The IRS’s Position on Material Participation by Trusts

According to the IRS, material participation for a non‑grantor trust should be determined solely by reference to the activities of the trustee acting as such; it should not include the trustee’s participation in any other capacity (e.g., as an employee of the corporation), nor should it consider the participation of any employees or agents of the trust. In other words, if the individual serving as trustee also participated in the activity in his or her personal capacity, that participation is irrelevant, according to the IRS, in determining the trust’s material participation.

See, for example, this TAM, in which the IRS concluded that the only way for a complex trust to establish material participation in the activity of an S corporation was the extent to which its trustees, in their capacities as such, were involved in the operation of the corporation’s business.  The ruling noted that the time spent by a special trustee as a corporate officer did not count toward determining the trust’s material participation, especially where the officer-trustee was unable to differentiate his time into different capacities. The IRS also stated that, in order to be treated as a trustee for tax purposes, the special trustee must be vested, under the trust agreement, with some degree of discretionary power to act on behalf of the trust.  Under the facts of the TAM, the special trustee’s powers were restricted (so that the trustee could not commit the trust to any course of action as to the trust property other than selling it) and, so, the material participation requirement was not satisfied by the trust.

The Courts Disagree

The courts have been more forgiving. In Mattie Carter Trust, the trust operated a business directly, using employees an agents of the trust. The court decided that material participation of a trust should be determined by evaluating not only the activities of the trust through its trustees, but also through its employees and agents.  It stated that material participation by the trust in the business should be determined by reference to the persons who conducted the business on behalf of the trust, not just the trustee.

More recently, in Aragona Trust , a complex trust owned several rental properties, both directly and through a wholly-owned LLC (a disregarded entity for tax purposes—not a true operating company).  There were six trustees. Three trustees worked full-time managing the properties in various capacities; they were employees of, and drew a salary from, the LLC (i.e., from the trust for tax purposes).  The LLC also had other employees.

The court concluded that the activities of the trustees as employees of the LLC should be considered in determining whether the trust materially participated in the real estate operations.  It noted that, under the applicable state law, each trustee had to act as a prudent person in dealing with the property of another person (the beneficiary) while administering the trust.  They were not relieved of their duties to the beneficiaries by conducting activities through a business entity owned by the trust.

The court rejected the IRS’s argument that, because two of the LLC employee-trustees also held minority interests in the same real estate operation, their efforts were attributable to such individual ownership and not to the trust’s ownership.  The court pointed out that the trustees’ combined personal ownership was not a majority interest and was never greater than the trust’s.  It also noted that their interest as owners were compatible with those of the trust.

At this point, it is unclear whether the IRS will appeal or just non-acquiesce in the Aragona decision.

It appears, under the Court’s decision, that the work performed in a business by individual trustees should count toward the determination of the trust’s material participation.  The selection of the trustee, therefore, will be an important consideration in the context of a family business where trusts are often created to hold interests in the business.

However, a number of questions remain. For example, would it matter to the court if the trustees were employees of an S corporation (rather than of a disregarded LLC, the business of which is deemed owned by the trust) – would all the trustees’ time spent as employees count toward the trust’s material participation? Should the actions of the trust’s non-trustee employees be counted in determining material participation?