Effective Jan. 1, 2013, Sec. 1411(a)(2) imposes a tax of 3.8% on estates and trusts on the lesser of their undistributed net investment income or the excess of their adjusted gross income over the dollar amount at which the highest tax bracket in Sec. 1(e) begins for the tax year (the amount for 2013 is $11,950, which is inflation-adjusted). Although Congress did not provide a rule specifying which trusts are subject to Sec. 1411, Prop. Regs. Sec. 1.1411-3 indicates that the 3.8% tax applies to most nongrantor trusts (REG-130507-11).
Sec. 1411(c)(1)(A) defines net investment income, in part, by reference to trades or businesses described in Sec. 14 11(c)(2), which include passive activities (within the meaning of Sec. 469). Thus, one of the important exemptions from the 3.8% tax is for trade or business income derived from a business in which a taxpayer materially participates. (For an in-depth discussion of key issues for estates and trusts to consider regarding the new Medicare tax, see Nuckolls, et al., "Applying the New Net Investment Income Tax to Trusts and Estates," 44 The Tax Adviser 316 (May 2013)).
Statutory Guidance on Trust Material Participation
Sec. 469(h)(1) provides that a taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. Sec. 469(a)(2)(A) identifies trusts and estates as taxpayers to whom the passive activity rules apply. For individuals, the qualitative test of Sec. 469(h)(1) has largely been replaced by the more quantitative regulatory tests of Temp. Regs. Sees. 1.469-5T(a)(1)-(7). Although the Treasury Department reserved regulations addressing material participation to trusts, estates, and their beneficiaries almost 25 years ago (Temp. Regs. Sec. 1.469-5T(g) and Regs. Sec. 1.469-8), those regulations have never been issued. In the absence of explicit statutory or regulatory guidance on how a trust may establish material participation, the IRS has almost exclusively relied on the legislative history for Sec. 469, which provides 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't No. 99-313, 99th Cong., 2d Sess. at 735 (1985)).
Cases and Rulings
The only court opinion addressing how a trust establishes material participation for purposes of Sec. 469 is Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003). In Carter, the trust operated a 15,000-acre cattle ranch. The trustee spent a significant amount of time reviewing financial information and making financial decisions for the trust and the ranch. The day-to-day operations of the ranch were carried out by a full-time ranch manager and full-and part-time employees who performed...