Understanding and establishing ‘Material Participation’ for tax purposes
When it comes to your income taxes, U.S. tax law makes a distinction between different types of income — including income from passive investments and active businesses in which the taxpayer “materially participates.” The issue of material participation can be extremely important for you as a business owner or investor. Whether or not you qualify as a material participant determines the extent to which you are allowed to deduct losses on your tax return.
For example, let’s say you are completing Schedule C of Form 1040 (U.S. Individual Income Tax Return) to report your business’ profits and losses. You will have to check a box indicating whether you materially participated in the business during the tax year. Generally, you are eligible to claim material participation if you participated in a business on a “regular, continuous, and substantial basis.” To claim material participation check “yes” on your tax form.
Most sole proprietors are qualified to claim material participation because they typically spend substantial amounts of time running their business. However, merely having a financial interest in a business (even if it is significant) is not enough to meet the material participation criteria — unless you also handle the day-to-day management of the business. This means that your managerial tasks do not qualify you for material participation if you are simply reviewing financial statements, monitoring operations, or providing business advice.
On the other hand, if you check “no,” the business counts as a passive activity. This limits the losses you are permitted to deduct, since passive activity losses can only be deducted against passive activity income. Passive income generally refers to the proceeds from a financial investment, such as a business or rental property, that does not require significant time or effort to manage after the investment is made. This question is posed because the Federal government does not want taxpayers to try to claim losses on passive investments as regular business losses, which are deductible against their ordinary income. If you do not have sufficient passive income to deduct passive income losses, the deductions must be suspended and claimed in a year when you have more passive income or when you sell the investment.
According to the IRS, a trade or business is considered a passive activity unless the taxpayer materially participates.
You can claim to have materially participated in the operation of a trade or business activity by meeting one of seven following tests:
1. You work 500 hours or more in the activity during the year.
2. You do all, or nearly all, of the work in the activity.
3. You work more than 100 hours in the activity during the year, and no one else works more than you do.
4. The activity is a significant participation activity (SPA), and the sum of the SPAs in which you work 100–500 hours exceeds 500 hours for the year.
5. You materially participated in the activity in any 5 of the previous 10 years.
6. The activity is a personal service activity and you materially participated in that activity in any three prior years.
7. Based on all of the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis during that year. Note that this test only applies if you work at least 100 hours in the activity, no one else works more hours than you in the activity, and no one else receives compensation for managing the activity.
In some cases, you may be able to group together related businesses as a “single activity” in order to meet one of the above tests. Participation by your spouse during the tax year in a business you own can also be counted as your participation in the activity — even if your spouse does not own an interest in the activity, and regardless of whether you file a joint income tax return. However, it is important to note that the IRS may become suspicious of your claim that you or your spouse materially participated in the business if, for example, you live far from the business, you were not compensated for your work, or you have a full-time job or many other businesses and investments to manage.
When it comes to rental activities, it can be more difficult for one to claim material participation. According to the IRS, the long-term leasing or rental of real estate is considered a passive activity even if you materially participated in the activity. This is true unless you materially participated in a rental activity as a real estate professional. To qualify as a real estate professional, more than half of the work you perform in trades or businesses during the taxable year must be in real property activity in which you materially participate. Additionally, you must work more than 750 hours a year in these trades/businesses.
Keep in mind, however, that you may be allowed to deduct up to $25,000 of rental property passive income losses as long as you can demonstrate that you actively participate in the property. Active participation means that you must own at least a 10% stake, and you must be making management decisions (such as approving tenants, setting rental terms, and authorizing repairs). Note that this tax deduction phases out at modified adjusted gross incomes (MAGIs) that are between $100,000 and $150,000.