3.8% Medicare Surtax on Real Estate Asset Owned and Managed by Trusts
As of January 1, 2013, pursuant to the Healthcare and Education Reconciliation Act of 2010 (also known by its acronym “Obama Care”) a new tax was imposed on certain taxpayers, including individuals and trusts, on their investment income. It is also known as the “Medicare Surtax”, even though the tax is really just a revenue raiser and is not utilized in any way to fund the Medicare System. Individuals are not subject to the tax unless their modified adjusted gross income exceeds $200,000 if single or $250,000 if married. For trusts, the tax is imposed once the trust has adjusted gross income in excess of $11,950 (for 2013).
There are several types of trusts, and the two basic tax categories are Grantor Trusts and Irrevocable Trusts and a subcategory thereof known as “Complex Trusts”. The Grantor Trust itself is not subject to the tax or any income tax, but rather the deemed tax owner of the trust, usually the Grantor, pays the tax on income earned by assets owned by the trust. In the case of the Irrevocable Trust which are Complex Trusts, then to the extent income is not distributed out (also called “DNI”), the trust itself is subject to tax. There are ever more complex rules regarding Irrevocable Trusts which own stock in a Subchapter S corporation and which have made an election to be an Electing Small Business Trust (“ESBT”), in that they do not have a deduction against their taxable income for distributions to beneficiaries but the trust itself always pays the full tax on its share of the income earned by the S corporation.
The Medicare Surtax is imposed on investment income, which includes:
- Gross income from interest, dividends, annuities, royalties and rents;
- Gross income from a passive activity or a trade or business trading of financial instruments or commodities; and
- Net gain from sale of an asset, for example capital gains.
There is an extremely complex set of rules regarding certain types of characterizations and treatment of income. In determining whether an activity is active or passive, Section 1411 IRC, which imposes the new Medicare Surtax, refers to Code Section 469 IRC which deals with the definition of passive income for purposes of the allowance of loss rules. The two main areas in which tax practitioners have focused for purposes of tax planning, is whether an activity is passive, and then the subcategory of passive income for rental activities. One of the big questions is whether a trust, which owns subchapter S stock, can treat the income earned by the trust as a pass-through from its ownership in a subchapter S corporation, as active? The analysis involves whether the Trustee is active in the business, i.e., as an officer or employee, or especially in a case of a trust for minor beneficiaries (for example children and grandchildren of the owners), can the activities of the trustee be attributed or used to determine whether the income is active or passive, and therefore if passive subject to the Medicare Surtax. An even a more difficult test than determining whether the activity is active or passive, is whether rental income generated by assets owned by the trust can qualify for the rental income exemption from the passive activity rules and thus the rental income would not be subject to an additional 3.8% tax. This can have a significant effect in trust taxation in that the trust income becomes subject to the highest tax rate of individuals, starting at the $11,985 level, so therefore you get very little benefit from tax brackets. The leading case up till March of 2014 was the Mattie Carter decision which held that the activity of the trustees could determine the characterization of ranch and farming income.
On March 27, 2014, the United States Tax Court issued its decision in Frank Aragona Trust, Petitioner v. Commissioner of Internal Revenue. This is a major decision that benefits trusts and their beneficiaries subject to tax. The fact situation is very common in the estate planning arena, the Aragona family had accumulated a substantial amount of income producing real estate assets over an extended period of time. The founder of the business,Mr. Aragona, established a trust for the benefit of his children and grandchildren and future generations. Upon his death, his five children and an independent trustee were appointed to take responsibility of management of the trust assets. The trust had extensive real estate activities, conducted primarily in the Limited Liability Company (LLC) format. The trustees met every few months to discuss the trust business and were paid a trustees fee. Three of the children who served as trustees were also employed by the LLC Management Company set up by the trust to manage the trust’s rental real estate properties. It included several other people, including a Controller, leasing agents, maintenance workers, accounts payable clerks and accounts receivable clerks. The fthree trustees who worked for the business also received a salary from the management company.
The tax issue was whether the losses for the years 2005 and 2006 from the real estate activities were active or passive. The trust also owned other business entities which reported income and the trust wanted to reduce its income taxes by using its rental property losses to offset the income earned on other activities.
Section 469 (c)(7) IRC, imposes tests including a 750 hour test for real estate to determine whether the activity of the business is active or passive. The primary issue before the Tax Court was whether a trust can qualify for the Section 469 (c)(7) exceptions and thus convert what would normally be considered a passive activity into an active activity. After a very detailed analysis the Tax Court held that the activities of the trustees, including their activities as employees of the management company should be considered in determining whether the trust materially participated in the real estate operations. Basically the Tax Court is allowing the attribution of activity from the individual trustees to the trust itself. This decision would be consistent with the Mattie Carter decision and is a major victory for tax planning purposes for families doing long term business and estate planning involving their real estate holdings. It also should help achieve a similar result for those ESBT’s (Electing Small Business Trust), which own subchapter S stock where the trustees that serve as trustees also serve as officers and employees of the S Corporation and are directly involved in the operations or management of the subchapter S corporation.