What Fiduciaries and Their Advisors Need to Know

Report
What Fiduciaries and Their Advisors
Need to Know About Navigating the
3.8% Net Investment Income Tax under
Code Section 1411
Presented to the Chicago Estate Planning Council on
December 10, 2014
By Richard L. Dees
McDermott Will & Emery LLP
Chicago Illinois
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What is in the Final and
Reproposed Regulations?





1.1411-1
1.1411-2
1.1411-3
1.1411-4
1.1411-5
General Rules
Specific Rules Applicable to Individuals
Specific Rules Applicable to Estates and Trusts
Definition of Net Investment Income
Trades or Businesses Subject to Tax: Passive Activities,
Financial Instruments/Commodities Trading
 1.1411-6 Income on Working Capital
 1.1411-7 Dispositions of Partnerships and S corporations
(Reproposed)
 1.1411-8 Exception for Qualified Plan Distributions
 1.1411-9 Exception for Self-Employment Income
 1.1411-10 CFC and PFIC rules
 1.1411-11 Effective Date and Transition Rules
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2
Net Investment Income Tax:
General Rules
 For an individual, 3.8% tax on the lesser of (a) an individual’s net
investment income (“NII”) or (b) the excess of the individual’s modified
adjusted gross income (“MAGI”)* over certain thresholds (not indexed
for inflation):
– $250,000 in the case of a joint return or surviving spouse,
– $125,000 in the case of a married individual filing a separate return,
or
– $200,000 in any other case
*Only modification to AGI relates to foreign earned income for an
individual living abroad.
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Net Investment Income Tax:
General Rules
 Net Investment Income is the excess (if any) of
– the sum of
• (i) Gross Income from (a) interest, (b) dividends, (c) annuities, (d) royalties, and
(e) rents (collectively “Specified Income”), other than Specified Income derived in
the ordinary course of a trade or business that is not a “Covered trade or
business”,
• (ii) Other gross income derived from a “Covered trade or business”, and
• (iii) Net gain attributable to the disposition of property other than property held
in a trade or business that is not a “Covered trade or business” (“Includable Net
Gain”), over
– the deductions allowed by Code Sections 1 through 1563 (subtitle A)
that are properly allocable to this gross income or net gain.
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Net Investment Income Tax:
General Rules
 Note that there is no look-through rule for dividends
from a subsidiary engaged in the same trade or business.
 Compare Code Section 1362(d)(3)(c)(iv) (referenced by
Code Section 1375(b)(3)):
– If an S corporation holds stock in a C corporation meeting the
requirements of section 1504(a)(2), the term “passive
investment income” shall not include dividends from such C
corporation to the extent such dividends are attributable to the
earnings and profits of such C corporation derived from the
active conduct of a trade or business.
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Net Investment Income Tax:
General Rules
 A trade or business is a “Covered trade or business” if such trade or
business is:
– (i) a passive activity (within the meaning of Code Section 469) with
respect to the taxpayer, or
– (ii) a trade or business of trading in financial instruments or
commodities (as defined in Code Section 475(e)(2)).
 Proposed Regulations under Code Section 1411 provide that a passive
activity is:
– (i) an activity that is a trade or business (within the meaning of Code
Section 162); and
– (ii) such trade or business is a passive activity within the meaning of
Code Section 469 and the regulations thereunder.
 Below we discuss how to ACTIVATE business and rental income
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Net Investment Income Tax:
General Rules
Prop. Treas. Reg. §1.1411-1(a):
Except as otherwise provided, all Internal
Revenue Code provisions that apply for
chapter 1 purposes in determining taxable
income (as defined in section 63(a)) of a
taxpayer also apply in determining the tax
imposed by section 1411.
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Net Investment Income Tax:
General Rules
 Timing: Unless provided otherwise, gain not recognized in a particular year under
chapter 1 is not recognized for that year for purposes of Code Section 1411
– Code Section 453 (installment sales)
– Code Section 1031 (like-kind exchanges)
– Code Section 1033 (involuntary conversions)
– Code Section 121 (sale of principal residence)
 Deferral and disallowance provisions used in determining taxable income apply in
determining NII
– Code Section 163(d) (limitation on investment interest)
– Code Section 265 (expenses and interest relating to tax-exempt income)
– Code Section 465 (at risk limitations)
– Code Section 469 (passive activity loss limitations)
– Code Section 704(d) (partner loss limitation)
– Code Section 1366 (S corporation shareholder loss limitations)
– Code Section 1212 (capital loss carryover limitations)
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Net Investment Income Tax:
General Rules
 Carryovers
– Allowed for determining NII in the same year as
allowed for taxable income
– Carryovers can be utilized even if carried from a year
that precedes the effective date of Code Section1411
 No reduction to NII for net operating loss carry
forwards
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Fiduciaries: Which trusts and
estates are subject to the NII Tax?
 Section 1411(a)(2) imposes a tax of 3.8% on the net investment income
of trusts and estates above an income threshold
– Treas. Reg. § 1.1411-3 provides special rules for applying section
1411 to estates and trusts, including an estate or trust with a short
taxable year due to the formation or termination of the estate or
trust (do not prorate the income threshold) or a change in
accounting period (do prorate)
– The preamble to the Final Regulations thoughtfully reexamines
which trusts taxed under the income tax also should be subject to
the NII Tax, including –
• Pooled Income Funds (yes)
• Cemetery Perpetual Care Funds (No) and Qualified Funeral Trusts
(practically No)
• Alaska Native Settlement Trusts (No)
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Fiduciaries: What are the
specifically excluded trusts?
– In addition, Treas. Reg. § 1.1411-3(b) specifically excludes the following
fiduciary arrangements from the NII Tax:
• Estates or Trusts set up for wholly charitable purposes as defined in section
170(c)(2)(B)
• Trusts exempt from tax under section 501(a)
• A charitable remainder trust ("CRT") under section 664, but distributions to
beneficiaries may be taxable
• Any other trust, fund, or account that is exempt from taxes under sections 641 –
646 (i.e., health savings accounts, 529 plans, Archer medical savings accounts,
Coverdell education savings accounts)
• Foreign Estates and Trusts with no U.S. beneficiaries
– The preamble indicates that section 1411 does not apply to business trusts at
the entity level, common trust funds and designated settlement funds
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Fiduciaries: Are Grantor Trusts
treated as individuals or trusts?
 A trust (or any portion of a trust) deemed owned by its grantor (creator)
or other person (usually a holder of an unrestricted power of
withdrawal) for fiduciary income tax purposes is disregarded for
purposes of the NII Tax
 Therefore, each item of income or deduction attributable to the grantor
trust (or portion thereof) is treated as if it had been received by, or paid
directly to, the grantor or other deemed owner for purposes of
calculating such person's net investment income
 The cause for grantor trust status is irrelevant and can result from:
– "Defective" grantor trust
– Power of withdrawal
– QSST as to K-1 income
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Fiduciaries: What about Charitable
Remainder Trusts?
 CRTs are not subject to the NII Tax
 However, annuity and unitrust payments to non-charitable beneficiaries
are deemed to consist of NII equal to the lesser of:
– The total amount of the distribution or
– The sum of the current and accumulated NII
 Accumulated NII is
– The total amount of post 12/31/12 NII
Less
– The amount of NII distributed in all taxable years post 12/31/12
 The final regulations provide a more complicated scheme for taxing
distributions from a CRT demanded by taxpayers’ advisors (NII Tax
included in income tax rate for “worst out first” rules)
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Fiduciaries: How is AGI
determined for the NII Tax?
AGI for a trust or estate is same as an individual, except that IRC
§67(e) adds three deductions that apply only to trusts and
estates:
 Administration expenses unique to the fiduciary arrangement
– Other administration expenses are miscellaneous itemized deductions
 Distributions to the beneficiaries limited to distributable net income
("DNI")
 The fiduciary's "personal exemption"
– $600 exemption for an estate
– $300 for a simple trust (a trust distributing all its fiduciary accounting
income)
– $100 for a complex trust; except the $300 exemption applies if the
trust is a simple trust taxed as a complex trust due to distributions in
excess of fiduciary accounting income
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Fiduciaries: How is undistributed
net income computed?
•
For an estate or trust, the 3.8% NII Tax is imposed on the lesser of:
– Undistributed Net Investment Income ("UNII") or
– The excess of AGI over the threshold amount
• The threshold amount for 2014 is $12,150 (income level at which
39.6% rate applies) is adjusted for inflation
• The Regulations compute UNII using existing fiduciary income tax
concepts in Subchapter J
•
UNII is determined by reducing the total NII by
– Distributed NII and
– Charitable deductions taken into account under IRC § 642(c)
•
Distributed NII is the lesser of:
– The distribution deduction under IRC § 651 or IRC § 661 or
– The NII of the estate or trust
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Fiduciaries: How is the charitable
“deduction“ computed?
 IRC § 642(c) reduces fiduciary gross income paid to a charity
(or permanently set aside by an estate for charity)
 Items of income are allocated to charity, rather than
deducted
 IRC § 642(c) reduces undistributed NII, but not AGI
 All items of gross income must be included in the distribution
pro rata unless allocation has economic significance
 Compare with individual charitable deduction that reduces
neither AGI nor NII
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Fiduciaries: How does DNI affect
the NII Tax computation?
•
DNI is taxable income (as defined in IRC § 63) of the estate or trust
reduced by items in Treas. Reg. § 1.643(a)-2 through 1.643(a)-7:
–
–
–
–
–
–
Personal exemption
Capital gains and losses allocable to fiduciary accounting principal
Extraordinary dividends and taxable stock dividends allocable to principal
Tax-exempt income
Income of a foreign trust
Exclusion for dividends (repealed in 1986)
•
Treas. Reg. § 1.1411-3 fixes a flaw in the proposed regulations in the
computation of DNI
•
The definition of DNI encourages distributions when beneficiaries are
middle or lower income, pressuring trustees
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Tax Rates for Trusts and Single
Individuals Assuming Investment
Income
AGI
ORD INCOME
CAP GAINS
SINGLE INDIVIDUAL TAXPAYER
$
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ORD INCOME
CAP GAINS
COMPLEX TRUST TAXPAYER
-
0.00%
0.00%
$100 exempt
15.00%-33.00%
20.00%
$
10,000
10.00%
0.00%
33.00%
20.00%
$
12,050
10.00%
0.00%
43.40%
23.80%
$
18,925
15.00%
0.00%
43.40%
23.80%
$
46,250
25.00%
15.00%
43.40%
23.80%
$
97,850
28.00%
15.00%
43.40%
23.80%
$
193,250
33.00%
15.00%
43.40%
23.80%
$
200,000
37.83%
18.80%
43.40%
23.80%
$
372,500
36.80%
18.80%
43.40%
23.80%
$
408,350
39.80%
18.80%
43.40%
23.80%
$
410,000
43.40%
23.80%
43.40%
23.80%
18
Fiduciaries: Can (should) capital
gains be included in DNI?
•
Adding capital gains to accounting income with a mandatory income
trust will usually be contrary to grantor's intent
•
Treas. Reg. § 1.643(a)-3 provides three situations for allocating capital
gains to DNI:
•
–
Allocated to income by trust or state law due to a unitrust payout or power
to adjust
–
If consistently treated as part of distributions to beneficiaries from
inception (The final regulations deny trustees a fresh start election)
–
Actually distributed or considered by the fiduciary in determining
distributions
Partnership distributions of accounting income including capital gains, if
instrument or state law provides (Crisp v. US); consider effect of
ownership of entire entity by trust
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Redline between proposed and final
regulations for capital gain
inclusion: consistency required?
(b)Capital gains included in distributable net income. Gains from the sale or
exchange of capital assets are included in distributable net income to the extent
they are, pursuant to the terms of the governing instrument and applicable local
law, or pursuant to a reasonable and consistentimpartial exercise of discretion by
the fiduciary (in accordance with a power granted to the fiduciary by applicable
local law or by the governing instrument, if not inconsistent withprohibited by
applicable local law)(1) Allocated to income (but if income under the state statute is defined as, or
consists of, a unitrust amount, a discretionary power to allocate gains to income
must also be exercised consistently and the amount so allocated may not be
greater than the excess of the unitrust amount over the amount of distributable
net income determined without regard to this subparagraph §1.643(a)-3(b));
(2) Allocated to corpus but treated consistently by the fiduciary on the trust's
books, records, and tax returns as part of a distribution to a beneficiary; or
(3) Allocated to corpus but actually distributed to the beneficiary or utilized by the
fiduciary in determining the amount whichthat is distributed or required to be
distributed to a beneficiary.
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Fiduciaries: Pro rata or "Topping
Off“ included capital gains?
•
Exception 1 of the regulations "top off" DNI with capital gains only to the extent
necessary to fill in the gap between accounting income and the total
distribution of "income“ in unitrust case with consistent exercise of trustee
discretion (other situations less clear)
•
•
•
Shows that different categories of income can be treated differently, despite cash
being fungible and power of traditional accounting income concepts
Exception 2 of the regulations appears to include capital gains proportionately
with other accounting income items in DNI
•
This can increase total taxes paid by swapping ordinary income items subject to the
highest tax rate in the trust for capital gains subject to lower tax rates [however
consider dividends taxed at 23.8% while short term capital gains are taxed at 43.4%]
•
Use of entity would result in pro rata inclusion too
Unclear which approach applies under Exception 3, but trustee is likely to
consider available accounting income before distributing capital gains, when the
capital gains distribution is discretionary [no consistency required]
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Fiduciaries: Are “Gross” or “Net”
Capital Gains included in DNI?
 Treas. Reg. sec. 1.643-3(d):
– (d) Capital losses. Losses from the sale or exchange of capital assets shall first
be netted at the trust level against any gains from the sale or exchange of capital
assets, except for a capital gain that is utilized under paragraph (b)(3) of this
section in determining the amount that is distributed or required to be
distributed to a particular beneficiary.
 Does (d) say that capital losses are trapped in the trust if capital gains
are allocated to DNI? In most cases, no!
 Because this regulation was unchanged between the proposed and final
versions, it literally does not apply in the clearest case under (b)(3) when
the trustee distributes specific gains to a beneficiary.
 Is there an implication that (b)(3) only applies when gross capital gains
are utilized to compute the amount distributed (as opposed to net
capital gains during the year being considered)? No, otherwise only a
cross-reference to the subsection would be needed.
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Fiduciaries: Effect of swapping capital
gains for ordinary income in DNI
Tax Rate Reduction from a Distribution
Difference in Difference in
Beneficiary
Ord. Inc.
Cap. Gains
AGI
Rates
Rates
$
-43.40%
-23.80%
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Cost to swap CG for Ord. Inc.
19.60%
$
10,000
-33.40%
-23.80%
9.60%
$
18,925
-28.40%
-23.80%
4.60%
$
46,250
-18.40%
-8.80%
9.60%
$
97,850
-15.40%
-8.80%
6.60%
$
193,250
-10.40%
-8.80%
1.60%
$
200,000
-5.57%
-5.00%
0.57%
$
372,500
-6.60%
-5.00%
1.60%
$
408,350
-3.60%
-5.00%
-1.40%
$
410,000
0.00%
0.00%
0.00%
23
Cumulative Trust Example
 Trust with income of $140,000 in capital gains, $40,000 in rental income
and $40,000 in dividends. Total income of $220,000. Trust has two
orphan children as beneficiaries. Assume a $60,000 distribution per
child and the child has no other income. Assume 2013 Rates and
Exemptions.
 Scenario I – No distribution
 Scenario II – DNI does not include capital gains
 Scenario III – DNI includes capital gains pro rata
 Scenario IV – DNI is "topped off" with capital gains
 Scenario V – All taxable income is deemed distributed
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Cumulative Trust Example
(cont.)
Tax Item
$20,588
III.
DNI w/ CG
pro rata
$21,803
IV.
DNI w/ CG
"top off"
$14,588
$7,906
$4,866
$3,346
$3,346
$0
$57,985
$25,453
$25,149
$17,933
$0
$0
$2,108
$4,307
$6,233
$21,233
Total tax – trust
and children
$57,985
$27,561
$29,455
$24,166
$21,233
Effective rate
26.36%
12.53%
13.39%
10.98%
9.65%
Trust income
tax
Trust NII tax
Trust total tax
Children income
tax
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I.
No
Distribution
$50,079
II.
DNI w/o CG
IV.
Total Deemed
Distribution
$0
25
How Do You Activate Business and
Rental Income to Avoid NII Tax?
 Active business income is determined under Code Section 469 as income
from a trade or business in which the taxpayer does not materially
participate
 Section 1411(c)(7) also excludes from the NII Tax certain capital gain
from the sale of an interest in an S Corp or Partnership owning an
activity in which the seller is active
 Extensive regulations under Code Section 469 address individuals and
closely-held and personal service corporations, but largely ignore trusts
and estates
 The Code Section 1411 Regulations generally incorporate the Code
Section 469 rules
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How does an individual materially
participate under Code Section 469?
 Code Section 469(h)(1): 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 basis
which is—(A) regular, (B) continuous, and (C) substantial.
 Temp. Treas. Reg. §1.469-5: An individual shall be
treated as materially participating in an activity for the
taxable year if and only if:
– (1) The individual participates in the activity for more than 500
hours during such year;
– (2) The individual's participation in the activity for the taxable
year constitutes substantially all of the participation in such
activity of all individuals (including individuals who are not
owners of interests in the activity) for such year;
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How does an individual materially
participate (cont.)?
 Seven tests (continued):
– (3) The individual participates in the activity for more than 100 hours during
the taxable year, and such individual's participation in the activity for the
taxable 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 such year;
– (4) The activity is a significant participation activity (within the meaning of
Temp. Treas. Reg. §1.469-5T(c)) for the taxable year, and the individual's
aggregate participation in all significant participation activities during such
year exceeds 500 hours;
– (5) The individual materially participated in the activity (determined without
regard to this test (5)) for any five taxable years (whether or not
consecutive) during the ten taxable years that immediately precede the
taxable year;
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How does an individual materially
participate (cont.)?
 Seven tests (continued):
– (6) The activity is a personal service activity (within the meaning of Temp.
Treas. Reg. §1.469-5T(d)), and the individual materially participated in the
activity for any three taxable years (whether or not consecutive) preceding
the taxable year; or
– (7) Based on all of the facts and circumstances (taking into account the rules
in Temp. Treas. Reg. §1.469-5T(b)), the individual participates in the activity
on a regular, continuous, and substantial basis during such year; provided
the individual participates in the activity for more than 100 hours during the
taxable year.
 Holder of only limited partnership interest can only establish
material participation under tests (1), (5) and (6)
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How do Code Sections 469 and 1411
play together? The Anti-PIG’s
 The regulations under Code Section 469 contained much criticized rules that limited
the ability of taxpayers to generate passive income to offset against passive losses.
These anti-passive income generator (“PIG”) rules were criticized as “Heads IRS
wins; Tails taxpayer loses” because the income from these investments would not
be passive income but the losses would be passive. When passive income is
recharacterized as non-passive under the anti-PIG rules, the Code Section 1411
regulations keep the non-passive character as long as the income is not further
recharacterized under section 469 as “portfolio income”. See Treas. Reg. § 1.14115(b)(2)(iii).
 Treas. Reg sec. 1.1411-5(b)(2)(i) provides:
– “To the extent that any income or gain from a trade or business is recharacterized as
‘not from a passive activity’ by reason of Regs. 1.469-2T(f)(2) [significant participation
passive activities], (f)(5) [net income from property rented incidental to
developmental activity] or (f)(6) [property rented to a nonpassive activity], such
trade or business does not constitute a passive activity within the meaning of
[section 1411] solely with respect to such recharacterized income or gain.”
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How do Code Sections 469 and
1411 play together? The Anti-PIG’s
(cont.)
 Treas. Reg. § 1.469-2T(f)(2)(i) recharacterizes certain income from a significant participation
passive activity (“SPPA”) as non-passive to the extent that “the taxpayer’s passive activity gross
income from all significant participation passive activities for the taxable year [prior to any
recharacterization] exceeds the taxpayer’s passive activity deductions from all such activities for
such year.”
 Treas. Reg. § 1.469-2T(f)(2)(ii) defines an SPPA as (i) a trade or business in which an individual
participates for at least 100 hours during the taxable year and (ii) which the taxpayer does not
materially participate in for the taxable year (i.e., less than 500 hours, hasn’t materially
participated for 5 of the last 10 years, and participation in all SPPAs doesn’t exceed 500 hours).
 With respect to each SPPA, Treas. Reg. § 1.469-2T(f)(2)(i) recharacterizes as nonpassive a ratable
portion of the taxpayer’s net passive income from a SPPA for the taxable year determined by
multiplying (i) the net passive income from the SPPA by (ii) (a) the total net passive income from
all SPPAs, divided by (b) the total net passive income from SPPAs which generated net income.
– NOTE: This results in netting passive income or loss from separate SPPAs first. If a loss, the
loss would be passive and offset passive income from other sources for NII Tax purposes. If
the netting results in income, the income would not be subject to the NII Tax.
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How does the fiduciary
materially participate? Treasury
and Taxpayers Agree
• Treas. Reg. § 1.469-5T(g) has been reserved for
regulations applying the material participation
requirements to trusts and estates; therefore, the
"regular, continuous and substantial" standard under IRC
§ 469(h)(1) applies to determine whether a trust or
estate satisfies the material participation requirement
• The Senate Report to IRC § 469 treats a trust as
materially participating "if an executor or fiduciary, in his
capacity as such, is so participating....”
• They agree on what it says, but not necessarily on what it means: that is,
what actions of the fiduciary count towards material participation by the
trust or estate?
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How does the fiduciary materially
participate? Taxpayers and Treasury
Agree (but Treasury forgets)
•
•
IRS's Passive Activity Loss Audit Technique Guide provides:
"If a business activity is owned by a trust, the examiner will need to determine if
the material participation standard is met in order for losses to be fully deductible….
The IRC § 469(h) requires regular, continuous and substantial participation in the
operations of the business to meet material participation and for losses to be fully
deductible. There is no guidance in the regulations at this time for material
participation of trusts and estates. As an administrative proxy, we look to the seven
tests in Reg. § 1.469-5T(a) for material participation, and generally will not raise
an issue if the trustee meets one of the tests. However, as a technical matter the
tests apply to individuals, not to a trust or trustee. Thus, as a legal matter, the
trustee must prove he works on a regular basis in operations, on a continuous basis,
and on a substantial basis in operations, i.e. rise to the requirements of IRC §
469(h)."
Treas. Reg. § 20.2032A-3 provides material participation regulations for
determining whether a decedent's estate qualifies for special use valuation (see
below)
• IRC § 469 material participation was modeled on IRC §§ 2032A and 1402
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How does the fiduciary materially
participate? Frank Aragona Trust
Frank Aragona Trust, was decided by the Tax Court on
March 27, 2014.
 Decedent died owning substantial rental real estate properties
that passed in trust. The children, who are the trustees, are
concerned about liability risk to the other trust assets, so they
contribute the real estate to a single member LLC. Three of the
trustee children are active in the rental activities as employees of
the LLC. The trust has other real estate businesses that are nonrental.
 The IRS argued that the single member LLC should not be
disregarded for this purpose, but the court does not address this
issue.
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How does the fiduciary materially
participate? Frank Aragona Trust (cont.)
•
The IRS challenged the deductibility of the losses by the trust on two
grounds: (1) the trust is not a real estate professional under IRC §
469(c)(7) excepted from PAL rules, and (2) the trustees' activities as
employees could not count toward material participation by the trust
• The IRS argued that only individuals can perform "personal services," a
requirement of the IRC § 469(c)(7) status, and that the legislative
history left out trusts.
• The IRS argued that the trustees' actions as employees could not count
toward material participation by the trust, but the taxpayer countered
that the continuing fiduciary obligations of the trustees under local law
even when acting as employees of the LLC
• The only response that the IRS could muster to the state law argument
was that the managers elected to be treated as employees of the LLC for
self-employment tax purposes and, therefore, were precluded from
claiming to act as trustees.
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How does the fiduciary materially
participate? Frank Aragona Trust (cont.)
•
•
•
•
Taxpayer won a total victory!
Court held that a trust could be a real estate professional meaning that
the trust could then show that it materially participated in its rental real
estate businesses.
A real estate professional must satisfy a two part test: she must
participate for at least 750 hours in real estate businesses and must
expend more time in real estate businesses than in all other trades or
businesses.
The court stated that it did not have to determine how to apply these
hours tests to the trusts as the IRS failed to argue that the trust failed
the hours tests. Rather, the IRS argued only that a trust cannot be a real
estate professional. Commentators , therefore, sometimes can’t end
that the court’s decision has less precedential significance, although as
we will see below, the court actually did provide guidance on counting
hours.
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The “Money” Quote from the
Aragona Trust Court
•
The court held that the trustees could count their time spent working as
employees because of their fiduciary duties to the beneficiaries:
“Even if the activities of the trust’s non-trustee employees should be disregarded, the activities of
the trustees--including their activities as employees of Holiday Enterprises, LLC--should be
considered in determining whether the trust materially participated in its real-estate operations. The
trustees were required by Michigan statutory law to administer the trust solely in the interests of the
trust beneficiaries, because trustees have a duty to act as a prudent person would in dealing with the
property of another, i.e., a beneficiary….Trustees are not relieved of their duties of loyalty to
beneficiaries by conducting activities through a corporation wholly owned by the trust. ... (“Trustees
who also happen to be directors of the corporation which is owned or controlled by the trust cannot
insulate themselves from probate scrutiny [i.e., duties imposed on trustees by Michigan courts]
under the guise of calling themselves corporate directors who are exercising their business judgment
concerning matters of corporate policy.”). Therefore their activities as employees of Holiday
Enterprises, LLC, should be considered in determining whether the trust materially participated in its
real-estate operations. [Citations and footnotes omitted]”
•
Despite the court’s statement that counting hours is unnecessary, the court
provides a method to count hours for all purposes (including real estate
professional exception and SPPA’s by considering those actions undertaken
while subject to fiduciary duties owed to beneficiaries
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Can a Trustee Take Off Her Trustee "Hat"
While She Acts As Employee, Director,
Manager of a Trust-Owned Business?
• State law is clear, however, that the trustee does not elect between her role as a
fiduciary or as an employee in a trust-owned business: fiduciary duties still apply
• See, In re Schulman, 165 A.D.2d 499, 502 (N.Y. App. Div. 3d Dep't 1991) (citing
Matter of Hubbell, 302 NY 246, 254-255; Matter of Horowitz, 297 NY 252, 258259; Matter of Shehan, 285 App Div 785, 793-794), for example:
• "A decision on behalf of the trust to have a trustee assume a role in the
corporation or other enterprise … necessarily carries with it an acceptance
on behalf of the trust that the trustee's duties to it will be subordinated to
any legal duties to which the trustee is subject when acting in the role of
director, officer, manager, or the like. A trustee's election to a role of this
type is a matter of which beneficiaries should ordinarily be informed…[t]hat
duties of prudence, loyalty, impartiality (including re: income productivity),
and other fiduciary duties apply to the trustee's decisions and conduct in,
e.g., incorporating business or investment activities of the trust
• See Restatement of Trusts, 3d § 78; § 86 at comment e; Bogert, Trust and
Trustees, Westlaw December 2012 Edition, § 543 (No complete elimination of
fiduciary duties is possible or it ceases to be a trust)
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What are the drafting implications of
Aragona Trust? Aragona Trust Structure
Frank Aragona
Trust
• Trustees: 5 children and a lawyer – one son Anthony was disabled, Salvatore was
a full-time dentist, Paul and Frank were full-time in the real estate businesses and
Annette was a full-time employee of Holiday Enterprises, LLC, although not fulltime in real estate apparently
• Beneficiaries: All of the children with income paid annually in equal shares,
discretionary principal could be paid by lawyer’s direction as independent
trustee
• Holiday Enterprises, LLC, that employed the three trustees was a disregarded
entity, but that does not figure in the court’s decision. IRS argued that it should
NOT be disregarded for purposes of determining material participation. How
might a member-managed LLC have changed the IRS analysis?
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What are the drafting implications of
Aragona Trust? Separate trusts but same
trustees
Anthony
Trust
Annette
Trust
Paul
Trust
Frank
Trust
Salvatore
Trust
• Trustees: 5 children and a lawyer – one son Anthony was disabled, Salvatore
was a full-time dentist, Paul and Frank were full-time in the real estate
businesses and Annette was a full-time employee of Holiday Enterprises, LLC,
although not full-time in real estate apparently
• Beneficiaries: Each child is a beneficiary of his or her own separate trust
• Each trust should materially participate under current law.
• Should the hours of the three active trustees have to be divided by 5 for each
separate trust?
• No support for division. Trusts are not like individuals as they start with zero
hours as opposed to individuals who start with 2500-3000 hours. No purpose is
served by requiring one trust to have different materially participating trustees
from other trusts.
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What are the drafting implications of
Aragona Trust? Separate Trusts with
Different Trustees
Anthony
Trust
Annette
Trust
Paul
Trust
Frank
Trust
Salvatore
Trust
• Trustees of each trust: named child and lawyer
• Beneficiaries: Each child is a beneficiary of his or her own separate trust
• Holiday Enterprises, LLC, that employed the three trustees would not be
disregarded. Assume each trustee elects himself or herself to the Board of
Managers of LLC
• Current law would cause only those trusts with materially participating
trustees to materially participate
• What if the three active siblings became the investment advisers or protectors
for each separate trust with control over the real estate business?
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Who Is the "Fiduciary" for Purposes of
Determining the Material Participation of
a Trust?
• The "fiduciary" who must materially participate for a trust need not
be the named trustee. See TAM 200733023
• Although the TAM held against the taxpayer, it cites the relevant
authority:
• IRC § 7701(a)(6) defines a fiduciary as "a guardian, trustee, executor,
administrator, receiver, conservator, or any person acting in any fiduciary
capacity for any person." The authorities emphasize the facts, rather than
titles
• Rev Rul 69-300
• Rev Rul 82-177 (as modified by Rev Rul 92-51) ruled that a bank merely
holding money for an estate and paying interest is not a fiduciary
• City Nat'l Bank & Trust Co, 109 F 2d 191 (7th Cir 1940)
• Although holding against the taxpayer, TAM 2013 17010 held the
"special trustee" was the fiduciary for tax purposes
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What are the implications of Aragona
Trust? Separate Trusts with Private
Trust Company
Anthony
Trust
Annette
Trust
Paul
Trust
Frank
Trust
Salvatore
Trust
• Trustees of each trust is a Private Trust Company
• Independent board member for each trust is the lawyer
• Each trust has the same real estate investment committee consisting of
three children active in the real estate businesses. Would Notice 2008-63
apply a “look-through rule” to treat these members as the “fiduciaries”?
• Beneficiaries: Each child is a beneficiary of his or her own separate trust
• Despite Mattie Carter Trust, the IRS would have to treat the
corporation’s agents and employees actions as those of the trustee
and, therefore, of the trust, resulting in each trust materially
participating.
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How does a trust with a Trust
Company trustee materially
participate?
•
•
•
•
Trust companies will rely on the activities of the agents, employees, officers, directors and
managers in the trust-owned business; despite the IRS opposition to Mattie Carter Trust,
which dealt only with the trust's employees and agents
The closely-held corporation material participation rules under IRC § 469 supports this
conclusion, but should not apply to trust companies
When a private trust company acts as trustee, the actual decision-makers are considered
as if they were trustees for certain tax purposes [2008-2 CB 261 (7/11/2008)]
• `The same result could be reached by applying the definition of "fiduciary"
discussed above
• These individuals in the trust company also owe fiduciary duties directly to the
beneficiaries of the trust under state law
• However, the reason for looking through the PTC to actual decision-makers is due to
the need to make “tax sensitive decisions;” a purpose not applicable here
Congress spoke in IRC § 42(h)(5)(B): "…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 IRC § 469(h)) in the development and operation of the project throughout
the compliance period.“ Non-profit = Corporation or Trust
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Rethinking Mattie Carter
Trust?
• In Carter, the trust owned a ranch that the trustee operated through
employees and agents and the opinion holds:
• "IRS' contention that Carter Trust's participation in the ranch operations
should be measured by reference to Fortson [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"
• "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"
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Rethinking Mattie Carter
Trust?(cont.)
• Is a trust a "Legal Entity" so that it acts through its agents and employees?
• IRS position of no agents ties back to IRC § 1402 (and §2032A), which is
used to distinguish between crop share lease income that is subject to SE Tax
(or not)
• Most trusts do not operate a business directly, but rather through an entity
• Mattie Carter Trust, however, does look at the entire relationship between
trust and business to determine material participation, a subjective test
• Because trusts do not have employees and agents – trustees do – Mattie
Carter should be interpreted as attributing the actions of those employees
and agents to the trustees
• The court in Aragona Trust did not need to consider Mattie Carter, but the
court appeared to consider the case favorably
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What Steps Might the Trustee Take to
Protect the Active Business Exception for a
Family Business Held in Trust?
– Remove and replace current trustee (or add a co-trustee) with
someone who is active in the trust-owned business
– How are multiple fiduciaries treated? Without further guidance, one
cannot count on aggregation of trustees’ actions.
– Add another fiduciary
• Special trustee
• Adviser for special investments
• Director under directed trust/bank trustee
– If terms of trust agreement are restrictive
• Court order to reform trust terms
• Decant if state law or instrument permits
– Generation skipping tax issues
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How did the IRS change fiduciary
material participation after 25
Years? Stopped by Aragona Trust
 TAM 201317010 addresses material participation under IRC § 56(b)(2)(D) (applying
IRC § 469 rules). Two complex trusts and individual A owned 100% of the interests
in an S corporation, which in turn owned a qualified subchapter S subsidiary
("QSub"). Individual A was special trustee of the trusts and the President of the
QSub.
– The issue was whether the trusts materially participated (within the meaning of
IRC § 469(h)) in the activity so that R&D expenses did not need to be capitalized
and amortized over 10 years by the trusts (as opposed to expensed currently) for
AMT purposes under IRC § 56(b)(2)(D)
– The IRS stated that the sole means for the trusts to establish material
participation in the relevant activities of the S corporation and QSub was
through the activities of the trust fiduciaries, in their capacity as fiduciaries
– The IRS ruled that the trust did not materially participate because the day-to-day
work performed by A was as an employee of the business and not in A's role as a
fiduciary of the trusts, and A's time spent as special trustee did not rise to the
level of being "regular, continuous and substantial" within the meaning of IRC §
469(h)(1)
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How did the IRS twist the
meaning of “fiduciary capacity”?
• Because the trustee could only vote or sell the stock, TAM 201317010 asserts that no
trustee could materially participate: a unique twist on the fiduciary capacity argument
• IRC § 469 treats only one type of equity as significant: a limited partnership interest,
because state law restricts the participation of a limited partner (LP). Thus, the Tax Court
holds that an LLC member is not an LP. See Garnett v Comm., 132 TC 368 (2009),
Thompson v US, 87 Fed Cl 728 (2009), and Gregg v US, 186 F Supp. 2d 1123 (D Or 2000)
(same). The IRS apparently will no longer litigate the issue (2010-14 IRB)
• IRC § 469 places no limits on proving material participation if the taxpayer owns nonvoting S corporation stock or preferred equity interests in an LLC
• Because IRC § 469 has only one purpose -- ensuring a taxpayer is not investing to obtain
tax losses -- the nature of the equity interest is irrelevant, except an LP interest was
usually the preferred form of a tax shelter
• If this extreme view succeeds, almost no trust could materially participate. Without
apparent irony, the TAM says: "[a]n interpretation that renders part of a statute
inoperative or superfluous should be avoided," despite doing exactly that with its fiduciary
capacity argument
• The narrow view was rejected by the Frank Aragona Trust court (IRS did not appeal)
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What Steps Might the Trustee Take to Protect the
Active Business Exception for a Family Business
Held in Trust if IRS Extreme View Prevails?
– States could amend their business statutes to allow fiduciaries to act in
a business entity as director, officer or manager in that capacity
• Could undermine state fiduciary law
– Dramatic business governance changes may be needed to provide
management by owners:
• Member managed LLC
• Close corporation managed by its shareholders
– The trustee, in its capacity as such, may be able to enter into a contract
with the trust-owned business to provide services
• Services need not include management by analogy to individual rules
• Particularly suited if trustee is a private trust company
• Verify that the trusts are being compensated, rather than individual
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Trust Material Participation
Summary
 Grantor Trusts
–
–
–

Non-Grantor Trusts (including ESBTs) - Activities of fiduciaries
•
•
•
•



Activities of deemed owner
Revocable trusts
Qualified subchapter S trusts – S portion only
Individual Trustees
Special Trustee – degree of discretionary power to act for trust – TAM 200733023
Corporate Trustee (Bank Trustee or Private Trust Company) – whether and how?
Employees and agents – Mattie K. Carter Trust v. United States
Nature of activities undertaken – investor v. day-to-day management
Activities undertaken in "capacity as such" – PLR 201029014 vs. TAM 201317010
(broad vs. narrow interpretation)
The authorities all support considering all of the trustees actions in whatever
capacity rendered in the business, only recent IRS guidance and argument are to
the contrary.
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How might the Final Code Section
469 regulations approach fiduciary
material participation?
The Preamble provides:
• The Treasury Department and the IRS believe that the commentators have raised valid
concerns about fiduciary material participation.
• The Treasury Department and the IRS considered whether the scope of these regulations
should be broadened to include guidance on material participation of estates and trusts.
• The Treasury Department and the IRS, however, believe that this guidance would be
addressed more appropriately in the section 469 regulations.
• Further, because the issues inherent in drafting administrable rules under section 469
regarding the material participation of estates and trusts are very complex, the Treasury
Department and the IRS believe that addressing material participation of trusts and
estates at this time would significantly delay the finalization of these regulations.
• However, the issue of material participation of estates and trusts is currently under study
by the Treasury Department and the IRS and may be addressed in a separate guidance
project issued under section 469 at a later date.
• The Treasury Department and the IRS welcome any comments concerning this issue,
including recommendations on the scope of any such guidance and on specific
approaches to the issue.
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What are a few questions the new
regulations may answer?
• Whose actions are relevant to determining a trust’s material participation?
•
•
The IRS says the fiduciary’s and Mattie Carter says all of the trust’s fiduciary’s, employees and
agents
Decedent’s activities relevant to estate or revocable trust qualification
• Who is a fiduciary?
•
Not just the trustee but whomever the actual decision-maker over the business acting in a
fiduciary capacity
• What actions of the fiduciary are relevant towards determining the trust’s
material participation?
•
State law and tax authorities say all and the IRS most recently has disagreed
• What measure of the fiduciary’s actions are sufficient for the trust to
materially participate?
•
•
•
Objective (Aragona Trust counts hours) vs. Subjective test (Mattie Carter considers all factors
and allows attribution)
Do the individual tests apply? Parity?
Aggregation of actions by multiple fiduciaries?
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Which trusts own eligible S
corporation stock?
•
•
Grantor Trust (discussed above)
Qualified subchapter S trust ("QSST")
– Treated as a grantor trust of beneficiary as to S corporation stock it owns
– Special treatment of sales of S corporation stock (reproposed regulations
provide simpler rules)
– Proposed regulations create problems for sales if trustee does not materially
participate
•
•
Electing small business trust ("ESBT") (discussed below)
Certain transitional trusts created at, or becoming irrevocable due to, an
individual's death, whose eligibility is temporally limited
–
•
Subject to the ordinary fiduciary income tax rules
With the exception of transitional trusts, S Corp Trusts do not carry out DNI by
distributions so the character of distributed income need not be reevaluated
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How are electing small business
trusts ("ESBTs") taxed?
 Section 641(c)(1) provides that the portion of the ESBT that holds S corporation
stock ("the S portion") shall be considered a separate trust from the remainder
of assets held in the ESBT ("the non-S portion")
 For section 1411 purposes, the UNII from the S and non-S portions of the trust
are calculated separately and then combined
 An ESBT will then be considered a single trust when determining if the trust has
AGI above the threshold amount
 The trust's AGI for threshold purposes is calculated by combining the AGI of the
non-S portion of the trust with a single item of ordinary income from the S
portion (after taking into account all deductions, carryovers, and loss
limitations)
 The trust's NII tax will then be paid on the lesser of the total UNII or the trust's
total AGI above the threshold amount
 See Example in Treas. Reg. § 1.1411-3(c)(3)
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How does a fiduciary determine the
character of distributed income?
 Business income from Tax Partnerships is characterized by distributions so does
the fiduciary’s material participation or the beneficiary’s material participation
determine whether the distributed income is active?
 Without much comment, Treas. Reg. sec. 1.1411-3(e)(3)(ii) provides that the
character of active or passive at the trust level will carry out to the beneficiary
of the trust if distributed:
– “If one or more items of net investment income comprise all or part of a distribution
for which a deduction is allowed …, such items retain their character as net
investment income … for purposes of computing net investment income of the
recipient of the distribution….” [cross-references omitted]
 This regulation prevents trustees from avoiding the uncertainty of the
application of Code Section 469 to trusts by distributing the business income of
the trust to beneficiaries who materially participate in the business under the
individual rules or distributing rental income to beneficiaries who are real
estate professionals.
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Did the Government Follow Its Own
Policy with the 1411 Character Rule?
 The income distributed to the beneficiaries retains its “character” under
Subchapter J. For example, tax-exempt interest is included in DNI. When
distributed to the beneficiaries, it remains tax-exempt interest. Business income
earned by the trust included in DNI and allocated to a beneficiary should remain
business income. Some argue that this character rule requires active or passive
income of the trust to remain so when distributed to beneficiaries, but that
treatment is not certain. Treasury Regulations section 1.652(b)-1, provides:
– The tax treatment of amounts determined under §1.652(a)-1 depends upon the
beneficiary’s status with respect to them not upon the status of the trust. Thus, if a
beneficiary is deemed to have received foreign income of a foreign trust, the
includability of such income in his gross income depends upon his taxable status with
respect to that income.
 Treas. Reg. sec. 1.662 contains no comparable statement, but the character rule
applies to complex trusts too. See Rev. Rul. 57-277, 1957-1 C.B. 12.
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Does Code Section 469 provide
any guidance?
 A beneficiary has an equitable ownership in trust assets under state law.
However, the existing Code Section 469 regulations ignore this
ownership interest. Treas. Reg. sec. 1.469- regulation on grouping
activities provides as follows:
– (a) Scope and purpose. This section sets forth the rules for grouping a taxpayer’s
trade or business activities and rental activities for purposes of applying the
passive activity loss and credit limitation rules of section 469. A taxpayer’s
activities include those conducted through C corporations that are subject to
section 469, S corporations, and partnerships.
 Treasury Regulations section 1.469-5(f) complicates using the
beneficiary’s material participation to characterize distributed income:
– [A]ny work done by an individual (without regard to the capacity in which the
individual does the work) in connection with an activity in which the individual
owns an interest at the time the work is done shall be treated for purposes of
this section as participation of the individual in the activity.
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What other factors may effect the
classification of distributed
income?
 Recharacterization rule for an active beneficiary
(passive trust income becomes active)?
 Transitional rule that may come from new regulations
related to the death of a decedent or change between
grantor and non-grantor trust status?
 Depreciation and depletion ordinarily apportioned
outside of DNI, but apportionment may be restricted
by Code Section 469 to allow directly to a beneficiary
only if the trustee is active in the trust owned
business?
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How are different entities
treated for NII Tax and SE Tax
purposes?
Tax Status
S Corp
State Law LP
Other Tax
Partnership
Trust
SelfEmployment
Income
Salary Payments Guaranteed
only, but not K- payments for
1 income
services and GP
K-1 income
Disputed, but
likely all K-1
income
Trustee Fees (at
most)
Active under
IRC § 469
Type of stock
does not
matter; material
participation
under any of 7
tests
LP may
materially
participate only
under 3 of 7
tests
Disputed, but
most likely able
to qualify under
any of 7 tests
Before Aragona
Trust unclear due to
IRS "fiduciary
capacity" argument;
may change with
new regs
Subject to NII
Tax
Passive or
trading K-1
income
Passive or
trading K-1
income
Passive or
trading K-1
income
Passive or
Trading K-1 income
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