What Is Material Participation from an Income Tax Standpoint?

JC Leahy

The the question of material participation is important.  If you have income (or loss) from an activity and did not materially participate, the income is generally classified as "passive income," rather than "earned income."   Having passive income or loss can have all sorts of income tax ramifications.  For example, we saw in our last article on the Earned Income Tax Credit (EITC) that having passive income can bar you from qualifying for the EITC.

The IRS gives us this definition of material participation:

To determine material participation in an activity, the taxpayer must meet ONE of the following:

1.____ Does taxpayer and/or spouse work more than 500 hours a year in the business?

2.____ Does taxpayer do most of the work?  Even if taxpayer does not meet 500 hour test, but his participation is the only activity in the business,  he materially participates.  Example:  sole proprietor with no employees.

3.____ Does taxpayer work more than l00 hours and no one (including non-owners or employees) works more hours?    Example:  If owner puts in l75 hours a year and an employee works 190 hours a year, taxpayer would not meet material participation test.



 4.____ Does taxpayer have several passive activities in which he participates between 100-500 hours each, and the total time is more than  500 hours?  The following activities should not be included in the above test: rental activities: activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.

5.____ Did taxpayer materially participate in activity for any 5 out of l0 preceding years (need not be consecutive)?  Example:  taxpayer who retired and his children now run business, but he stills owns part of partnership.

6.____ Did taxpayer materially participate in a personal service activity for any 3 prior years (need not be consecutive)?  Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.

7.____ Do the facts and circumstances indicate taxpayer is materially participating?  Test does not apply unless taxpayer worked more than 100 hours a year.  Furthermore, it does not apply if:

    any person, other than the taxpayer, received compensation for managing the activity; or,
    if any person spent more hours than taxpayer managing the activity.

REMINDER:  Limited partners under IRC § 469(h)(2) are generally passive.  The exceptions to the limited partner rule are tests 1, 5 and 6 above.   If taxpayer holds both a general and limited partner interest, he will have all seven tests available.

If the answer to any of the above questions is YES the taxpayer meets the material participation standard.  Losses or income should not be reflected on Form 8582, and the taxpayer may generally deduct in full the amount of the loss in the current year.  If the taxpayer materially participated, losses or income are reflected on the return as non-passive.

If the answer is NO to all seven tests, the material participation standard is not met, and losses are passive.

Reminder:  If the taxpayer does not materially participate, credits arising from the business are generally passive.  In the absence of passive income, a passive activity credit is nondeductible in the current year.