entity taxed as a partnership and not any particular kind of partnership entity. 2 For a general look at the 3.8 percent tax, see, e.g., Ruth Wimer, New Medicare 0.9 Percent and 3.8 Percent Taxes: Executive Compensation Year-End Tax Planning, 245 DTR J-1 (Dec. 21, 2012). 3 REG The preamble, cited throughout this report, is at 77 F.R wonks may want to start reading there. The ultimate question is whether the future decisions of the IRS and Treasury will be hostile to trusts, causing the 3.8 percent tax to become the widows and orphans tax. Question 1: Bottom Line: Can a Trust Avoid the 3.8 Percent Tax on the K-1 Business Income of a Family-Owned Business? Probably yes. (The answers get better, I promise.) The report s purpose is to answer this question. The rest is commentary, and a lot of commentary is necessary. Answering just this one question requires asking and answering 19 more: Questions beget answers, and answers beget more questions. Question 2: What Is the New 3.8 Percent Tax? Beginning in 2013, section 1411 imposes a 3.8 percent tax on the NII of upper-income individuals, estates, and trusts. An individual is subject to the tax on NII above an adjusted gross income threshold of $200,000 ($250,000 if married filing jointly). Estates and trusts, however, will be subject to the tax on undistributed NII above the threshold income level at which the top federal income tax rate begins ($11,950 in 2013). Thus, nearly every fiduciary will need to plan to minimize the NII tax. Question 3: How Does the NII Tax Relate to the Hospital Insurance Medicare Tax? The Patient Protection and Affordable Care Act of 2010 increased the 2.9 percent hospital insurance Medicare tax (HI tax) rate imposed on all payroll and self-employment (SE) income to 3.8 percent on earned income above a specified income threshold. Further, the Health Care and Education Reconciliation Act of 2010 imposed a 3.8 percent tax on net investment unearned income of individuals, estates, and trusts above specified income thresholds (the NII tax). Although Social Security benefits are calculated based on a taxpayer s lifetime earnings from employment or SE, medical benefits are not. Thus, Congress decided it should fund healthcare not only by increased taxes on earned income, but also by a new 3.8 percent tax on unearned passive income. 4 Although the statute and legislative history refer to the tax as an unearned income Medicare contribution, 5 the tax proceeds remain in the general fund and are not required to be transferred 4 The NII tax is an income tax and, unlike the SE tax, is not deductible for purposes of the income tax. Preamble, 77 F.R. at Health Care and Education Reconciliation Act of 2010, section TAX NOTES, August 12, 2013

3 to the Medicare Trust Fund. 6 Yet the NII tax continues to be referred to as a Medicare tax. 7 Question 4: What Net Income Is Subject to the NII Tax? The tax is imposed on NII, which comprises three categories of gross income: specified income (category 1), covered business income (category 2), and covered gain (category 3). First, specified income means the taxpayer s gross income from interest, dividends, annuities, royalties, rents, and other passive investment income other than excluded business income 8 (defined below). Second, covered business income means gross trade or business income 9 that is (1) derived in the trade or business of trading in financial instruments or commodities 10 (a trading business), (2) earned in a passive activity of the taxpayer within the meaning of section (the passive activity loss (PAL) rules) and (3) produced from the investment of working capital. 12 Income derived in the ordinary course of a trade or business that is not described in the preceding sentence is excluded business income. Finally, covered gain means net gain (to the extent taken into account in computing taxable income) from dispositions of property other than gain comprising excluded business income The Joint Committee on Taxation in 2011 said that in the case of an individual, estate, or trust an unearned income Medicare contribution tax is imposed. No provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund. JCT, General Explanation of Tax Legislation Enacted in the 111th Congress, JCS-2-11, at 363 (Mar. 24, 2011). 7 See, e.g., Jonathan G. Blattmachr et al., Imposition of the 3.8 Percent Medicare Tax on Estates and Trusts, 40 Estate Planning 3 (Apr. 2013). 8 New York State Bar Association Tax Section, Report on the Proposed Regulations Under Section 1411, at 4 (May 15, 2013), refers to section 1411 businesses and non-section 1411 businesses, but the same business could be both, depending on whether its owner is active or passive; therefore, the titles confuse rather than clarify. Section 1411 does the same, referring to a trade or business not described in paragraph (2). By contrast, the definition of a trading business is useful because that type of business always produces NII, whether the owner is active or passive. 9 Section 1411(c)(2). 10 Commodities are defined in section 475(e)(2). 11 Although section 469 refers to non-passive income or loss, this report uses active to refer to non-passive business income or loss of an owner who materially participates in her business under section 469. The report also refers to an active owner (an owner who materially participates in an activity) and active business (a business in which an owner materially participates). 12 Section 1411(c)(3), with income from working capital determined as under section 469(e)(1)(B). 13 The many problems with the definition of net gain are discussed in the answer to Question 16. COMMENTARY / SPECIAL REPORT Section 1411(c)(1)(B) provides the net in NII by reducing the aggregate amount of the three categories of gross income by specified deductions (NII deductions): deductions allowed by this subtitle which are properly allocable to such gross income or net gain. The proposed regulations under section 1411 interpret allowed by this subtitle as meaning that NII deductions are to be determined after applying all the other income tax rules. 14 For example, the limitations on itemized deductions under sections 67 and 68 apply. The proposed regulations provide a method for allocating those limits among itemized deductions, treating all deductions alike. 15 Because section 67 limits only miscellaneous itemized deductions, that limitation is applied first. Because section 68 limits all itemized deductions, that limitation is applied next to all deductions, including miscellaneous itemized deductions allowed under section 67. As a result, deductions required to produce investment income, such as investment adviser fees, are not fully allowed, meaning NII is not truly net. 16 Section 1411 also exempts specific types of income from the NII tax. Because SE income and compensation are subject to the HI tax, that income is not subject to the NII tax. 17 Qualified plan distributions are not subject to the NII tax. Income excluded from income tax is similarly excluded from the NII tax, including tax-exempt interest on state and municipal bonds, life insurance proceeds, and deferred or excluded gain (for example, from a like-kind exchange or the sale of a personal residence). 18 A more extensive discussion of these concepts and definitions as interpreted by the proposed regulations appears below in the answer to Question Prop. reg. section (f)(3)(ii). 15 Id. 16 American Bar Association Section of Taxation, Comments Concerning Proposed Treasury Regulations Under Section 1411, at 30 (Apr. 5, 2013) (ABA 2013 comments), recommends that itemized deductions related to the production of NII not be reduced under these limits, unless all the other itemized deductions are less than the denied deductions, i.e., a but for test. Before the enactment of section 212, investment expenses were entirely disallowed. When Congress enacted section 212 to allow deductions for expenses incurred in the production of income and to reinforce that the income tax is a net income tax, it could not have anticipated the shameful erosion of the concept by the alternative minimum tax and the limits on itemized deductions incurred in the production of income. 17 Section 1411(c)(6). 18 Preamble, 77 F.R. at TAX NOTES, August 12,

4 Question 5: How Is the NII Tax of a Trust Computed? The NII tax requires three basic calculations for determining the tax on individuals. 19 First, the individual determines her NII using the above rules. Next, AGI, 20 which includes the items of NII, over the applicable threshold amount is determined. Finally, the 3.8 percent tax rate is applied to the lesser of those two numbers. As a consequence, an individual will not pay any NII tax if her AGI is less than the threshold or she has no NII. 21 Moreover, she cannot pay the tax on an amount more than her NII, no matter how much taxable income she may have. Grantor trusts are disregarded for purposes of the NII tax, as under other income tax provisions. 22 Each item of income or deduction that is included in computing taxable income of the grantor or other deemed owner under section 671 is treated as if it had been received by, or paid directly to, the deemed owner for purposes of calculating that person s NII. 23 Thus, the NII tax on grantor trusts is computed in the same manner as for individuals. The starting point for the computation of the NII tax for a non-grantor trust or estate is nearly the same as an individual s computation. The principal difference is that the tax is imposed on undistributed NII rather than just NII. A trust s undistributed NII is the trust s NII, reduced by distributions of NII to beneficiaries under sections 651 and 661 and by deductions for amounts set aside for a charitable purpose under section 642(c). 24 The ordinary rules under subchapter J apply to determine whether distributions for the tax year carry out NII to the beneficiary, which will be included in the determination of her NII, or if they will remain in the trust or estate to be included in its undistributed NII. 25 AGI for a trust or estate is the same as for an individual, except that section 67(e) permits three additional types of deductions: those for (1) administration expenses unique to the fiduciary arrangement; (2) distributions to the beneficiaries, limited to distributable net income (DNI); and (3) the trust 19 For a comprehensive discussion of the application of the NII tax to trusts, see Blattmachr et al., supra note Section 1411 and the proposed regulations refer to modified AGI as defined under section 1411(d). Because the modification relates to personal service income earned overseas, it should have no relevance to trusts or estates. Thus, this report does not use the term modified adjusted gross income. 21 Section 1411(a)(1). 22 Prop. reg. section (b)(5). 23 Id. 24 Prop. reg. section (e)(2). 25 Prop. reg. section (f). or estate s personal exemption. 26 Deductions 1 and 2 warrant a closer examination in the NII tax context. A trust or estate may have administration expenses of two types. The first is an expense unique to a trust or estate, such as fees paid to fiduciaries for administering, rather than investing, the trust. That type of pure administration expense, which is the kind referenced as deduction 1 above, reduces both AGI and NII dollar for dollar. The second type is an expense, such as an investment expense, that is not unique to a fiduciary because an individual might incur it. That type of expense is deductible when determining taxable income only to the extent the aggregate expenses of that type exceed 2 percent of the trust or estate s AGI. 27 Those expenses allowed for income tax purposes will reduce the fiduciary s taxable income and NII but will not reduce AGI. 28 Because the distribution deduction is limited by DNI, the determination of DNI will affect the amount of the NII tax of a trust or estate. 29 The difficulty of understanding DNI can be seen in the failure of the proposed section 1411 regulations to determine DNI properly. Reg. section 1.643(a)-0 defines DNI for the tax year as the taxable income (as defined in section 63) of the estate or trust, computed with the modifications set forth in [reg. sections] 1.643(a)-1 through 1.643(a)-7. Those modifications are the DNI deduction itself, the personal exemption, capital gains and losses properly allocable to fiduciary accounting principal, extraordinary dividends and taxable stock dividends allocable to principal, tax-exempt income, 26 Section 642(b) provides for a $600 exemption for an estate, $300 for a simple trust (a trust distributing all its fiduciary accounting income), and $100 for a complex trust. The $300 exemption applies if the trust is a simple trust taxed as a complex trust because of distributions in excess of fiduciary accounting income. This exemption is allowed in computing AGI. 27 Section The Supreme Court s decision in Knight v. United States, 552 U.S. 181 (2008), limited administration expenses that are not subject to the 2 percent floor to those that are purely connected to the trust or estate. Those pure deductions do not include investment expenses and similar expenses that might be incurred by an individual. In response to Knight, Treasury promulgated prop. reg. section , which provides for unbundling a trustee s fee into its component parts of both types of deductions. That regulation has yet to be finalized. 29 NYSBA tax section, Medicare Contribution Tax Definition of Net Investment Income, at 9 (Sept. 29, 2010), expresses an unlikely concern that undistributed might be defined without regard to the DNI rules. As would be expected, the proposed regulations incorporate the DNI concept. Prop. reg. section (e)(3). However, the NYSBA s concerns about the interaction between sections 1411 and 642(c) (id. at 11-15) and foreign trusts (id. at 16-17) are well taken. 4 TAX NOTES, August 12, 2013

5 30 Reg. section Prop. reg. section (f). 32 Although the income distributed from the trust to minor children may be subject to regular income tax at their parents rate under section 1(g), a minor child will not be subject to the NII tax unless the child s AGI exceeds the individual threshold. 33 ($120,000 - $11,950) x 3.8 percent. 34 ($240,000 - $11,950) x 3.8 percent. 35 See, e.g., Jonathan G. Blattmachr and Mitchell M. Gans, The Final Income Regulations: Their Meaning and Importance, Tax Notes, May 17, 2004, p COMMENTARY / SPECIAL REPORT income of a foreign trust, 30 and the exclusion for dividends (repealed in 1986). Although three of the DNI modifications concern items of taxable income that are allocable to fiduciary accounting principal rather than income, the regulations do not provide that all items of taxable income allocable to accounting principal will be removed from DNI. Yet, the examples in the proposed regulations improperly provide that of the $60,000 of income received by a trust from an IRA distribution, $35,000 is allocated to principal and therefore excluded from DNI. 31 Because the threshold amount for imposing the NII tax on a trust or estate is less than 6 percent of the threshold amount for an individual, a fiduciary will be under pressure to make distributions to its beneficiaries to reduce NII tax. 32 For example, assume that now-deceased parents created a trust with $300,000 of investment income on $6 million of assets for three single children in college. Assume further that each child needs $60,000 in distributions per year, resulting in minimum annual distributions of $180,000. If the trustee retains the additional $120,000, just the added NII tax will be $4, As is typical in today s investment environment, we will assume that only about 20 percent of the trust s gross income is from interest and dividends, while the balance is from net capital gains. Because capital gains usually do not enter into DNI, in our example DNI would be composed of only $60,000 and the distribution deduction would be limited to $60,000, despite actual distributions totaling $180,000. Thus, in this example all of the capital gains of $240,000 will be taxed to the trust, increasing the NII tax by $8, If a trust has beneficiaries with AGI under the individual threshold, the trustee may want to consider whether capital gains can be allocated to DNI. 35 Treasury should revise the regulations on the computation of DNI; a statutory change should be unnecessary. The threshold for trusts for payment of the NII tax and the highest marginal rate is set so low (at $11,950) that trusts are unfairly taxed under the current regime. Reducing this tax unfairness requires a different definition for DNI one that allows the trustee to make distributions to beneficiaries that will carry out capital gains and other types of income normally trapped in the trust as a result of the definition of DNI, without the necessity of an election to treat capital gains as accounting income. I believe that items of income that are allocable to fiduciary accounting income under state law, such as interest and dividends, should make up a new DNI tier 1. If distributions from the trust exceed the aggregate of tier 1 net income, DNI tier 2 would include any items of income, such as capital gains, that are allocable to fiduciary accounting principal. If a retirement plan distributes to the trust, all the resulting taxable income is included in DNI, despite being allocated to fiduciary accounting principal, contrary to the proposed regulations discussed above. Under my proposed change to the DNI definition, however, the retirement plan income would be divided between DNI tier 1 as to the portion allocable to fiduciary accounting income and DNI tier 2 as to the portion allocable to fiduciary accounting principal. The regulatory change actually makes the proposed section 1411 regulations closer to correct. The concept of the proposed regulations that taxable income allocable to principal should not enter DNI would define DNI tier 1. Distributions would draw down the DNI tier 2, however, if they exceed the DNI tier 1, which does not happen under current law or under the examples in the proposed regulations. This regulatory change largely preserves the current definition of DNI while allowing a fairer tax result if distributions exceed fiduciary accounting income. Both the NII tax and the 39.6 percent top income tax rate apply when the trust has income of only $11,950, despite the trust possibly having many beneficiaries with little other income allowing them to use their individual $200,000 exemption from the NII tax. Although the trust s lower threshold for applying the maximum income tax rate and the 3.8 percent tax will not affect high-income beneficiaries, the lower thresholds will frustrate the deceased middle-income parent who used her life insurance and retirement benefits 36 to fund a trust to provide for her orphaned children. Because middle-income parents have limited resources, they are more likely to set up one trust for all of their children rather than separate trusts for each child, magnifying the cost of the NII tax. Moreover, if the trustee makes distributions to reduce current income taxes, the distributions would need to go out of the trust, perhaps to 36 Although the insurance proceeds and retirement benefits are exempt from the NII tax, the investment earnings on those proceeds are subject to it. TAX NOTES, August 12,

6 custodianships for minor children that would become their property at age 21. These distributions will deplete the capital available to the trust beneficiaries later when they start college, graduate school, or professional school. My proposed changes to the definition of DNI in the regulations would not solve that problem. I therefore propose a statutory change that would provide for a joint election by the trustee and the trust beneficiaries to treat all the DNI tier 1 and DNI tier 2 of a trust as if it were distributed to the beneficiaries during a calendar year, without the necessity of making any distributions. Because Treasury may be concerned that a trust might include straw beneficiaries whose lower income might be used to artificially reduce the taxes on trust income, the election would need to be limited to avoid manipulation. The first limit should be that the beneficiaries of the trust should consist only of one or more of the surviving spouses of an individual, that individual s children or stepchildren, and that individual s grandchildren or step-grandchildren. The second limit should be that the deemed distribution will be treated as made to the surviving spouse, or if not a beneficiary, per stirpes among the descendants of that individual, disregarding the distinction between children and stepchildren. In other words, if a trust benefits all the descendants of a couple that has three living children, all of the trust DNI would be treated as distributed equally among those three children. If one child has died and that child was survived by two children, the DNI would be treated as distributed one-third to each living child and one-sixth to each surviving grandchild. No flexibility would be allowed. If a separate trust was created for each living child, the DNI from each trust would be treated as distributed to the child, if living, or otherwise equally to the surviving grandchildren. Third, the election would have to apply to all the DNI tier 1 and DNI tier 2 remaining after all distributions. No discretion would be allowed to split DNI between the trust and its beneficiaries. Finally, the joint election would have to be timely filed in both the fiduciary return and in the return of each individual beneficiary who is treated as receiving a distribution from the trust. Although not a deduction allowed in determining the AGI of a trust, section 642(c) permits a fiduciary to reduce the gross income of a trust or estate by amounts paid to a charity (or permanently set aside by an estate for charity). Although sometimes referred to as a deduction, the items of income are more accurately described as allocated to the charity, rather than the trust or estate. Thus, when section 642(c) applies, it will reduce undistributed NII but not AGI. Question 6: How Do You Determine Whether a Business Interest Is a Passive Activity? A passive activity for purposes of the NII tax is the same as a passive activity for purposes of the PAL rules. 37 Congress enacted the PAL rules in section 469 in 1986 to prevent taxpayers from purchasing investments to produce tax losses to shelter other sources of positive income, such as salary and investment income. However, it did not want to limit active business owners from deducting their losses against all their income. So Congress made material participation the touchstone for distinguishing active owners from passive ones. Thus, a passive activity of a taxpayer is one in which she does not materially participate. The regulations under section 469 added another purpose for the PAL rules: It appears that the [IRS] was more concerned in the Regulations with passive INCOME rather than passive LOSSES, even though Section 469 was not intended to prevent a taxpayer from offsetting the former with the latter. 38 That latter purpose motivated the use of seven quantitative tests in the regulations mostly based on hours 39 for material participation, 37 Section 469 contains the PAL rules. For a comprehensive discussion of the application of the PAL rules to trusts, see Byrle M. Abbin, Income Taxation of Fiduciaries and Beneficiaries, ch. 8 (2008). 38 See ABA tax section, Comments on the Proposed and Temporary Regulations Sec (May 31, 1988) (ABA 1988 comments). I participated in the development of those comments as chair of the ABA tax section s agriculture committee. The regulations did not stop with just those two purposes. They also provided that some investments that were clearly passive, such as a ground rent lease, but were certain to produce income and not losses, would be deemed non-passive income. The regulations thereby shut the door on the infamous passive income generators or PIGs. 39 Under reg. section T(a), an individual will be found to materially participate in an activity if she meets one of seven tests: 1. the individual participates in the activity for more than 500 hours during the year (test 1); 2. the individual s participation for the tax year constitutes substantially all the participation in that activity of all individuals (including individuals who are not owners of interests in the activity) for that year (test 2); 3. the individual participates in the activity for more than 100 hours during the tax year, and that individual s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for that year (test 3); 4. the activity is a significant participation activity, and the individual s aggregate participation in all significant participation activities during the year exceeds 500 hours (test 4); 5. the individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years immediately preceding the tax year (test 5); (Footnote continued on next page.) 6 TAX NOTES, August 12, 2013

7 rather than the more subjective tests for determining material participation used previously in other tax contexts. 40 If the only purpose of the PAL rules had remained to ensure that a business owner was sufficiently involved in an unprofitable business to fully deduct its losses against the owner s salary and portfolio income, the regulations could have been based on subjective factors that would have emphasized all of the connections between the business and that owner. Because Treasury determined that the regulations also needed to apply to profitable businesses to sort their income into the active or passive basket, a more precise test became necessary. 41 Nothing in the statute or legislative history suggested that a primary purpose of section 469 was to prevent an owner from offsetting losses and income from various business activities. That difference between the objectives of the statute and its regulations remains unreconciled after more than 25 years. Section 469 is therefore a shaky foundation on which to build the new NII tax. Because the NII tax simply adopts the section 469 passive activity definition, the taxable income from a business investment should be subject to NII tax only when the owner of that investment is likely to have purchased it to shelter her positive income. The closer the owner s involvement with the operations of the business investment, the less likely the income from that investment should be subject to NII tax. The greater the percentage of the owner s wealth invested in the business, the less likely the income from the investment should be subject to NII tax. Those considerations should remain valid when the owner is a trustee rather than an individual. 6. the activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year (test 6); or 7. based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year (test 7). 40 I wrote a seven-page section in the 1988 ABA comments that was critical of the proposed regulations because of their drastically different tax treatment, despite Congress having based its material participation requirement on long-standing agricultural tax principles. The final regulations made only minor adjustments in response to that criticism. 41 It is hard to know whether the idea of quantitative tests arose from Treasury or taxpayer representatives. See David H. Evaul and Richard M. Lipton letter (Dec. 9, 1987) (suggesting quantitative approach to define material participation). Treasury usually views quantitative tests as inviting taxpayer manipulation. COMMENTARY / SPECIAL REPORT Question 7: Please Get to the Point Already: Can A Trust Materially Participate Under Section 469 (and Thus Section 1411)? Definitely yes. Despite the length and depth of the section 469 regulations, they reserve on the question of how estates and trusts materially participate. 42 The most definitive authority on whether a trust can materially participate for purposes of section 469 predates the regulations. The Senate report accompanying the Tax Reform Act of 1986, which included section 469, treats an estate or trust as materially participating in an activity if an executor or fiduciary, in his capacity as such, isso participating. 43 The Senate report further provides that in the case of a grantor trust...material participation is determined at the grantor rather than the entity level. 44 The proposed regulations under section 1411 propose a rule for grantor trusts that is consistent with the Senate report. 45 The only other authority on whether a trust can materially participate is a decision by a federal district court in Texas. In Mattie K. Carter Trust v. United States, 46 the court considered whether a trust operating a ranch business materially participated in that business. The contested issue in Carter Trust was how a trust could establish material participation for purposes of section 469, not whether it could. (The how is discussed in the answer to Question 8 below.) One important aspect of Carter Trust was that the trust operated its ranch business directly using employees and agents of the trust, rather than through an entity owned by the trust. Despite the invitation in the Joint Committee on Taxation blue book explaining TRA 1986, the IRS does not appear to have argued that the trust might be an association for tax purposes because it directly operated the ranch. Association treatment would mean that the trust would be taxed the same as a C corporation, rather than as a trust, resulting in the potential double taxation of its income. The JCT said a trust would be a trust for income tax purposes, and not an association taxable as a corporation, only if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility 42 Reg. section T(g); reg. section S. Rep. No (1986), at 735 and n.287 (emphasis added). 44 Id. 45 Prop. reg. section (b)(5) F. Supp.2d 536 (N.D. Tex. 2003). TAX NOTES, August 12,

8 and, therefore, are not associates in a joint venture for the conduct of business for profit. 47 If the blue book s arguments were viable when written, which is doubtful, subsequent legal developments have foreclosed its assertions. The IRS did argue for association treatment in Estate of Harry Bedell Sr. Trust v. Commissioner, 48 which involved the disposition of the decedent s manufacturing business, which operated as a sole proprietorship, to a testamentary trust. 49 The decision traces the trust as association history beginning with the Supreme Court s holding against the taxpayer in Morrissey v. Commissioner. 50 The six tests for characterizing organizations for income tax purposes in Morrissey became reg. section through All the cases under those regulations, including Bedell Trust, have concluded that traditional trusts are not associations. 52 By 1988 the IRS was willing to conclude in a private letter ruling that a traditional trust lacked the required associates for association treatment: The trusts here were created as part of GR [grantor] s estate plan. BE [beneficiary] did not participate in their [the trusts ] creation or funding, but will merely accept the benefits therefrom. Although BE has the power to remove any trustee, there is no indication that she has or will control management of trust affairs. Indeed, the retention by TT [trustee] of the subchapter S corporation to perform management functions demonstrated that BE is to have no voice in management. Finally, BE s interests in the trust cannot be alienated. 53 Nevertheless, based on little authority, the blue book concluded almost contemporaneously with Bedell Trust: It is unlikely that a trust as such for Federal income tax purposes will be materially 47 JCT, General Explanation of the Tax Reform Act of 1986, at 242, n.33 (1987) (TRA 1986 blue book). General explanations of tax legislation prepared by the JCT, however, constitute authority on which taxpayers may rely in determining whether there is substantial authority for the federal income tax treatment of an item. See reg. section (d)(3)(iii) T.C (1986), acq. in result, C.B In other words, a trust created by a will (or last testament) at death, rather than a trust created by an instrument or agreement while the creator is living U.S. 344 (1935). 51 In 1996 Treasury amended these regulations with the check-the-box regulations. T.D However, the amendments did not change the rules for differentiating between an ordinary trust and an association for income tax purposes. 52 See, e.g., Curt Teich Trust No. One v. Commissioner, 25 T.C. 884 (1956), acq., C.B. 8; Elm Street Realty Trust v. Commissioner, 76 T.C. 803 (1981), acq., C.B LTR The 1988 letter ruling identified the mere existence of an S corporation to manage the oil and gas interests held in trust as evidence of the lack of associates. participating in a trade or business activity, within the meaning of the passive loss rule. 54 Thus, the blue book said, No special rule is provided for determining material participation by a trust. 55 The blue book differed significantly from the approach taken in the Senate report about how a trust materially participates. In this instance particularly, the blue book deserves its status as lacking the authority of the Senate report. The American Bar Association Section of Taxation has said the blue book s extraordinary statement is based on a misconception of business realities. 56 I wrote at the time that the blue book not only misstated the law but it failed to recognize that a trust might own a partnership or S corporation interest (which could not result in the trust being taxed as an association) but with respect to which the Blue Book fails to give any rules to determine the trust s material participation in the activities of the entity. 57 The IRS heaped the final indignity on the blue book when it stated in a 2007 technical advice memorandum: The legislative history is somewhat complicated by subsequent comments in the Bluebook to the 1986 Act....However, the Bluebook is not legislative history. In addition, the discussion is based on the assumption that trusts would rarely (if ever) materially participate in a trade or business activity. 58 Both Congress and the IRS clearly view trusts as able to materially participate under section 469. Some commentators have suggested that the Senate report was written contemplating that a business would be operated directly by the trust, rather than through an entity. I strenuously disagree because of the answers to three questions. First, if Congress intended that only a trust directly operating a business could materially participate, would the blue book have specifically prohibited that one type of trust business operation from materially participating? Second, would the IRS have first specifically targeted that type of direct operation in Carter Trust to challenge the trust s material participation, rather than an entity operated by a trust? Finally, if trusts have a history of operating directly only real estate businesses, would Congress have approved direct operations by trusts at the same time it was prohibiting material participation in 54 TRA 1986 blue book, supra note Id. 56 ABA tax section, Comments on Passive Activity Loss Regulations to Trusts and Estates (1993) (ABA 1993 comments). 57 Richard L. Dees, The Passive Loss Rules and Alternative Minimum Tax: Estate Planning From an Income Tax Perspective, Tax Notes, Mar. 1, 1988, p TAM , at n.2 (emphasis added). 8 TAX NOTES, August 12, 2013

9 rental real estate activities? Obviously, the answer to all three questions is no. None of these would have happened if Congress was assuming that only businesses operated directly by trustees could materially participate. Congress later reinforced its intention that a trust can materially participate when it enacted section 42(h)(5)(B), stating that a qualified low-income housing project is described in this subparagraph if a qualified nonprofit organization is to own an interest in the project (directly or through a partnership) and materially participates (within the meaning of section 469(h)) in the development and operation of the project throughout the compliance period (emphasis added). A nonprofit organization necessarily would be either a corporation or a trust; it could never be an individual. Congress would not enact a meaningless test that no nonprofit organization could satisfy by materially participating. 59 Thus, this low-income housing statutory provision reinforces Congress s intent that a trust or a corporation would be able to materially participate under section 469. The applicable guidance consistently provides that a trust can materially participate under section 469 and, accordingly, under section Thus, the trade or business income of an entity owned by a trust, or directly operated by the trust, will not be subject to the NII tax when the trust materially participates in the trade or business. Question 8: How Then Does a Trust Materially Participate Under Section 469 (and Section 1411)? Neither the code nor the regulations 60 provide how to determine the material participation of a trust or estate under section 469, so the answer is murky. 61 As discussed in the answer to Question 7, the only authorities addressing this issue are the Senate committee report and a Texas federal district court decision. The Senate report accompanying the enactment of section 469 authoritatively states that a trust or estate materially participates when its fiduciary materially participates. For the reasons discussed above, 62 the blue book fails to undermine that authority. The federal district case, Carter Trust, expanded the Senate report test to allow the trust to include the actions of the trust s agents and employees, not just the actions of the trustee, in determining material participation. 63 The court stated: IRS contention that Carter Trust s participation in the ranch operations should be measured by reference to [the trustee] finds no support within the plain meaning of the statute. Such a contention is arbitrary, subverts common sense, and attempts to create ambiguity where there is none. 64 Because under section 469(a)(2)(A) trusts are defined as taxpayers and material participation is to be determined at the taxpayer level, the court concluded that the material participation standard applies at the trust level: It is undisputed that Carter Trust, not [the trustee], is the taxpayer. Common sense dictates that the participation of Carter Trust in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of Carter Trust. 65 The Texas district court treated the Carter trust as a legal entity, expressing sympathy with the trustee s analogy to a closely held corporation. The IRS s view, however, more nearly aligns with the traditional view of a trust as a fiduciary arrangement rather than a legal entity: The trustee is the legal owner of the trust assets but owes fiduciary duties to the beneficiaries (who are sometimes called the beneficial owners). The 1993 comments by the ABA tax section carried this traditional understanding to its logical conclusion: The character of the income or loss from an activity of the trust should be preliminarily determined by whether the fiduciary (executor or trustee) materially participates in the activity, with the fiduciary s participation determined under the general rule of Temp. Reg. Sec T as if he personally owned the interest of the trust or estate. 66 In its recent comments on the proposed regulations under section 1411, the ABA tax section recommends a more comprehensive test, which incorporates the Carter Trust holding: 59 See, e.g., Housing Pioneers Inc. v. Commissioner, 49 F.3d 1395, 58 F.3d 401 (9th Cir. 1995). The court held that the nonprofit failed to participate on a continuous, regular, and substantial basis. 60 Reg. section T(g); reg. section The Abbin treatise asserts that authority supports allowing the taxpayer to use any reasonable method to apply the PAL rules to trusts in the absence of regulations, citing reg. section T(p). Abbin, supra note 37, at See answer to Question The court also noted that the trustee s activities regarding the ranch operations, standing alone, were regular, continuous, and substantial, so as to constitute material participation by him, as trustee, during the relevant periods. As a result, even if the court had accepted the legal standard promoted by the IRS, the Carter trust would have prevailed. 64 Carter Trust, 256 F. Supp.2d at Id. 66 ABA 1993 comments, supra note 56. TAX NOTES, August 12,

10 In this regard, we recommend that the new proposed regulation package would provide that material participation by a trust or estate can be accomplished through meeting at least one of three tests: a. The fiduciary materially participates under the standards that apply to individuals under previously promulgated Regulations. b. The fiduciary, based on all facts and circumstances, participates in the activity on a regular, continuous and substantial basis during the year. c. The fiduciary participates in the activity on a regular, continuous and substantial basis, either directly or through employees or contractors whose services are directly related to the conduct of the activity. 67 Until Treasury or the IRS adopts either of the ABA suggestions, however, only the regular, continuous and substantial standard under section 469(h)(1) applies in determining whether a trust or estate satisfies the material participation requirement of section Question 9: How Does the Senate Report s Statement That the Fiduciary Must Materially Participate in His Capacity as Such Affect How A Trust Materially Participates? For more than 25 years, this question would have had a very simple answer: not at all. In the absence of any section 469 regulations providing material participation rules for trusts and estates, commentators have expressed concern that the IRS might argue that the Senate report s language in his capacity as such permits only the trustee s actions as the owner of the trust business interest to be counted toward the trust s material participation. 69 During that period, however, the IRS had never proffered this fiduciary capacity argument. In the 67 ABA 2013 comments, supra note 16, at 19. At note 82, the comments cite to the rules for material participation by a C corporation in reg. section T(a)(7), but this third alternative also could be based on the holding in Carter Trust. 68 TAM , supra note 58 ( Until regulations are promulgated, sec. 469(h)(1) remains the sole standard for determining whether a trust or estate satisfies the material participation requirement of Sec. 469 ). 69 See ABA 1993 comments, supra note 56 ( Moreover, in focusing on participation by the fiduciary in his capacity as such, the 1986 Senate Report suggests that time spent by the fiduciary in another capacity (e.g., as an employee of the business or as an owner in his own right) is to be disregarded. This result differs from the general rule adopted in later regulations that participation is considered without regard to the capacity in which rendered (citation omitted)). last two years, however, the IRS s position appears to have changed as it made the fiduciary capacity argument in two related contexts. The starting point for evaluating the fiduciary capacity argument should be a 2010 letter ruling. 70 The trust that was the subject of the ruling owned an interest in a partnership that owned an interest in another entity (Sub 1). Sub 1, in turn, owned an interest in another entity (Sub 2). The taxpayer asked the IRS to rule that the trust could materially participate in Sub 2. The purpose of the ruling is somewhat obscure: The IRS would not rule on what actual activities by the trustee in Sub 2 s business would constitute material participation by the trust. Nonetheless, the IRS ruled that the trust could materially participate in Sub 2 through the trustee s regular, continuous, and substantial involvement in Sub 2 s operations, which it owned only indirectly. Although the ruling cites the Senate report s in such capacity language, the IRS did not apply it narrowly to limit the trustee s actions that would count toward the trust s material participation to only actions as the owner of the trust assets. Because the trust did not own Sub 2, a narrow reading of in such capacity would have barred the trust from materially participating in the business of Sub 2 because any of the trustee s actions would have to be taken in some capacity other than as trustee. The taxpayer s purpose in asking for the letter ruling appears to be countering this crimped interpretation of the legislative history, and the IRS agreed with the taxpayer. 71 Although not applicable to trusts and estates, the section 469 regulations allow an individual to consider her actions in an activity without regard to the capacity in which the actions are undertaken: 70 LTR The ruling also reaffirmed the IRS s continuing opposition to Carter Trust: The focus on a trustee s activities for purposes of section 469 accords with the general policy rationale underlying the passive loss regime. As a general matter, the owner of a business may not look to the activities of the owner s employees to satisfy the material participation requirement. See S. Rep. No , at 735 (1986) ( the activities of [employees]...arenotattributed to the taxpayer. ). Indeed, because an owner s trade or business will generally involve employees or agents, a contrary approach would result in an owner invariably being treated as materially participating in the trade or business activity. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of other business owners, therefore, it is appropriate in the trust context to look only to the activities of the trustee. Thus, the sole means for a trust to establish material participation is if its fiduciary is involved in the operations of the activity on a regular, continuous, and substantial basis. 10 TAX NOTES, August 12, 2013