Material Participation by S Corp. Trusts

Since the enactment of the “material participation” test, as part of the passive activity loss (“PAL”) rules, in 1986, the IRS has issued very little guidance on how the test applies to trusts. Neither the Code nor the Regulations are helpful.

When the IRS issued proposed regulations for the surtax, many commentators asked for such guidance. Nevertheless, the IRS punted, saying that the issue would be best addressed in future regulations under the PAL rules.

However, with the imposition of the new 3.8% surtax on the NII of trusts, the proper characterization of any S corporation business activity is vital.  Until such guidance is issued, there are only a few IRS rulings and two court cases to which taxpayers may refer.

In the case of a trust that owns an interest in a trade or business through an S corporation, the determination of whether an item of ordinary business income or of gain allocated to the trust from the S corporation is derived in a trade or business that is a passive activity with respect to the trust is made by applying the PAL rules to determine whether the trust materially participates in the S corporation’s trade or business.

The determination of whether an S corporation business is or is not passive as to a trust will depend on several factors. Among these factors are:

– the trustee’s participation in the corporation’s business;

– the grantor’s participation in that business;

– the beneficiary’s participation in that business; and

– the tax status of the trust, including the tax elections made by the trust or the beneficiary.

If the trust does not materially participate in the activity, the trust is deemed to be passive as to that activity. In that case, its income from such activity will be subject to the 3.8% surtax.

Generally, under the PAL rules, a taxpayer, including a trust, is treated as materially participating in an activity only if the taxpayer is involved in the operations of the trade or business on a regular, continuous and substantial basis.

In determining a trust’s material participation in a trade or business activity being conducted by an S corporation, one must first consider the type of trust that owns shares of stock in the S corporation.

Grantor Trust

A grantor trust is disregarded for federal income tax purposes.  The trust property is treated as being owned by the grantor.  Its income is not taxed as trust income, but is treated as being the income of, and taxable to, the deemed owner.  The same rule applies for purposes of the surtax.  Accordingly, material participation should be determined based on whether the grantor materially participates in the activity.

If a grantor of a grantor trust is materially participating in the business of the S corporation in which the grantor trust is a shareholder, the income from such activity will not be subject to the 3.8% surtax.

Many business owners use grantor trusts in their gift planning so as to leverage their gifts and further reduce their estates; if the grantor is materially participating in the business, the ability to avoid the surtax provides yet another reason for using a grantor trust.


For a QSST, the beneficiary of the trust is treated as the owner of that portion of the trust that consists of S corporation stock, at least for purposes of the flow-through of S corporation income and gain.  Consequently, material participation for such a trust should be determined by reference to the beneficiary’s participation in the activity.  If the beneficiary is active in the business, the trust’s income will be “active” for purposes of the surtax. (The same analysis will apply in the event the trust has a successor beneficiary.)

 ESBT and Other Trusts

For an ESBT, the character of the income is determined and taxed at the trust level.  Accordingly, material participation should be determined at the trust level.

Similarly, in the case of a former grantor trust or a testamentary trust, material participation and the character of the income should be determined (and may be taxed) at the trust level.

The same seems to apply as to a QSST for purposes of determining the gain from the trust’s sale of S corporation stock.

Under the Code and general trust principles, if a simple or complex trust that has NII makes a distribution to its beneficiary, the trust income allocated to the beneficiary has the same character in the hands of the beneficiary as in the hands of the trust.  The nature of the activity as passive or active, at the trust level, should also be carried out to the beneficiary upon distribution of the trust’s income.  Thus, if a simple or complex trust determines that an activity is passive at the trust level, and the trust distributes all of its NII to a beneficiary, then the activity would be considered passive at the beneficiary level, regardless of the beneficiary’s participation in the activity.

In the event an ESBT is subject to the surtax, it should be noted that it will not be able to use distributions to its beneficiaries to reduce its NII tax liability because ESBTs are denied distribution deductions.

 Limited Application

It should be noted that a former grantor trust (including a former QSST whose income beneficiary has died) and a testamentary trust may be S corporation shareholders for a period of only two years, at which time they must elect either QSST or ESBT status (if they qualify). Thus, the nature of their material participation may change over time, depending upon the election made.

The more difficult “material participation issue” arises in the case of an ESBT or other type of permitted S corporation trust.  How is the material participation test to be applied with respect to one of these trusts? This will be the subject of our next post.