The Tax Court Weighs in on the Debate Over a Trust’s Material Participation in a Business

May 13, 2014Articles Estate Planning Blog

Last month, the Tax Court became yet another voice in the debate over a trust’s material participation in a business for the purposes of the new 3.8 percent surtax on net investment income. A trust can avoid this surtax if the trust materially participates in the activity that generates the investment income.

In Frank Aragona Trust v. Commissioner, the Tax Court ruled that a trustee’s involvement in a business as an employee of an entity owned by the trust counts toward a trust’s material participation in the business. In so holding, the Aragona court reasoned that a trustee may not shed his fiduciary duties simply because he is acting in his role as an employee to the business. Therefore, any activities performed by a trustee in his role as an employee of the business should count toward the trust’s material participation in the business. The Tax Court applied Michigan law in its analysis of a trustee's duties.

The Aragona court also implied that the activities of those other than the trustee, such as a trust’s employees, may also count towards the trust’s material participation in a business. The Aragona court, however, did not go so far as to rule on this issue because the court was content that the trustees' activities, without regard to the other trust employees activities, satisfied the material participation requirement.

The Aragona ruling is beneficial to a trust that holds an ownership interest in a business. The ruling supports including the activities of the trustees in their roles as employees of a business owned by the trust for the purposes of the trust’s material participation. Thus, under Aragona, the trustees’ day-to-day activities as officers and consultants of the trust-owned business will count towards the trust’s material participation in the business.

Prior to the Aragona ruling, IRS publications had stated that only the trustee’s activities in the trustee’s capacity as a fiduciary should be counted for purposes of determining material participation. Conversely, case law had held that the activities of the trustee, beneficiaries and trust employees, collectively, should be considered in determining whether a trust materially participates in a business.

For more discussion on the material participation of a trust for the purposes of the 3.8 percent surtax on net investment income, click here.