Kevin Leifer, Tax Director, advises on Trusts & Estates and the New Medicare Tax

One of the provisions of the 2010 Health Care Act (as amended by the 2010 Health Care Reconciliation Act) added a new 3.8% Medicare contribution tax on “net investment income” of high income individuals, estates, and trusts (“Medicare Tax”). The new tax is effective for tax years beginning after 2012. The Medicare Tax, as it applies to individuals, has been the subject of many articles and has received much publicity. The purpose of this writing is to highlight an important issue with respect to this tax as it relates to trusts and estates.

The Medicare Tax

The tax on trusts and estates is imposed, in addition to an income tax, on the trust or estate’s net investment income (“NII”), which generally includes gross income from interest (not tax-exempt interest), dividends, annuities, royalties, rents, capital gains, and income from passive activities, reduced by expenses attributable to such income. The Medicare Tax is calculated by multiplying 3.8% by the lesser of (a) the trust’s undistributed NII or (b) the excess of the trust’s adjusted gross income over the dollar amount at which the highest trust income tax bracket begins ($7,500 for 2013). It should be pointed out that the Medicare Tax probably won’t apply to simple trusts and to grantor trusts. Simple trusts require all income to be distributed currently and as such, generally won’t have any undistributed net investment income. Since grantor trusts are generally disregarded for income tax purposes, the grantor trust’s net investment income will be reported on the grantor’s personal income tax return where it will potentially be subject to the Medicare Tax. Passive Income as Net Investment Income; Exception for Real Estate Professionals As is noted above, income from passive activities is included in NII. In general, a passive activity is a trade or business in which the taxpayer does not materially participate. There are seven ways a taxpayer can materially participate but the most well-known and commonly-used way is by the taxpayer spending at least 500 hours in the taxable year engaged in the trade or business. Income from rental real estate is always treated as being from a passive activity unless certain exceptions apply, one of which is where the taxpayer qualifies as a “real estate professional.” A trust or estate will be treated as a real estate professional if (i) more than 50% of the personal services performed by the trust or estate in all trades or businesses during the tax year are performed in real property trades or businesses in which the trust or estate materially participates; and (ii) the trust or estate performs more than 750 hours of service during the tax year in real property trades or businesses in which it materially participates. Income that is not considered to be from a passive activity is not subject to the Medicare Tax. Therefore, it clearly is important to understand how a trust or estate materially participates. Material Participation by a Trust or Estate Regulatory guidance on material participation of trusts and estates is reserved and will be included in to-be-issued regulations. However, the legislative history of the passive activity rules says that an estate or trust materially participates in an activity if the executor or other fiduciary, in his capacity as executor or fiduciary, so participates. But in Mattie K. Carter Trust v. U.S., (2003, DC TX), 91 AFTR 2d 2003-1946 , 2003-1 USTC 50418, 256 F Supp 2d 536, the court held that since the trust is the taxpayer for purposes of the passive loss rules, the participation of the trust itself should be scrutinized; which means assessing the activities of those who labor on the trust’s business, or otherwise in furtherance of that business. So, where a complex trust operated a 15,000 acre ranch used for raising cattle (4,700 head and 3,300 head during the two years in issue) and for oil and gas interests, the court determined that the trust’s material participation in the ranch operations should be determined by reference to the persons who conducted the ranch’s business on the trust’s behalf (a full-time manager and other full- and part-time employees), including the trustee, and not, as IRS argued, by reference only to the trustee’s activities. In Letter Ruling 200733023, the IRS specifically rejected the court’s holding in Mattie K. Carter Trust and instead followed the legislative history indicating that an estate or trust materially participates in an activity only if the executor or other fiduciary so participates. In addition, the IRS found that, in the absence of regulations, material participation by a fiduciary requires the fiduciary’s “regular, continuous, and substantial” participation in the estate’s or trust’s business activities, in his capacity as a fiduciary. The IRS held the same way in IRS Letter Ruling 201029014. Conclusion It certainly appears that until regulations are issued, the question of whether a trust or estate’s income from a trade or business is subject to the Medicare Tax may be the subject of future IRS audits. In the meantime, it would appear that the fiduciary of the trust or estate should participate, as much as possible, in any of its profitable trades or businesses to minimize any exposure to challenge by the IRS on whether the income from such trades or businesses is subject to the Medicare Tax.