When your business has a loss, your participation in your business may limit your ability to take that loss and reduce your taxes. The key to being able to take the full amount of the tax loss on your tac return is what the IRS calls material participation.
IRS Rules for Business Losses
Two sets of rules apply when determining your ability to take a loss in your business:
At-risk rules. You have a risk in your business based on your investment in the business or for amounts you borrowed for the business for which you are personally liable or for which you pledged personal property. You can't deduct more than the amount you have at risk for a year.
Passive activity rules. These rules relate to your activity, and whether you have materially participated in the business or you have a passive role in the business.
You must apply the at-risk rules before the passive activity rules.
The IRS limits the amount of losses that business owners can take on their tax returns. It looks first at the amount of an owner's investment in the business and then the owner's activity in the business to determine the owner's share of business losses. In any one year, either or both of these factors can limit the owner's tax situation.
Material Participation and Business Owners
The IRS has determined that an individual materially participates in business activities if they do so on a "regular, continuous, and substantial basis." An owner who doesn't participate in the business can't deduct losses to the same extent as a business owner who does materially participate in the business.
Material participation is determined on an individual basis, and it's determined each tax year. The opposite of material participation is called passive activity. If you haven't materially participated in the business during the year, your share of any business deductions for the year is limited.
Although any business owner can be affected by this regulation, two types of businesses are especially affected:
Limited partners in a partnership whose participation is limited to their investment and who don't materially participate in day-to-day business activities.
Rental businesses, of both equipment and real estate. Generally, rental activities are considered passive activities, even if you materially participated in them. The exception is real estate professionals if they meet certain IRS criteria.
How Material Participation Is Determined
Material participation is determined separately for each tax year. The IRS has several tests to determine material participation in the activities of the business, using both time worked and type of work.
These material participation rules apply to individual owners of businesses, not to the business entity (partnership or S corporation).
Time Worked. You can be considered to materially participate in the business if you work on a regular, continuous, and substantial basis during the year, 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.
Type of Work. The work you do on your business should be work usually done by a business owner, in the day-to-day management of the business, but not as an investor.
The IRS wants to make sure your main reason for doing the work isn't to avoid the passive activity rules. It also can't be work as an investor.
You will need to find a way to establish your participation in a reasonable way, to satisfy the IRS. You don't have to keep a daily time report, but you could use your appointment book, calendar, or narrative summary to show the amount and type of your participation in your business during the year.
How to Report Losses on Your Tax Return
Depending on your situation in your business, your loss for the year might be limited by (a) the at-risk rules and/or (b) the passive activity limits. The forms you file depend on the specific situation. For example, you must use Form 6198 to report at-risk loss limits and Form 8582 to report passive activity loss limitations. You may need to file other forms, based on your specific situation.
Why Material Participation is 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. The owner's taxes are particularly affected if the business has a loss in any given year.
The IRS looks at both at-risk limits and passive activity limits (material participation) to see if these business losses are in excess. An excess business loss is an amount by which the total deductions for a business are greater than the gross income (as calculated by the IRS) and gains (capital gains) plus $250,000 (or $500,000 in the case of a joint return).
The tax regulations for business losses, these excess loss calculations, and the reporting of losses are complicated. If your business has a loss for the year, be sure to get help from a tax professional to make sure you get the full amount of any tax deductions you're entitled to, but not more than you can take.
This article focuses on material participation and passive activity loss rules. For more information on at-risk rules and more detailed information about material participation and passive activity rules, see IRS Publication 925 Passive Activity and At-Risk Rules.
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.