A trade or businesses is a passive activity if the taxpayer does not materially participate. The taxpayer materially participates if and only if he or she meets one of the following seven tests.
1. The taxpayer works 500 hours or more during the year in the activity
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.[3]
Note: The first four tests look to a set number of hours of participation in the tax year. The next two tests look to material participation in prior tax years. The final test looks to the facts and circumstances, but is highly restrictive.
Material participation applies to income as well as to losses. One of the purposes of the last four material participation tests is to prevent the taxpayer from “failing” material participation when the activity generates income instead of losses.
500 Hours
If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive. Participation of both spouses is counted, but not participation of the children or employees.
Participation in operations must be regular, continuous, and substantial.
Examination Techniques:
The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.
- Review W-2s and other non-passive activities. Does it seem likely that the taxpayer could spend 500 hours on the activity in light of other employment obligations?
- Ask questions on taxpayer activity time early in the examination. Establish time the taxpayer spends on all activities during the initial interview if possible. See exhibit with log at the end of the chapter.
- Determine the location of each activity. If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?
Substantially All
Stated simply, if the taxpayer does most of the work, income or loss will be non-passive. The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test.
Note: There is no specific number of hours associated with this test. In addition, the term “substantially” is not defined in the regulations.
100 Hours
If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.
Examination Techniques:
- Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C & F).
- When reviewing taxpayer hours, watch for “investor” activities (Reg. § 1.469-5T(f)(2)(ii)). The taxpayer must be involved in the activity’s day-to-day management or operations. Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.
Does material participation matter? You bet it does. It means the difference between being able to deduct a business loss or having to defer it to future years when it may not be worth as much.
