What are Material Participation Tests?
Material participation tests are a set of Internal Revenue Services (IRS) criteria that evaluate whether a taxpayer has materially participated in a trade, business, rental, or other income-producing activity. A taxpayer materially participates if they pass one of the seven material participation tests.
However, passive activity rules limit the deductibility of losses when taxpayer participation fails to meet at least one of the seven material participation tests.
How Do Material Participation Tests Work?
Note that when you are actively participating in your business, it is taken to be a non-passive activity. Therefore, any net income or loss the business generates becomes a non-passive income. This means that you can deduct business activity’s losses from your other active income.
Examples of other income include dividends, spouses income, interests, and income from your other business where you are an active participant. Passive income occurs when a taxpayers participation does not meet any of the seven material participation tests. Rules to do with passive activity do limit the deductions made from active losses.
How to Determine Material Participation
The U.S. Internal Revenue Service (IRS) sets rules to determine if a taxpayer materially participated in a business or trade during the tax year. The entity runs multiple tests to determine material participation in a business, trade, or other income-producing activity, based on the type of work and the amount of time worked. The tests only apply to individual owners of businesses, and not business entities such as limited partnerships and S corporations whose participation is considered passive.
The two main factors used to determine material participation include:
1. Amount of time worked
An individual taxpayer is considered to have materially participated in an income-producing activity if they worked on a regular, continuous, and substantial basis for at least 100 hours in the tax year. The business should not have any party other than the taxpayer who receives compensation or works more hours in managing the business.
2. Type of work
The type of work that the individual taxpayer participates in should be work done by the business owner on a day-to-day basis in the regular management of the business. The taxpayer should find ways to establish their participation in the business to meet the requirements set by the IRS.
The taxpayer can prove their participation by providing their work calendar, work logs, or an appointment book to show their level of participation in the business during the tax year.
Types of Material Participation Tests
There are seven material participation tests. If a taxpayer satisfies any one of these tests for a trade or business activity, they are not subject to the passive activity rules for that activity for the year.
If a taxpayer satisfies any one of these tests for a rental real estate activity and the taxpayer also qualifies as a real estate professional for the year, the activity is not subject to the passive activity rules for the year.
The seven IRS material participation tests are listed below. Note that as long as a taxpayer meets one of these tests for a given activity, they are considered to have materially participated in that activity for the year.
The taxpayer participated in the activity for more than 500 hours during the year.
- The taxpayer’s participation in the activity constituted a substantial part of all the participation in the activity during the year.
- The taxpayer participated in the activity for more than 100 hours during the year and participated in the activity at least as much as any other individual.
- The taxpayer participated in multiple activities for more than 100 hours each during the year, but their participation in each of these activities, viewed in isolation, did not rise to the level of material participation. However, the taxpayer’s participation in all such activities, when combined, exceeded 500 hours. These kinds of activities are known as significant participation activities.
- The taxpayer materially participated in the activity for any five of the previous 10 years, and they qualified for material participation in the activity by any of the tests other than by participation in the activity for any five of the previous 10 years.
- The taxpayer materially participated in the activity for any three of the previous 10 years, and the activity is a personal service activity. A personal service activity, in general, is an activity that involves the taxpayer’s personal time and effort, and in which capital is not a major income-producing factor.
- The taxpayer participated in the activity on a regular, continuous, and substantial basis.
- The IRS has some guidelines in place to avoid abuse. For example, to meet test number 7, the taxpayer must have participated in the activity for more than 100 hours during the year.