The term “material participation” is used to describe your involvement in a business activity. Generally speaking, you materially participate in an activity if you’re involved in the operation of the activity on a regular, continuous, and substantial basis. If you meet these requirements, any losses from the activity are not limited by the passive activity rules.
Key Takeaways:
- Material participation determines if a business activity is passive or active
- Losses from passive activities cannot be deducted against nonpassive income
- Disallowed losses are carried forward until used to offset passive income or the activity is disposed of
What Is Material Participation?
The IRS established seven tests to determine if you have materially participated in a trade or business. If you meet one or more of the following tests, you can deduct losses from both active and passive income because you have materially participated. Keep in mind that you’ll need to meet one or more of the criteria annually.
Test 1: You participated in the activity for more than 500 hours during the tax year.
- Example: Xavier spent more than 500 hours during the 2022 tax year running his construction firm. His duties included approving new contracts, deciding the terms of the contracts, getting licenses from the city, and overseeing his construction team. For the purpose of this rule, he meets the criteria for Test 1.
Test 2: Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- Example: During the year, Ike spent 50 hours engaged in business activity. He didn’t have any employees and didn’t hire any contractors. Since he did everything for his business by himself, he meets the standards for Test 2.
Test 3: You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual, including individuals who didn’t own any interest in the activity, for the year.
- Example: Amara owns two car services; she spent 200 hours in 2022 running her business. She also has an assistant who helps her manage the fleet. The assistant spent 100 hours on business activities. Since Amara spent more hours engaged in business activities than anyone else, she meets the requirements for Test 3.
Test 4: The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests.
- Example: Arinze participated in four business activities during the tax year: activities A, B, C, and D. He spent the following hours on each activity:
- A: 120 hours
- B: 200 hours
- C: 150 hours
- D: 50 hours
He significantly participated in activities A, B, and C, but they only total 470 hours. As such, he does not meet the material participation prong under this rule.
If, however, Arinze participated in activity D for 100 hours instead of 50, it would be considered a significant participation activity. Then, his total participation in significant activities would be 520 hours, and he would materially participate in all four activities.
Test 5: You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 years immediately preceding the tax year.
- Example: Diego opened a business in 2012, and he has materially participated in business activities since 2017. In the years 2017–2021, he spent 700 hours annually making management decisions, such as expanding his business locations, getting licenses from the city, and hiring and firing employees. Since he has met these criteria every year for the last five of the 10 years, he will be a material participant for each of the years 2022–2026 under this rule.
Test 6: The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years. A personal service activity involves the performance of personal services in the fields of health―including veterinary services―law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Example: Joel owned and operated an accounting firm for three years and then retired. As the owner, he was responsible for preparing and checking his tax returns, running the company’s file room, and getting new customers. He will always be considered a material participant because it was a personal service activity, and he materially participated for three years before retiring.
Test 7: Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. This final test provides a last-ditch effort for taxpayers to claim material participation even if they haven’t met one of the first six tests. It’s best to plan your participation levels to meet one of the other tests rather than rely on arguing under Test 7.
- Example: Lin spent 251 hours engaging in business activities for her widget business during the tax year. Her husband Johnathan spent 249 hours engaged in the same business activities during the year. Lin and Johnathan plan to file separately for the tax year. Based on these facts and circumstances, Lin will meet the criteria for this test for the tax year.
A business activity that doesn’t meet one of the seven material participation tests is considered a passive activity by the IRS, and the income derived from a passive activity is subject to limitation.
The material participation tests discussed above are for business activities. Rental activities are always considered passive unless owned by a real estate professional. However, active participants in rental activities might be able to deduct a portion of their loss under special rules.
What Is Participation in an Activity?
Generally, participation in an activity is being involved in the day-to-day operations of the activity. Under these rules, work done as an investor doesn’t count as participation unless you are directly involved in running or managing the activity daily. This is because as an investor, you might look over financial statements or other reports, write summaries or studies for your own use, and keep an eye on the activity’s finances or operations without being in charge of them:
- Spouse’s participation: For the purposes of these rules, a spouse’s participation in an activity is treated the same as your participation. This is true even if you and your spouse do not file a joint return for the year.
- Limited partner’s participation: A limited partner is considered not to have materially participated in an activity. Thus, a partner’s share of income or loss that is distributed in their capacity as a limited partner is generally treated as passive income or loss—unless the partner uses tests 1, 5, or 6 as a workaround to the passive activity rules.
- C corporation’s (C-corp’s) participation: A C-corp is considered to be materially involved in an activity only if one or more shareholders with more than 50% of the value of the corporation’s outstanding stock are materially involved in the activity.
Passive Activity Loss Rules
The passive loss rules do not allow offsetting of active income with passive losses. In other words, if you don’t have passive income, your passive losses will be suspended and carried forward to future periods.
If you materially participate in a business activity, any income and loss will be classified as “active.” One source of active income is wages. On the flip side, if you don’t materially participate in a business activity, the income or loss is considered passive. One common source of passive income is rental activity.
During the year, Carlos worked as a general manager for Widgets ‘R’ Us, and he also engaged in a number of business activities. Here are his earnings/losses from the year:
- Wages: $100,000
- Activity A: $30,000 net income
- Activity B: $30,000 net loss
Based on Carlos’s income/losses, the following projections could apply:
- Let’s assume the income from activity A was derived from materially participating in the operation of a driving school; thus, the income is active, and the income from activity B is derived from investing in a laundromat, and thus the income is passive. Given these facts, Carlos will have $130,000 of income and $30,000 of suspended losses from B.
- Let’s take a look at another hypothetical. This time, the income from activity A is derived from investing in a laundromat, and the income from activity B is from operating a driving school. The active loss from B can offset the passive income from A, so Carlos will have $100,000 of income and no losses to suspend.
- Now let’s look at one last scenario: A and B are both passive activities. As such, he will have $100,000 in income. His $30,000 in passive income will be offset by the $30,000 in passive losses.
Suspended Loss Carryover Rules
Suspended losses each year must be assigned to the particular activity that generated the loss. They can be used to offset future passive income from any passive activity. When a passive activity is eventually disposed of, the suspended loss for that activity is “released” and can be deducted against all sources of income. Oftentimes, a passive activity will be sold at a gain, and the suspended loss released can be used to offset the gain.
- In 2022, Tom had $10,000 in passive losses that were generated from investment activity. The losses were suspended.
- In 2023, the same activity will have another passive loss of $3,000, but a new rental activity will have a passive income of $5,000.
The 2023 loss of $3,000 plus $2,000 of the suspended loss from 2022 offsets the passive rental income of $5,000. The remaining $8,000 of suspended loss is carried forward to 2024.
Let’s assume that in 2024, the passive activity is sold at a gain of $5,000. The $8,000 of suspended activity is “released” and will offset the $5,000 gain plus offset an additional $3,000 of active income from any source.
Frequently Asked Questions (FAQs)
You can prove your participation by providing your work calendar, work logs, appointment book, or other business records.
Yes, the IRS determines whether or not you have materially participated annually. So, you’ll need to be sure you qualify for one of the seven tests each year.
Yes, you can, and if you group two or more activities into one larger activity, you only need to show material participation in the activity as a whole.
Bottom Line
If you participate in business activity regularly, continuously, and substantially, you can deduct losses from that business against your other sources of income. See if your business passes one of the seven tests to learn if you materially participated this tax year.
