TAM 201317010: IRS Finds No Material Participation for Trust Where Special Trustee Was Officer of Company in His Individual Capacity

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In TAM 201317010, the IRS National Office concluded that two trusts did not materially participate in the relevant activities of S corporation for the tax years at issue because the trustees, in their role as trustees of the trusts, were not involved in the operations of S corporation's relevant activities on a regular, continuous and substantial basis during the tax years at issue. The National Office noted that the special trustee's employment as president of the S corporation's qualified Subchapter S subsidiary ("QSub") did not count towards the material participation because these activities were not in his capacity as a fiduciary. Under the logic of this TAM, it will be virtually impossible for a trust to be considered to be materially participating in a passthrough entity.

Trust A and Trust B were complex trusts. Trust A and Trust B were set up by C and D, respectively, for the benefit of C and his family. D was the trustee of both Trust A and Trust B. C was the special trustee of both Trust A and Trust B. Trust A and Trust B each owned an interest in an S corporation ("Company X"). The remaining shares of Company X were held directly by C. Company X wholly owns a QSub ("Company Y"). Trust A and Trust B each reported positive taxable income from their interests in Company X on their respective tax returns for tax years 2007 through 2010. C, as special trustee had all the power with decisions regarding the sale or retention of Company X or Company Y stock and all voting of such stock.

Section 56(b) imposes an alternative minimum tax (AMT) adjustment with respect to research and experimental expenditures, which requires a corporation's research and development expenses to be amortized over a 10-year period for purposes of the AMT. However, under §56(b)(2)(D), the AMT adjustment does not apply to expenditures paid or incurred in connection with an activity in which the taxpayer materially participates. Under §469(h)(1), a taxpayer materially participates in an activity if he or she works on a regular, continuous and substantial basis in operations.

The legislative history for §469(h) provides that, as a general matter, the owner of a business may not look to the activities of employees or agents to satisfy the material participation requirement.The National Office noted that if an owner's could count the participation of employees or agents, the owner would invariably be treated as materially participating. The National Office stated that a "trust should be treated no differently. A trustee performs its duties on behalf of the beneficial owners. Consistent with the treatment of business owners, therefore, it is appropriate in the trust context to look only to the activities of the trustee to determine whether the trust materially participated in the activity."

Although Trust A and Trust B represented that the special trustee was involved in the day-to-day operations and management decisions of Company X and Company Y, his powers as special trustee were restricted by the trust agreements to selling or voting the stock. Therefore, the National Office stated that the day-to-day work that the special trustee performed was as an employee of the QSub, and not in the role of a fiduciary of Trust A and Trust B.  The National Office, therefore, concluded, that it does not count for purposes of determining whether the trusts materially participated in the trade or business activities of the companies under §469(h).  While the time the special trustee spent as special trustee - voting the stock or considering sales of stock in either company - would count for purposes of determining the trusts' material participation, the National Office concluded that "time spent performing those specific functions does not rise to the level of being `regular, continuous, and substantial' within the meaning of §469(h)(1)."

In reaching its conclusion, the National Office expressly declined to follow the federal district court decision to the contrary in Mattie K. Carter Trust v. U.S. , 256 F. Supp. 2d 536 (N.D. Tx. 2003). In Mattie K. Carter Trust, the district court held that a trust's material participation should be determined by assessing the trust's activities through its fiduciaries, employees and agents. Although the IRS had not issued a formal nonacquiescence in that decision, the reasoning of the case was previously rejected by the National Office in TAM 200733023.

Under the logic of this TAM, it will be virtually impossible for trust to be considered to be materially participating in a passthrough entity. Therefore, all income generated by the passthrough entity will be considered passive income to the trust. Since the new 3.8% Medicare tax is imposed on passive income, a trust holding interests in a passthrough entity will almost certainly be subject to the 3.8% tax on any income generated by the passthrough entity.

For more information, in the Tax Management Portfolios, see Acker, 852 T.M., Income Taxation of Trusts and Estates,  and in Tax Practice Series, see ¶2980, Passive Loss Rules.

  1 See S. Rep. No. 99-313, at 735 (1986) ("the activities of [employees] are not attributed to the taxpayer").

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