United States

Electing Small Business Trusts and the passive loss rules

INSIGHT ARTICLE  | 

Background

The Tax Reform Act of 1986 (TRA of 1986) imposed suspended deductibility of losses from passive activities to the extent losses exceed income from passive activities.1 Passive activities are business activities in which the owner does not materially participate, i.e., is not involved in business operations on a regular, continuous, and substantial basis.2

In 1996, the Electing Small Business Trust (ESBT) was permitted to own S corporation stock.3 ESBTs are trusts (1) that have only individuals, estates, and certain charitable organizations as beneficiaries; (2) the beneficial interests in which were not acquired by purchase; (3) that are not Qualified Subchapter S Trusts (QSSTs), trusts exempt from income tax, or charitable remainder trusts; and (4) that make an election to be an ESBT. An ESBT must pay Federal income tax on its S corporation income at a flat 35 percent rate.

Discussion

The recession caused many S corporations to incur losses passed through to shareholders, including ESBTs. If the ESBT only owns stock in a single S corporation, and the S corporation's losses are treated as passive losses, the losses are suspended until a year in which the S corporation passes through passive income. They cannot be carried back for refunds of tax paid in previous years. If the S corporation's losses are treated as non-passive, the ESBT would be able to carryback its losses to previous tax years for refunds of the 35 percent Federal tax it paid on S corporation income. Is it possible for an ESBT to have non-passive S corporation income?

The Senate Finance Committee Report to Section 501 of TRA of 1986 provided that "an estate or trust is treated as materially participating in an activity … if an executor or fiduciary, in his capacity as such, is so participating.” This language causes doubt as to whether material participation can only come if it occurs because of the trustee's position as trustee. What if the trustee's material participation in the S corporation was not from his capacity as a trustee, but rather as an employee of the S corporation?

The Joint Committee on Taxation's General Explanation of TRA of 1986, in Footnote 33 on page 242, states:

"No special rule is provided for determining material participation by a trust. … A trust may be treated as an association taxable as a corporation, for tax purposes, if it is a joint enterprise for the conduct of business for profit. Thus, it is unlikely that a trust as such for Federal income tax purposes will be materially participating in a trade or business activity, within the meaning of the passive loss rule.”

This statement reflects the Joint Committee on Taxation's conclusion that a trust that rises to the level of a non-passive participant in a business activity is really an association that will be taxed as a corporation. Since an S corporation cannot have a corporate shareholder, such treatment would lead to the loss of the S corporation's status; a potentially disastrous outcome.

No regulations have been issued addressing material participation by trust owners of business interests. In 2003, in the case of Mattie K. Carter Trust v. U.S.4, the U.S. District Court for the Northern District of Texas ruled that, based on the activities of the trust through its trustee, fiduciaries, employees, and agents, the material participation requirement was satisfied. The Court noted that it had studied the "snippet" of legislative history purporting to provide insight on how Congress intended section 469 to apply to a trust's participation in a business, including the Senate Finance Committee Report and the footnote in the Joint Committee on Taxation's Explanation, but did not find it helpful.

It is clear that the IRS believes that, contrary to the ruling in Mattie K. Carter Trust, only the trustee's material participation is to be considered in determining whether a trust's business losses should be treated as passive or non-passive. Two Private Letter Rulings, 200733023 and 201029014, ruled that it is appropriate in the trust context to look only to the activities of the trustee to determine material participation.

The IRS, in their Audit Technique Guide (ATG) for Passive Activity Loss, addresses material participation by trusts. The ATG states that IRS will generally not raise an issue if the trustee meets one of the material participation tests included in Reg. 1.469-5T(a).

Conclusion

Neither the District Court in Mattie K. Carter Trust or the IRS appear to be strictly following the "association taxable as a corporation" guidance given in the Joint Committee on Taxation's Explanation of the 1986 Tax Reform Act. This is fortunate because the great risk is that such treatment would cause a termination of S corporation status for all shareholders if QSST or ESBT shareholders filed as non-passive shareholders.

Taxpayers appear to be on safe ground if they look to the material participation of the trustee of an ESBT in determining whether business losses of the trust are passive or non-passive. To rely on Mattie K. Carter Trust in looking to the material participation of an employee, lesser fiduciary, or agent of the trust to make this determination would invite IRS challenge.

1 IRC section 469

2 IRC sections 469(c) and (h)(1)

3 IRC section1361(c)(2)(A)(v)

4 2003-1 U.S.T.C. ¶50,418, (Apr. 11, 2003)

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