Differing points of view have arisen regarding determining the active participation of S-Corporation shareholdings held in Trust.  The uncertainty centers on IRC § 469. Section 469 defines a passive activity as any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate, and the section specifically includes trusts within its scope. It does not, however, explain how the section applies in the context of a trust.  Furthermore, the Treasury Department has not yet issued regulations addressing the practical participation requirements for trusts.  Questions have arisen whether the participation requirements can be satisfied by the trustee (including a special trustee or trust advisor), the officers, employees, agents or even the beneficiaries of a trust.  The IRS recently set forth its position on this issue in Technical Advice Memorandum 201317010.

In 2003, the Northern District of Texas held (in the Mattie K. Carter case) that in determining material participation for trusts, the activities of the trust’s fiduciaries, employees and agents should be considered to determine whether a trust’s participation in the corporation’s business is regular, continuous and substantial.  The IRS disagrees with the holding of this case, as specifically stated in TAM 201317010.  Instead, the IRS asserts that a trust is no different from an individual shareholder, who is not able to utilize the efforts of the shareholder’s or the corporation’s employees to satisfy the material participation requirement. According to the IRS, only the activities of the trustee may be evaluated to determine whether the trust has materially participated.  Further, the day-to-day activities of a special trustee are not counted if the special trustee’s duties under the trust agreement are limited to selling or voting the corporation’s shares and do not include the power to commit the trust to any course of action or control trust property.  Under TAM 201317010, only the special trustee’s time devoted to voting the stock or considering the sale of the stock (which is not considered to be regular, continuous and substantial) is counted for material participation purposes.

Recently, many trustees holding S-Corporation shares have carefully considered how to meet the material participation requirements to avoid the 3.8% Net Investment Income Tax generally applicable to passive income.  If a shareholder of an S-Corporation actively participates, then the corporation’s income is not classified as passive, and the shareholder trust can avoid the 3.8% Net Investment Income Tax.  With TAM 201317010, the IRS cast a significant obstacle on the path to material participation.  It remains to be seen whether the more tax-payer friendly position of Mattie K. Carter will prevail over TAM 201317010.  The Wealth Planning Examiner will continue to track this issue as it develops.