Will a Special Trustee Permit a Trust to Avoid the 3.8% Surcharge?

Trusts and estates are now subject to the new 3.8% tax on Net Investment Income (NII) in excess of an income threshold of $11,950 in 2013. NII includes interest, dividends, rents, royalties or income from a trade or business that is a passive activity under IRC §469 (Passive Loss Rules). A trust can avoid the 3.8% tax by distributing NII, in other words, becoming a “Special Trustee”. The threshold is called Modified Adjusted Gross Income (MAGI) and is equal to $11,950 for trusts, $250,000 for a married couple and $125,000 for a single filer. (MAGI may be subject to other adjustments that are not covered here.) The 3.8% tax may be avoided if MAGI of the recipient beneficiaries is below the MAGI threshold applicable to their filing status.

Where a profitable business is held in trust and the beneficiary has other substantial income, distribution of income from the Trust may not avoid the 3.8% tax. One should also note that trust may not have been intended to provide the beneficiaries with substantial distributions. The grantor of the trust may have intended that income be accumulated rather than distributed. The income could be accumulated for future needs or a nest egg. It may be accumulated in order to encourage the beneficiary to become self-reliant and a productive member of society. In either case, avoiding the 3.8% tax is important.

Interest, dividends, royalties and rents may be excluded from the definition of NII if they are derived in the ordinary course of a trade or business. Having a trade or business makes the income active and avoids the 3.8% tax on passive income. How does a trust owning stock in an S corporation that operates a business qualify for this exception?  How does a limited liability company that owns a shopping center qualify where it provides substantial services?

The IRS takes (and litigates) the position that only the direct actions of the trustee may be considered in determining whether a trust materially participates in the business thereby converting income from passive subject to 3.8% tax to active income and avoiding this tax. Some states permit a trustee to delegate authority to agents (e.g. Estate of Carter in Texas) while other states permit the use of special trustees whose sole function is to operate the business.

Now is the time to review trusts and the income earned. States that permit the use of special trustees and self-directed trusts are closer to solving the problem.