Planning for the Surtax

The best time to plan for any tax event is well before it occurs, and this also applies to the surtax.  The trustee of a trust will almost always want the business income of the trust to be characterized as active income. The surtax may be addressed, at least partially, in a number of ways:  the trust’s level of activity may be adjusted, its stock may be shifted to lower-income beneficiaries, and/or its other investments may be used to offset NII.  While some of the planning alternatives may carry an economic cost, it behooves the trust to at least consider them since some combination thereof may help reduce the surtax.

For example, the owner of a business who materially participates therein will often create a grantor trust to hold interests in the business for the benefit of family members.  There are several ways by which a trust may be treated as a grantor trust without causing the inclusion of the trust in the grantor’s estate. The trust’s grantor trust status results in the owner being taxed on the trust’s share of the business income, thereby allowing the trust to grow in value without reduction for income taxes.  Because of the grantor’s participation in the business, the income from the business should be non‑passive as to the grantor and, therefore, should also not be subject to the tax.

Similarly, when faced with a choice between making a QSST or an ESBT election as to a trust, one must consider the participation of the trustee and of the beneficiary in the S corporation’s business.  If the trustee is a material participant, then an ESBT election may be advisable for purposes of the surtax.  If the beneficiary of the trust is a material participant (for example, he or she is an officer of the S corporation), a QSST election may be advisable.

In other circumstances in which the beneficiary of the trust (that would otherwise be a complex or simple trust) is a material participant in the business, the grantor may also want to consider giving the beneficiary a withdrawal right over net investment income so as to cause the trust to be treated as a grantor trust. [IRC §678]  Be aware, however, of the lapse of this power and its potential for creating a taxable gift.

In the case of non‑grantor trusts—complex, simple and ESBT trusts—the selection of the trustee may impact the application of the surtax to the trust’s share of the S corporation’s business income.  Because material participation for the trust is determined by looking to the trust, the grantor should consider the addition of a trustee who materially participates in the S corporation’s business.  Based on Aragona, discussed in our last post, at least one‑half of the trustees should be active in the business, and the trustees should not, in the aggregate, personally own a majority interest in the business.

In addition, notwithstanding the case law, it appears unlikely that the IRS will agree that a non‑grantor trust is materially participating in a trade or business activity unless the trustee is materially participating in the activity in his or her capacity as a trustee.  Focus, therefore, on the actions and involvement of the trustee. Query whether the trustee can be given a bona fide role to perform in the business in the trustee’s capacity as such?

The trustee should take affirmative actions to materially participate. Consider the appointment of a special trustee for the business (as in the TAM, also discussed in our last post), whose responsibility will be limited to the operation and management of the business, provided the trustee is given a measure of decision-making responsibility related to the trust’s business matters.

Where the trustee participates in the business in several capacities (not just as a trustee), the trust instrument should not excuse the trustee from fiduciary responsibility when acting in one of these other capacities.

Regardless, it will be vital for trustees to maintain accurate and contemporaneous records if they are to substantiate the trust’s material participation in an active trade or business and, thereby, avoid imposition of the surtax.  The burden will be on the taxpayer to establish the nature of his or her involvement, and the  amount of time spent, with respect to a business activity.

If a trustee is uncertain as to whether he or she has substantial authority for a reporting position on material participation, the trustee may want to consider paying the tax, but also filing a protective refund claim, pending the issuance of regulations.

The Dispositive Intent

In considering the various options set forth above, always be mindful of any other consequences that may flow therefrom.  Keep the surtax in perspective; the selection of a particular strategy may have tax consequences beyond the surtax. It may also produce economic or “business” results that are not in line with the grantor’s plans for disposing of his or her interests in the S corporation.  Don’t let the tax tail wag the dog.  Be mindful of the dispositive purpose of the trust.


Louis Vlahos recently participated in a national webinar in which he covered the foregoing topic.