Yes, distributions from a trust can be considered either passive or active income. The character of the income depends entirely on the nature of the underlying activity that generated the money within the trust and, crucially, the level of the trustee’s involvement in that activity. It is not the distribution itself, but the source of the money being distributed, that determines its tax classification.
The primary conflict stems from Internal Revenue Code (IRC) § 469, the federal statute governing passive activity losses. This rule was designed for individuals, creating a direct conflict with the legal structure of trusts, which are separate entities. The immediate negative consequence is that if a trust’s business income is automatically classified as “passive,” it can trigger the 3.8% Net Investment Income Tax (NIIT), unnecessarily costing beneficiaries and the trust thousands of dollars annually.
This issue is more relevant than ever, as over 13% of U.S. households with a net worth between $500,000 and $1 million use trusts as part of their estate plan, a figure that rises with wealth. Many of these trusts hold interests in family businesses or real estate, making this tax distinction critically important.
Here is what you will learn by reading this article:
- 🔍 Decode Your K-1: You will understand exactly where to look on your Schedule K-1 to determine if the income you received is active, passive, or portfolio, and what it means for your tax bill.
- 🏆 Master the “Material Participation” Tests: You will learn the seven specific IRS tests that determine if a business is an active or passive activity, giving you the power to classify your trust’s income correctly.
- ⚖️ Leverage a Landmark Court Ruling: You will discover how the Frank Aragona Trust case revolutionized the rules, allowing trustees’ work as employees to count toward “active” status and how you can use this precedent.
- 💰 Strategically Avoid the 3.8% Surtax: You will gain actionable knowledge on how to structure a trust’s operations to classify its business income as “active,” potentially saving a significant amount by avoiding the Net Investment Income Tax (NIIT).
- 🗺️ Navigate Complex State Tax Rules: You will get a clear overview of how different states tax trust income for out-of-state beneficiaries, preventing surprise tax bills from states you don’t even live in.
The Building Blocks: Understanding Trusts and Income Types
Who’s Who in the World of Trusts?
A trust is a legal arrangement, like a protective box for assets, created under state law. It involves a three-party relationship to manage property. Understanding these roles is the first step to understanding how the money flows.
- The Grantor (or Settlor): This is the person who creates the trust and puts their assets into it. They write the rulebook, called the trust instrument, that dictates how everything is managed and distributed.
- The Trustee: This is the person or institution (like a bank) that holds legal title to the assets and manages them according to the rulebook. They have a strict legal duty, known as a fiduciary duty, to act only in the best interests of the beneficiaries.
- The Beneficiary: This is the person or group of people for whom the trust was created. They hold the beneficial or equitable title and have the right to receive money and other assets from the trust.
The Two Trust Personalities: Grantor vs. Non-Grantor
For tax purposes, the most important distinction is whether the IRS sees the trust as a separate person or not. This depends on how much control the grantor kept over the assets.
A Grantor Trust is one where the grantor keeps certain powers, like the power to revoke the trust or change beneficiaries. The IRS essentially ignores the trust for income tax purposes and treats the grantor as the direct owner of the assets. All income, deductions, and credits are reported on the grantor’s personal Form 1040, and distributions to beneficiaries are typically considered tax-free gifts from the grantor.
A Non-Grantor Trust is a trust where the grantor has given up control. This kind of trust is treated as a separate, distinct taxpayer by the IRS. It must file its own tax return (Form 1041) and pays taxes on income it doesn’t distribute. The question of active versus passive income is primarily a concern for these non-grantor trusts.
The Three Flavors of Income: Active, Passive, and Portfolio
The IRS sorts all income into three buckets, and it’s crucial not to confuse them. The bucket your trust’s income falls into determines how it’s taxed when it gets to you.
| Income Type | Description | Common Examples |
| Active Income | Money earned from a trade or business where you are involved on a “regular, continuous, and substantial basis.” This is income from direct effort. | Wages, salaries, commissions, and profits from a business you actively run. |
| Passive Income | Money earned from a trade or business where you do not materially participate, or from rental activities. This is income that requires minimal ongoing effort. | Earnings from a limited partnership where you are just an investor; income from a rental property managed by someone else. |
| Portfolio Income | Money earned from investments that are not part of a regular trade or business. This is often called “investment income.” | Interest from bonds, dividends from stocks, royalties, and capital gains from selling securities. |
The distinction is critical because of the Passive Activity Loss (PAL) rules. These rules state that you generally cannot use losses from passive activities to offset your active or portfolio income. More importantly, both passive income and portfolio income can be hit with the 3.8% Net Investment Income Tax (NIIT), while active income is exempt.
The Heart of the Matter: Proving “Material Participation”
The entire debate over active versus passive income for a trust’s business hinges on one concept: material participation. If a trust “materially participates” in a business it owns, the income is active. If it doesn’t, the income is passive.
The Seven Magic Tests: How the IRS Defines “Active”
To prove material participation, you only need to meet one of the following seven tests for the tax year. These tests measure whether your involvement is “regular, continuous, and substantial.”
- The 500-Hour Test: You participated in the activity for more than 500 hours during the year. This is the most straightforward and common test.
- The “Substantially All” Test: Your participation was essentially all the participation in the activity from everyone, including non-owners. This works for solo operations.
- The 100-Hour-Plus Test: You participated for more than 100 hours, and no other single person participated more than you did.
- The Significant Participation Activity (SPA) Test: The activity is an SPA, and your combined time in all your SPAs is more than 500 hours. An SPA is a business where you spend more than 100 hours but don’t meet any other material participation test.
- The Five-Out-of-Ten-Years Test: You materially participated in the activity for any five of the ten years immediately before the current year. This prevents a long-time active owner from suddenly becoming passive right before a sale.
- The Three-Year Personal Service Test: The activity is a personal service (like law, health, accounting, or consulting), and you materially participated for any three prior years.
- The “Facts and Circumstances” Test: Based on all the facts, you participated on a regular, continuous, and substantial basis. This test requires a minimum of 100 hours of participation and considers if you are the primary manager of the activity.
The Billion-Dollar Question: How Can a Trust “Participate”?
This is where the central conflict arises. A trust is a legal document, not a person. It can’t drive to an office or manage employees. So, whose hours and activities count? For decades, the answer was murky and contested.
The IRS historically took a very narrow and rigid stance, often called the “fiduciary capacity doctrine.” They argued that only the work performed by the trustee in their specific role as a trustee could be counted. Any work the trustee did as an employee or CEO of the trust’s business was ignored, creating a nonsensical distinction that was difficult for family businesses to overcome.
This position was first seriously challenged in the 2003 case Mattie K. Carter Trust v. United States. The court sided with the trust, which owned a large ranch, ruling that the activities of all individuals acting on the trust’s behalf—including employees and agents, not just the trustee—should be considered. The court called the IRS’s position an attempt “to create ambiguity where there is none.” Despite this, the IRS announced it would not follow the Carter decision and stuck to its narrow view.
The Court Case That Changed Everything for Family Business Trusts
The legal landscape shifted for good with the 2014 Tax Court ruling in Frank Aragona Trust v. Commissioner. This case is now the most important precedent on the issue and provides a clear roadmap for trusts.
The Aragona Trust owned a large real estate business operated through an LLC wholly owned by the trust. Six family members were co-trustees, and three of them also worked as full-time, salaried employees of the LLC, managing the day-to-day operations. The trust claimed its real estate income was active, but the IRS disallowed it, using its old argument that the work done as “employees” didn’t count toward the trust’s participation.
The Tax Court sided decisively with the trust. The court’s groundbreaking reasoning was that trustees cannot simply take off their “fiduciary hat” when they go to work at the trust’s business. Under state law, a trustee’s duty of loyalty is constant. Managing the trust’s business, whether as a “trustee” or an “employee,” is all part of the same overarching duty to protect and grow the trust’s assets for the beneficiaries. Therefore, all the hours the trustees worked as employees counted, allowing the trust to easily pass the 500-hour test and classify its income as active.
Real-World Scenarios: Putting the Rules into Practice
Let’s see how these rules apply in the three most common situations for trust beneficiaries.
Scenario 1: The Passive Investor Trust
Imagine a trust is set up for you and your siblings. Its assets consist solely of a $2 million portfolio of stocks, bonds, and mutual funds. The trustee is a bank that manages the investments.
This trust generates dividend and interest income. This is portfolio income, not passive income from a trade or business. The material participation rules are completely irrelevant here. The income you receive is portfolio income, subject to regular income tax and potentially the 3.8% NIIT if your personal income is high enough.
| Action | Tax Consequence |
| Trust receives $50,000 in dividends and interest. | This is classified as portfolio income at the trust level. |
| Trust distributes $20,000 to you. | You receive a Schedule K-1 showing $20,000 of portfolio income, which you report on your Form 1040. |
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Scenario 2: The “Hands-Off” Rental Property Trust
Now, suppose the trust owns a small apartment building. The trustee has hired a professional property management company to handle everything: finding tenants, collecting rent, and arranging repairs. The trustee’s only involvement is reviewing monthly reports.
Rental activities are considered passive by default under IRC § 469. Because the trustee’s involvement is minimal and doesn’t meet the “real estate professional” exception, the net rental income is passive income. Any losses from the property can generally only be used to offset other passive income.
| Action | Tax Consequence |
| Trust generates $30,000 in net rental income. | This is classified as passive income at the trust level because the trustee does not materially participate. |
| Trust distributes $30,000 to you. | You receive a Schedule K-1 showing $30,000 of passive rental income, which you report on Schedule E of your Form 1040. |
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Scenario 3: The Active Family Business Trust
This is the “Aragona” scenario. A trust owns 100% of a family manufacturing business, held in an LLC. You are both a beneficiary and one of two trustees. You work full-time at the business, spending over 2,000 hours a year on operations, sales, and management.
Thanks to the Aragona ruling, your hours worked as an employee of the business count toward the trust’s material participation. Since your 2,000 hours far exceed the 500-hour test, the business income is classified as active income at the trust level. This income is not subject to the 3.8% NIIT.
| Action | Tax Consequence |
| The family business (owned by the trust) generates $200,000 in profit. | Because you, as trustee, worked over 500 hours, this is classified as active income at the trust level. |
| The trust distributes $100,000 to you. | You receive a Schedule K-1 showing $100,000 of non-passive (active) business income. This income is not subject to the 3.8% NIIT. |
Export to Sheets
Your Tax Map: Decoding the Schedule K-1
When a non-grantor trust makes a distribution to you, it must send you a Schedule K-1 (Form 1041). This document is your roadmap. It breaks down the distribution you received into its different income characters, telling you exactly what to report on your personal tax return.
A Guided Tour of the Key K-1 Boxes
You don’t need to understand every line, but knowing the key boxes will empower you to understand your tax situation.
- Boxes 1-5: Portfolio Income. These boxes report your share of interest, dividends, and capital gains. This is classic portfolio income. If these are the only boxes with numbers, your distribution is not from a passive or active business activity.
- Box 6: Ordinary Business Income. This reports income from a non-rental trade or business. The crucial detail is whether the trustee has designated this as passive or non-passive (active) on an attached statement.
- Box 7: Net Rental Real Estate Income. This is income from rental properties. This is almost always passive unless the trust qualifies for the “real estate professional” exception, which is rare but possible after the Aragona case.
- Box 14: Other Information. This is a critical box with various codes. The most important one for this topic is Code H: Adjustment for Net Investment Income. This amount is an adjustment used to calculate the 3.8% NIIT on Form 8960 and directly relates to whether the income is considered passive or active.
Strategic Planning: Do’s, Don’ts, and Common Mistakes
Do’s and Don’ts for Trustees and Beneficiaries
| Do’s | Don’ts |
| DO appoint trustees who are actively involved in the trust’s business. This is the clearest path to meeting the material participation tests post-Aragona. | DON’T assume any rental income is automatically passive. Explore if the trust can qualify for the “real estate professional” exception. |
| DO keep meticulous time logs for any trustee who is participating in a trust-owned business. Documenting hours is the best proof for the 500-hour test. | DON’T rely on the activities of a beneficiary who is not also a trustee. A beneficiary’s participation is legally irrelevant for a non-grantor trust’s tax status. |
| DO review the trust document. Some trusts may limit a trustee’s role to only making distributions, which could prevent their business activities from counting. | DON’T forget about state taxes. A trust can be considered a “resident” for tax purposes in multiple states based on the location of the trustee, beneficiaries, or administration. |
| DO analyze distributions to minor beneficiaries. Unearned income distributed to a child could be subject to the “Kiddie Tax,” which taxes income above a certain threshold at the parents’ higher rate. | DON’T mix up portfolio income with passive income. The material participation rules do not apply to interest, dividends, and capital gains from securities. |
| DO consult with a tax professional. The interaction between trust law, state law, and federal tax code is one of the most complex areas of taxation. | DON’T assume the IRS’s old, narrow view of trustee participation still holds. The Aragona case provides strong authority to count a trustee’s work as an employee. |
Mistakes to Avoid
- Ignoring State Law Nuances: States have wildly different rules for taxing trusts. Some states, like California, can tax a trust based on the residency of the trustee or the beneficiary. Others focus on where the trust was created or is administered. A non-resident beneficiary could get a surprise tax bill from a state they have no connection to, simply because that’s where the trust is deemed to be a “resident.”
- Miscounting Participation Hours: Not all work counts toward the seven tests. Time spent purely as an investor (reviewing financial statements), commuting time, or work done just to meet the hour threshold is not counted. You must be able to prove the hours were for “regular, continuous, and substantial” involvement in operations.
- Failing to Make Timely S-Corp Trust Elections: If a trust holds S-Corporation stock, it must be an eligible type of trust, like a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT). If a grantor trust holding S-Corp stock becomes irrevocable upon the grantor’s death, the trustee has a limited window (generally two years) to make a new election. Missing this deadline can cause the company to lose its S-Corp status, a disastrous tax outcome.
- Confusing “Principal” and “Income” Distributions: Beneficiaries generally do not pay tax on distributions of the trust’s principal (the original assets put into the trust). They only pay tax on distributions of the trust’s income (dividends, interest, business profits). The IRS assumes distributions come from income first, up to the amount of the trust’s Distributable Net Income (DNI) for the year.
State Law Headaches: A Multi-State Maze
Federal tax law is only half the battle. Each state has its own set of rules for taxing trust income, creating a complex web that can easily trap the unwary. States generally assert the right to tax a trust based on a combination of factors.
How States Decide a Trust is a “Resident”
A state can tax all of a resident trust’s accumulated income, regardless of where it was earned. A trust might be considered a resident if:
- The person who created the trust (the grantor) lived there when the trust was made.
- The trustee lives or works there.
- The beneficiaries live there.
- The trust is administered there (e.g., where the records are kept).
This means a single trust could theoretically be considered a resident of multiple states, leading to double taxation if not planned for carefully.
Sourcing Rules for Non-Resident Beneficiaries
If you are a beneficiary living in a different state from the trust, that state can generally only tax you on income that is “sourced” from within that state. This typically includes income from real estate located in the state or from a business that operates in the state.
However, income from intangible assets like stocks and bonds is usually sourced to the beneficiary’s state of residence. Some states, like California and New York, have “throwback” rules that can tax a resident beneficiary on income that the trust accumulated in prior years, even if the beneficiary lived elsewhere when the income was earned.
Frequently Asked Questions (FAQs)
Can a trust’s rental income ever be considered active? Yes. While rental income is passive by default, a trust can qualify for the “real estate professional” exception if its trustees spend more than 750 hours and over half their working time in real estate trades.
If I am a beneficiary, do my activities in the trust’s business matter? No. For a non-grantor trust, the IRS and courts agree that only the trustee’s participation counts. Your activities are irrelevant unless you are also serving as a trustee.
What happens if a trust has multiple trustees who work different amounts? The activities of all trustees are added together. The trust meets the test if the combined efforts of one or more trustees satisfy a material participation test, like collectively working more than 500 hours.
Is a distribution from a revocable living trust taxable to me as a beneficiary? No. Distributions from a revocable trust during the grantor’s life are treated as tax-free gifts from the grantor. All income is taxed to the grantor on their personal tax return, not to you.
How is a distribution to a minor child taxed? The distribution is considered “unearned income” for the child and may be subject to the “Kiddie Tax.” For 2025, unearned income over $2,700 is taxed at the parent’s higher marginal tax rate.
What is an ESBT and how is it taxed? An Electing Small Business Trust (ESBT) is a special trust that can own S-Corporation stock. Its share of S-Corp income is taxed at the highest individual rate at the trust level, not to the beneficiary.
Does the character of income (e.g., dividend, rental) pass through to the beneficiary? Yes. A trust acts as a conduit. If the trust earns tax-exempt interest and distributes it, it remains tax-exempt to you. The character of the income is preserved on the Schedule K-1. Yes, distributions from a trust can be considered either passive or active income. The character of the income depends entirely on the nature of the underlying activity that generated the money within the trust and, crucially, the level of the trustee’s involvement in that activity. It is not the distribution itself, but the source of the money being distributed, that determines its tax classification.
The primary conflict stems from Internal Revenue Code (IRC) § 469, the federal statute governing passive activity losses. This rule was designed for individuals, creating a direct conflict with the legal structure of trusts, which are separate entities. The immediate negative consequence is that if a trust’s business income is automatically classified as “passive,” it can trigger the 3.8% Net Investment Income Tax (NIIT), unnecessarily costing beneficiaries and the trust thousands of dollars annually.
This issue is more relevant than ever, as over 13% of U.S. households with a net worth between $500,000 and $1 million use trusts as part of their estate plan, a figure that rises with wealth. Many of these trusts hold interests in family businesses or real estate, making this tax distinction critically important.
Here is what you will learn by reading this article:
- 🔍 Decode Your K-1: You will understand exactly where to look on your Schedule K-1 to determine if the income you received is active, passive, or portfolio, and what it means for your tax bill.
- 🏆 Master the “Material Participation” Tests: You will learn the seven specific IRS tests that determine if a business is an active or passive activity, giving you the power to classify your trust’s income correctly.
- ⚖️ Leverage a Landmark Court Ruling: You will discover how the Frank Aragona Trust case revolutionized the rules, allowing trustees’ work as employees to count toward “active” status and how you can use this precedent.
- 💰 Strategically Avoid the 3.8% Surtax: You will gain actionable knowledge on how to structure a trust’s operations to classify its business income as “active,” potentially saving a significant amount by avoiding the Net Investment Income Tax (NIIT).
- 🗺️ Navigate Complex State Tax Rules: You will get a clear overview of how different states tax trust income for out-of-state beneficiaries, preventing surprise tax bills from states you don’t even live in.
The Building Blocks: Understanding Trusts and Income Types
Who’s Who in the World of Trusts?
A trust is a legal arrangement, like a protective box for assets, created under state law. It involves a three-party relationship to manage property. Understanding these roles is the first step to understanding how the money flows.
- The Grantor (or Settlor): This is the person who creates the trust and puts their assets into it. They write the rulebook, called the trust instrument, that dictates how everything is managed and distributed.
- The Trustee: This is the person or institution (like a bank) that holds legal title to the assets and manages them according to the rulebook. They have a strict legal duty, known as a fiduciary duty, to act only in the best interests of the beneficiaries.
- The Beneficiary: This is the person or group of people for whom the trust was created. They hold the beneficial or equitable title and have the right to receive money and other assets from the trust.
The Two Trust Personalities: Grantor vs. Non-Grantor
For tax purposes, the most important distinction is whether the IRS sees the trust as a separate person or not. This depends on how much control the grantor kept over the assets.
A Grantor Trust is one where the grantor keeps certain powers, like the power to revoke the trust or change beneficiaries. The IRS essentially ignores the trust for income tax purposes and treats the grantor as the direct owner of the assets. All income, deductions, and credits are reported on the grantor’s personal Form 1040, and distributions to beneficiaries are typically considered tax-free gifts from the grantor.
A Non-Grantor Trust is a trust where the grantor has given up control. This kind of trust is treated as a separate, distinct taxpayer by the IRS. It must file its own tax return (Form 1041) and pays taxes on income it doesn’t distribute. The question of active versus passive income is primarily a concern for these non-grantor trusts.
The Three Flavors of Income: Active, Passive, and Portfolio
The IRS sorts all income into three buckets, and it’s crucial not to confuse them. The bucket your trust’s income falls into determines how it’s taxed when it gets to you.
| Income Type | Description | Common Examples |
| Active Income | Money earned from a trade or business where you are involved on a “regular, continuous, and substantial basis.” This is income from direct effort. | Wages, salaries, commissions, and profits from a business you actively run. |
| Passive Income | Money earned from a trade or business where you do not materially participate, or from rental activities. This is income that requires minimal ongoing effort. | Earnings from a limited partnership where you are just an investor; income from a rental property managed by someone else. |
| Portfolio Income | Money earned from investments that are not part of a regular trade or business. This is often called “investment income.” | Interest from bonds, dividends from stocks, royalties, and capital gains from selling securities. |
The distinction is critical because of the Passive Activity Loss (PAL) rules. These rules state that you generally cannot use losses from passive activities to offset your active or portfolio income. More importantly, both passive income and portfolio income can be hit with the 3.8% Net Investment Income Tax (NIIT), while active income is exempt.
The Heart of the Matter: Proving “Material Participation”
The entire debate over active versus passive income for a trust’s business hinges on one concept: material participation. If a trust “materially participates” in a business it owns, the income is active. If it doesn’t, the income is passive.
The Seven Magic Tests: How the IRS Defines “Active”
To prove material participation, you only need to meet one of the following seven tests for the tax year. These tests measure whether your involvement is “regular, continuous, and substantial.”
- The 500-Hour Test: You participated in the activity for more than 500 hours during the year. This is the most straightforward and common test.
- The “Substantially All” Test: Your participation was essentially all the participation in the activity from everyone, including non-owners. This works for solo operations.
- The 100-Hour-Plus Test: You participated for more than 100 hours, and no other single person participated more than you did.
- The Significant Participation Activity (SPA) Test: The activity is an SPA, and your combined time in all your SPAs is more than 500 hours. An SPA is a business where you spend more than 100 hours but don’t meet any other material participation test.
- The Five-Out-of-Ten-Years Test: You materially participated in the activity for any five of the ten years immediately before the current year. This prevents a long-time active owner from suddenly becoming passive right before a sale.
- The Three-Year Personal Service Test: The activity is a personal service (like law, health, accounting, or consulting), and you materially participated for any three prior years.
- The “Facts and Circumstances” Test: Based on all the facts, you participated on a regular, continuous, and substantial basis. This test requires a minimum of 100 hours of participation and considers if you are the primary manager of the activity.
The Billion-Dollar Question: How Can a Trust “Participate”?
This is where the central conflict arises. A trust is a legal document, not a person. It can’t drive to an office or manage employees. So, whose hours and activities count? For decades, the answer was murky and contested.
The IRS historically took a very narrow and rigid stance, often called the “fiduciary capacity doctrine.” They argued that only the work performed by the trustee in their specific role as a trustee could be counted. Any work the trustee did as an employee or CEO of the trust’s business was ignored, creating a nonsensical distinction that was difficult for family businesses to overcome.
This position was first seriously challenged in the 2003 case Mattie K. Carter Trust v. United States. The court sided with the trust, which owned a large ranch, ruling that the activities of all individuals acting on the trust’s behalf—including employees and agents, not just the trustee—should be considered. The court called the IRS’s position an attempt “to create ambiguity where there is none.” Despite this, the IRS announced it would not follow the Carter decision and stuck to its narrow view.
The Court Case That Changed Everything for Family Business Trusts
The legal landscape shifted for good with the 2014 Tax Court ruling in Frank Aragona Trust v. Commissioner. This case is now the most important precedent on the issue and provides a clear roadmap for trusts.
The Aragona Trust owned a large real estate business operated through an LLC wholly owned by the trust. Six family members were co-trustees, and three of them also worked as full-time, salaried employees of the LLC, managing the day-to-day operations. The trust claimed its real estate income was active, but the IRS disallowed it, using its old argument that the work done as “employees” didn’t count toward the trust’s participation.
The Tax Court sided decisively with the trust. The court’s groundbreaking reasoning was that trustees cannot simply take off their “fiduciary hat” when they go to work at the trust’s business. Under state law, a trustee’s duty of loyalty is constant. Managing the trust’s business, whether as a “trustee” or an “employee,” is all part of the same overarching duty to protect and grow the trust’s assets for the beneficiaries. Therefore, all the hours the trustees worked as employees counted, allowing the trust to easily pass the 500-hour test and classify its income as active.
Real-World Scenarios: Putting the Rules into Practice
Let’s see how these rules apply in the three most common situations for trust beneficiaries.
Scenario 1: The Passive Investor Trust
Imagine a trust is set up for you and your siblings. Its assets consist solely of a $2 million portfolio of stocks, bonds, and mutual funds. The trustee is a bank that manages the investments.
This trust generates dividend and interest income. This is portfolio income, not passive income from a trade or business. The material participation rules are completely irrelevant here. The income you receive is portfolio income, subject to regular income tax and potentially the 3.8% NIIT if your personal income is high enough.
| Action | Tax Consequence |
| Trust receives $50,000 in dividends and interest. | This is classified as portfolio income at the trust level. |
| Trust distributes $20,000 to you. | You receive a Schedule K-1 showing $20,000 of portfolio income, which you report on your Form 1040. |
Export to Sheets
Scenario 2: The “Hands-Off” Rental Property Trust
Now, suppose the trust owns a small apartment building. The trustee has hired a professional property management company to handle everything: finding tenants, collecting rent, and arranging repairs. The trustee’s only involvement is reviewing monthly reports.
Rental activities are considered passive by default under IRC § 469. Because the trustee’s involvement is minimal and doesn’t meet the “real estate professional” exception, the net rental income is passive income. Any losses from the property can generally only be used to offset other passive income.
| Action | Tax Consequence |
| Trust generates $30,000 in net rental income. | This is classified as passive income at the trust level because the trustee does not materially participate. |
| Trust distributes $30,000 to you. | You receive a Schedule K-1 showing $30,000 of passive rental income, which you report on Schedule E of your Form 1040. |
Export to Sheets
Scenario 3: The Active Family Business Trust
This is the “Aragona” scenario. A trust owns 100% of a family manufacturing business, held in an LLC. You are both a beneficiary and one of two trustees. You work full-time at the business, spending over 2,000 hours a year on operations, sales, and management.
Thanks to the Aragona ruling, your hours worked as an employee of the business count toward the trust’s material participation. Since your 2,000 hours far exceed the 500-hour test, the business income is classified as active income at the trust level. This income is not subject to the 3.8% NIIT.
| Action | Tax Consequence |
| The family business (owned by the trust) generates $200,000 in profit. | Because you, as trustee, worked over 500 hours, this is classified as active income at the trust level. |
| The trust distributes $100,000 to you. | You receive a Schedule K-1 showing $100,000 of non-passive (active) business income. This income is not subject to the 3.8% NIIT. |
Export to Sheets
Your Tax Map: Decoding the Schedule K-1
When a non-grantor trust makes a distribution to you, it must send you a Schedule K-1 (Form 1041). This document is your roadmap. It breaks down the distribution you received into its different income characters, telling you exactly what to report on your personal tax return.
A Guided Tour of the Key K-1 Boxes
You don’t need to understand every line, but knowing the key boxes will empower you to understand your tax situation.
- Boxes 1-5: Portfolio Income. These boxes report your share of interest, dividends, and capital gains. This is classic portfolio income. If these are the only boxes with numbers, your distribution is not from a passive or active business activity.
- Box 6: Ordinary Business Income. This reports income from a non-rental trade or business. The crucial detail is whether the trustee has designated this as passive or non-passive (active) on an attached statement.
- Box 7: Net Rental Real Estate Income. This is income from rental properties. This is almost always passive unless the trust qualifies for the “real estate professional” exception, which is rare but possible after the Aragona case.
- Box 14: Other Information. This is a critical box with various codes. The most important one for this topic is Code H: Adjustment for Net Investment Income. This amount is an adjustment used to calculate the 3.8% NIIT on Form 8960 and directly relates to whether the income is considered passive or active.
Strategic Planning: Do’s, Don’ts, and Common Mistakes
Do’s and Don’ts for Trustees and Beneficiaries
| Do’s | Don’ts |
| DO appoint trustees who are actively involved in the trust’s business. This is the clearest path to meeting the material participation tests post-Aragona. | DON’T assume any rental income is automatically passive. Explore if the trust can qualify for the “real estate professional” exception. |
| DO keep meticulous time logs for any trustee who is participating in a trust-owned business. Documenting hours is the best proof for the 500-hour test. | DON’T rely on the activities of a beneficiary who is not also a trustee. A beneficiary’s participation is legally irrelevant for a non-grantor trust’s tax status. |
| DO review the trust document. Some trusts may limit a trustee’s role to only making distributions, which could prevent their business activities from counting. | DON’T forget about state taxes. A trust can be considered a “resident” for tax purposes in multiple states based on the location of the trustee, beneficiaries, or administration. |
| DO analyze distributions to minor beneficiaries. Unearned income distributed to a child could be subject to the “Kiddie Tax,” which taxes income above a certain threshold at the parents’ higher rate. | DON’T mix up portfolio income with passive income. The material participation rules do not apply to interest, dividends, and capital gains from securities. |
| DO consult with a tax professional. The interaction between trust law, state law, and federal tax code is one of the most complex areas of taxation. | DON’T assume the IRS’s old, narrow view of trustee participation still holds. The Aragona case provides strong authority to count a trustee’s work as an employee. |
Mistakes to Avoid
- Ignoring State Law Nuances: States have wildly different rules for taxing trusts. Some states, like California, can tax a trust based on the residency of the trustee or the beneficiary. Others focus on where the trust was created or is administered. A non-resident beneficiary could get a surprise tax bill from a state they have no connection to, simply because that’s where the trust is deemed to be a “resident.”
- Miscounting Participation Hours: Not all work counts toward the seven tests. Time spent purely as an investor (reviewing financial statements), commuting time, or work done just to meet the hour threshold is not counted. You must be able to prove the hours were for “regular, continuous, and substantial” involvement in operations.
- Failing to Make Timely S-Corp Trust Elections: If a trust holds S-Corporation stock, it must be an eligible type of trust, like a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT). If a grantor trust holding S-Corp stock becomes irrevocable upon the grantor’s death, the trustee has a limited window (generally two years) to make a new election. Missing this deadline can cause the company to lose its S-Corp status, a disastrous tax outcome.
- Confusing “Principal” and “Income” Distributions: Beneficiaries generally do not pay tax on distributions of the trust’s principal (the original assets put into the trust). They only pay tax on distributions of the trust’s income (dividends, interest, business profits). The IRS assumes distributions come from income first, up to the amount of the trust’s Distributable Net Income (DNI) for the year.
State Law Headaches: A Multi-State Maze
Federal tax law is only half the battle. Each state has its own set of rules for taxing trust income, creating a complex web that can easily trap the unwary. States generally assert the right to tax a trust based on a combination of factors.
How States Decide a Trust is a “Resident”
A state can tax all of a resident trust’s accumulated income, regardless of where it was earned. A trust might be considered a resident if:
- The person who created the trust (the grantor) lived there when the trust was made.
- The trustee lives or works there.
- The beneficiaries live there.
- The trust is administered there (e.g., where the records are kept).
This means a single trust could theoretically be considered a resident of multiple states, leading to double taxation if not planned for carefully.
Sourcing Rules for Non-Resident Beneficiaries
If you are a beneficiary living in a different state from the trust, that state can generally only tax you on income that is “sourced” from within that state. This typically includes income from real estate located in the state or from a business that operates in the state.
However, income from intangible assets like stocks and bonds is usually sourced to the beneficiary’s state of residence. Some states, like California and New York, have “throwback” rules that can tax a resident beneficiary on income that the trust accumulated in prior years, even if the beneficiary lived elsewhere when the income was earned.
Frequently Asked Questions (FAQs)
Can a trust’s rental income ever be considered active? Yes. While rental income is passive by default, a trust can qualify for the “real estate professional” exception if its trustees spend more than 750 hours and over half their working time in real estate trades.
If I am a beneficiary, do my activities in the trust’s business matter? No. For a non-grantor trust, the IRS and courts agree that only the trustee’s participation counts. Your activities are irrelevant unless you are also serving as a trustee.
What happens if a trust has multiple trustees who work different amounts? The activities of all trustees are added together. The trust meets the test if the combined efforts of one or more trustees satisfy a material participation test, like collectively working more than 500 hours.
Is a distribution from a revocable living trust taxable to me as a beneficiary? No. Distributions from a revocable trust during the grantor’s life are treated as tax-free gifts from the grantor. All income is taxed to the grantor on their personal tax return, not to you.
How is a distribution to a minor child taxed? The distribution is considered “unearned income” for the child and may be subject to the “Kiddie Tax.” For 2025, unearned income over $2,700 is taxed at the parent’s higher marginal tax rate.
What is an ESBT and how is it taxed? An Electing Small Business Trust (ESBT) is a special trust that can own S-Corporation stock. Its share of S-Corp income is taxed at the highest individual rate at the trust level, not to the beneficiary.
Does the character of income (e.g., dividend, rental) pass through to the beneficiary? Yes. A trust acts as a conduit. If the trust earns tax-exempt interest and distributes it, it remains tax-exempt to you. The character of the income is preserved on the Schedule K-1.