Passive Income: Good or Bad?

Passive activity loss rules are complicated and require careful attention. In general, their purpose is to limit or prevent taxpayers from deducting passive losses, unless the taxpayer has offsetting passive income.

Previously, passive income had been a positive: a taxpayer without passive losses would recognize the passive income regardless; a taxpayer with passive losses could offset the passive losses with passive income.

But starting in 2013, the recognition of passive income has a down side: the Medicare Tax on Net Investment Income (MTNII) [IRS §1411]. “Excess” passive income, that is passive income left after offsetting passive losses, may be subject to an additional 3.8% excise tax.

Taxpayers must take time to review their passive income, and investigate the options available for reducing or eliminating “excess” passive income. If a taxpayer can change his involvement with the activity (see the material participation rules in Regs. §§1.469-5T(a)(1)-(7)), he may be able to reduce his passive income and his exposure to the MTNII.

Fiduciaries will be hard-pressed to avoid the MTNII, since it is generally difficult for a fiduciary to demonstrate material participation. Combined with the trust’s low threshold, any trust which does not distribute out its net investment income will likely be subject to the excise tax.

Passive Activities: TAM 201317010

Trustees, executors, and their tax advisers have long struggled with the application of the passive activity rules to trusts and estates. While the rules for individual taxpayers are clear (or, clearer), the rules for fiduciaries remain vague.

A recent Technical Advice Memorandum (TAM ) from the IRS advance the set of parameters that fiduciaries must use to determine when an activity is treated as passive by a trust or estate.

An activity is passive if the taxpayer does not materially participate in the activity. IRC §469(h)(1) defines material participation. More specific guidance for individuals is given in the regulations [Temp. Treas. Reg §§ 1.469-tT(a)(1)-(7)].

However, no statutes or regulations specifically address how to determine material participation for a fiduciary. Instead, only one court decision and a few PLRs are available for guidance.

The one court case is Mattie K. Carter Trust v. U.S. (256 F. Supp.2d 536). In this case, the IRS argued that only the activities of the trustee could be used to determine material participation. Instead, the court considered the activities of the trustee, employees, and agents in terming material participation.

In the present TAM, the trustee argued that he materially participated in the activities of businesses owned by the trust. The TAM distinguished between the activities of the trustee in his fiduciary capacity and his activities as an employee of a business subsidiary, and found (in this case) that the trustee’s fiduciary authority was limited by the trust document.

See:  TAM 201317010

For more on this TAM, see Peter Reilly’s post on his Forbes blog.

Also, Joe Kristan has a great post on his blog at Roth & Co.