Estate Planning Q&A: Material participation for trusts and estates

Executive summary

• Not all business income earned by a trust or estate is taxed the same way.
• Material participation by the trustee or executor can influence whether business income receives more favorable tax treatment.
• Proper planning may help you maximize tax efficiency while supporting long-term business and wealth transfer goals.

The transfer of a business interest to a trust or estate can cause income from that interest to change character. This change in character may trigger the 3.8% net investment income tax (NIIT) or cause business losses to become passive and deferred. With proper planning, these detrimental changes in character can be avoided. The following questions and answers explore how fiduciary involvement can affect taxation and create long-term planning opportunities.

What is material participation and why does it matter for trusts and estates?

Material participation generally means involvement in a trade or business on a regular, continuous and substantial basis. If your trust or estate owns an interest in a business, material participation can allow losses to offset other sorts of income and avoid the 3.8% investment income tax, which can apply when business income is treated as passive rather than active.

Can a trust or estate materially participate in a business?

Generally, yes, although there is some uncertainty in how you get there. What constitutes regular, continuous and substantial for an individual is tried and true, but there is still some disagreement amongst the courts, IRS and tax practitioners as to what meets this standard for a trust.

Whether a trust or estate materially participates is fact sensitive. The fiduciary’s duties, involvement in business operations, the nature of the activities performed and the extent of ongoing oversight may all be relevant. Because the determination is highly fact-specific, there is no bright-line rule, and each situation should be evaluated individually.

Whose activities count?

Generally, the focus is on individuals acting in a fiduciary capacity, such as trustees and executors.

Questions often arise regarding the role of individual trustees, corporate trustees, beneficiaries, employees and other agents acting on behalf of the trust or estate. Case law suggests that active involvement by a fiduciary in the operation or management of the business may be considered when determining whether a trust or estate materially participates. However, be careful with limitations provided upon the powers of the fiduciary. Strictly limiting fiduciary power can cause only those hours spent in the stated activities to be counted.

You should carefully evaluate who is performing services for the business and maintain documentation substantiating those activities. For estates, the decedent's pre-death activities generally are not considered when determining whether the estate materially participates after death.

What planning opportunities should you consider?

When choosing a trustee or executor, income tax often does not factor into the mix. However, if you own a closely held business, it should likely be a consideration, but not the only one. Consider the following potential solutions:

• Choosing a trusted employee as trustee or co-trustee
• Assigning a special closely held business trustee to look after only those closely held assets that will be participating in day-to-day management
• Consider a separate family business trust to manage the business
• Take care to both not let the tax tail wag the dog and limit trustee powers to the point where involvement may not be counted

You should also evaluate material participation when terminating grantor trust status due to death or another triggering event. Planning before those transitions occur may help preserve favorable tax treatment and avoid unexpected tax consequences.