10.6 Material Participation Tests for Business
The IRS has seven tests for determining material participation in a business. Some tests require only a minimum amount of work, such as 500 hours a year, and others only 100 hours. You need to meet only one of the seven tests to qualify as a material participant. If you do, then the income and loss from that business is treated as nonpassive.
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Caution
Overcoming Investor Status
The IRS will not recognize time spent as an investor as “participation” unless you can show you are involved in daily operations or management of the activity. According to the IRS, this requires you to be at the business site on a regular basis. Even if you do appear daily, the IRS may ignore such evidence if there is an on-site manager or you have full-time business obligations at another site. Activity of an investor includes the studying and reviewing of financial reports for your own use that are considered unrelated to management decisions. If you invest in a business that is out of state or a distance from your home, you may also find it difficult to prove material participation.
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The tests apply whether you do business as a sole proprietor or in an S corporation or partnership. Losses and credits passed through S corporations and partnerships are subject to passive activity rules.
If you are a limited partner, the law presumes that you are not a material participant in the activities of the limited partnership, but IRS regulations provide a limited opportunity to show that you materially participate. Only three of the seven material participation tests are available to you; see 10.11.
Your tax position towards the IRS participation rules will depend on whether the particular activity produces income or loss. If you have passive activity losses from other activities, you may prefer to have a profitable business activity treated as a passive activity in order to offset the income by the losses from passive activities. On the other hand, if the business activity operates at a loss and you do not have passive income from other sources, you may want to meet the material participation test for that business activity in order to claim current loss deductions. IRS strategy in reviewing your activities would be the opposite. If your return were under audit, an agent would attempt to prevent you from treating income from a business activity as passive. For example, the IRS, by applying Tests 5 and 6, can prevent a retired person from treating post-retirement income from a prior business or profession as passive income to offset passive losses from another activity. If you realize a loss in one passive activity, Test 4 may prevent you from generating passive income by merely reducing your participation in another activity.
Material participation results in nonpassive treatment.
There are two key terms: material participation and significant participation. If you materially participate by meeting one of the seven IRS tests, your activity is not a passive activity. For example, under Test 1, work for more than 500 hours in an activity is considered material participation. Under Test 4, significant participation is work for more than 100 hours but less than 500 hours at an activity in which you do not otherwise materially participate. The IRS applies a significant participation rule to convert passive activity income into nonpassive income and to convert several significant participation activities into material participation if the total participation in those activities exceeds 500 hours; see Test 4.
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Planning Reminder
Proof of Material Participation
Material participation must be determined on an annual basis. Show proof of your participation by keeping an appointment book, calendar, or log of the days and time spent in the operation. If you want to treat contacts by phone as material activity, keep a log of phone calls showing the time and purpose of the calls.
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IRS Tests for Material Participation
If you meet one of the following tests for the year in question, you are considered to have materially participated in that activity, and therefore the activity is considered nonpassive for that year. Tests 5 and 6 prevent retired individuals from treating post-retirement income as passive income.
Rules for limited partners and members of LLCs and LLPs are at 10.11. For participation rules for personal service and closely held corporations, see 10.15.
Work by you or your spouse that counts as participation.
Apart from the exceptions listed below, any work you do in a business in which you have an ownership interest is treated as “participation.” If you are married, work by your spouse in the activity during the tax year is generally treated as participation by you. This is true even if your spouse does not own an interest in the business or if you file separately. However, this favorable spousal participation rule does not apply if you and your spouse elect to treat your jointly owned business as a qualified joint venture, thereby requiring each of you to report your respective shares of the business income, deductions, credits, gains, and losses on Schedule E; see 9.1 and the Schedule E instructions.
Do not count the following types of work as participation:
1. Work that is not of a type customarily done by an owner of an activity, if one of the principal reasons for the performance of the work is to avoid the passive loss rules (see the Example below).
2. An investor’s review of financial statements or analysis that is unrelated to day-to-day management or operation of the activity.
EXAMPLE
An attorney owns an interest in a professional football team for which he performs no services. He anticipates a net loss from the football activity and to qualify as a material participant, he hires his wife to work 15 hours a week as an office receptionist for the team. Although a spouse’s participation in an activity generally qualifies as participation by both spouses, the receptionist work here does not qualify as participation because (1) it is not the type of work customarily done by an owner of a football team and (2) the attorney hired his spouse to avoid disallowance of a passive loss.
Test 1. You participate in the activity for more than 500 hours during the tax year.
Test 2. Your participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals including non-owners for the year.
Test 3. You participate in the activity for more than 100 hours during the tax year, and your participation is at least as great as that of any other person including non-owners for that year.
EXAMPLE
Joan Brown and Pat Collins are partners in a moving van business that they conduct entirely on weekends with the help of two employees. They both work for eight hours each weekend. Although neither partner participates for more than 500 hours (Test 1) and do not meet Test 2, they are both treated as material participants under Test 3 because they each participate for more than 100 hours and no one else participates more.
Test 4. You are active in several enterprises but each activity does not in itself qualify as material participation. However, if you spend more than 100 hours in each activity and the total hours of these more-than-100-hour activities exceeds 500, you are treated as a material participant in each of these activities. This test is referred to as the “significant participation” test.
EXAMPLES
1. Mike Smith is a full-time accountant with ownership interests in a restaurant and shoe store. He works 150 hours in the shoe store and 360 hours in the restaurant. Under the significant participation test (Test 4), Smith is considered a material participant in both activities, as the total hours of both exceed 500.
2. Carl Young invests in five businesses. In activity (a) he works 110 hours; in activity (b), 100 hours; in activity (c), 125 hours; in activity (d), 120 hours; and in activity (e), 140 hours. He does not qualify under the significant participation test (Test 4). Although his total hours in the five activities exceed 500, activity (b) is ignored in the total count because the hours did not exceed 100. The total of the four other activities is 495.
3. Assume that Young worked one hour more for activity (b). It and all of the other activities would be considered as meeting the significant material participation test. The total hours are 596. Assuming that activity (a) totaled 125 hours and activity (b) remained at 100 hours or less, he would meet the test for all of the activities except for activity (b), which did not exceed 100 hours. The total of the four qualified activities is 510 hours.
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Caution
Retired Farmers
Retired or disabled farmers are treated as materially participating in a farming activity if they materially participated for five of the eight years preceding their retirement or disability. A surviving spouse is also treated as materially participating in a farming activity if the real property used in the activity meets the estate tax rules for special valuation of farm property passed from a qualified decedent and the surviving spouse actively manages the farm.
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Test 5. You materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in question. The five tax years do not have to be consecutive. Thus, if you are retired but meet the five-out-of-10-year participation test, you are currently considered a material participant, with the result that net income is treated as nonpassive, rather than passive. If you retired from a personal service profession, an even stricter rule applies; see Test 6.
Test 6. In a personal service activity, you materially participated for any three tax years preceding the tax year in question. The three years do not have to be consecutive. Examples of personal services within this test are the professions of health, law, engineering, architecture, accounting, actuarial science, the performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
Test 7. Under the facts and circumstances test, you participate in the activity on a regular, continuous, and substantial basis. According to the IRS, you do not come within this test if you participate less than 100 hours in the activity.
