Learn About Material Participation in a Business
Material Participation and Passive Activity Tax Rules
Material participation and passive activity loss rules were set by the Internal Revenue Service to prevent business owners who don't work day-to-day in the business from profiting from tax losses. Material participation of a business owner is determined for a business year, then he might or might not be able to take a deduction for a business loss in that year.
Material Participation in a Business
The IRS has determined that an individual materially participates in business activities if she does so on a "regular, continuous, and substantial basis." She can't deduct losses to the same extent as a business owner who does materially participate in the business if it's determined that her participation is not material.
There are two main types of businesses in which passive activities and passive losses play a part:
- Rental businesses, of both equipment and real estate, and
- Limited partnerships, in which there are limited partners whose participation is limited to their investment and who don't materially participate in day-to-day business activities.
How Material Participation Is Determined
Material participation is determined for each year. The IRS has seven tests to determine material participation:
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100 to 500 hours is more than 500 hours for the year.
- The taxpayer materially participated in the activity in any five of the previous 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any three previous years.
- Based on all facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year. However, this test only applies if the taxpayer works at least 100 hours in the activity, if no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
You need only meet one of the above tests to establish material participation.
Joe and Sally Cotterly are spouses and members (owners) of an LLC. Each of them has a 50 percent membership percentage.
Sally does the majority of the work in the business. Joe offers comments and suggestions, and he occasionally helps with fixing things. He shares in the profits and losses, but he doesn't meet any of the above criteria, so he isn't materially participating in the business.
Why Material Participation Important for Taxes
Determining whether a business owner's participation in the day-to-day activities of the business affects that owner's personal taxes. His taxes are particularly affected if the business has a loss in any given year.
The IRS labels losses to a business owner who does not materially participate as "passive activity losses." The IRS takes the view that this is the same as putting money in a savings account and watching the interest grow without doing anything to affect that growth.
Rental income is also considered passive unless you work as a real estate professional. In other words, you didn't just buy an investment property and put a tenant in there. Passive income is not treated the same tax-wise as income that's earned through an active business effort.
An owner can take the full amount of his losses on his personal tax return if he materially participates in the business and the business has losses. The owner's losses are limited to the amount of income reported if he doesn't materially participate and the business has losses.
Joe and Sally Cotter's business has a loss of $10,000 for the year. They have no income other than from the business. Their LLC operating agreement splits profits and losses equally.
Sally actively participates in the business so she can deduct her full $5,000 share of the losses. But Joe didn't materially participate so he can't deduct any of his $5,000 share because there was no other income to offset this loss.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.