Family Business in a Trust; the 3.8% Medicare Investment Tax

Here is the situation for this blog post. John Doe dies. John was the patriarch of his family’s 40-year operating business. John worked full-time, actively in the business.   The business operates as a pass-through LLC entity for tax reporting purposes. While John was alive the LLC’s net income was not subject to the 3.8% Medicare investment tax.   This is because John actively participated in the business.

Now, this example takes a different turn:

At John Doe’s death he leaves the family business to his wife Jane. John’s two adult sons work full-time in the family business.   Jane does not work in the business.

Following John’s death the 3.8% investment tax will now likely apply to the LLC’s net income. This can be a financial surprise to this Doe family where there was no 3.8% investment tax while John was alive, but the costly 3.8% tax surfaces after John’s death.

This example brings up three important points:

One. This 3.8% investment tax planning should be on the front-burner of your estate planner’s To-Do list in view of the early 2014 U.S. Tax Court opinion in Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (3/27/14).  Click here for a copy of this opinion.

[Keep in mind this Aragona case deals with whether business losses in a trust situation are passive activity losses that have to be suspended for later tax return recognition.  But, the relevance of Aragona to the 3.8% investment tax is the similar question of whether the ownership of a business is a passive activity triggering the 3.8% tax.]

Two. There are planning opportunities that can help avoid this 3.8% investment tax. This gets into the purposeful design of a surviving spouse trust for Jane that will hold the family business interest after John’s death, and the related design of the trustee designations.

Three. This is one of dozens of examples where income tax planning must now be a priority for one’s estate planning.

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