For purposes of the passive activity rules, the IRS has seven tests to determine if a taxpayer materially participated in the operation of a trade or business activity. Meeting any of these seven tests qualifies the taxpayer as having materially participated in the activity.
- The taxpayer participated in the activity for more than 500 hours during the tax year.
- The taxpayer's participation in the activity for the tax year was substantially all of the participation in the activity of all individuals (including individuals who did not own any interest in the activity) for the tax year.
- The taxpayer participated in the activity for more than 100 hours during the tax year, and also participated at least as much as any other person for the tax year. This includes individuals who did not own any interest in the activity.
- The activity is a "significant participation activity" for the tax year, and the taxpayer participated in all significant participation activities for more than 500 hours during the year. A significant participation activity involves (a) the conduct of a trade or business, (b) in which the taxpayer participated in for more than 100 hours during the tax year, and (c) they didn't meet any of the other six tests.
- The taxpayer materially participated in the activity for any 5 of the prior 10 tax years. Exception: For a retired or disabled farmer, they are treated as materially participating in a farming business if they materially participated 5 or more of the 8 years preceding their retirement or disability.
- The activity is a personal service activity in which the taxpayer materially participated for any 3 prior tax years. A personal service activity is an activity that involves performing personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or any other trade or business in which capital is not a material income-producing factor.
- Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis for more than 100 hours during the tax year. In meeting this test, the taxpayer's participation in managing the activity does not count if any other person (a) received compensation for performing management services in connection with the activity, or (b) spent more hours during the tax year than the taxpayer spent performing management services in connection with the activity (regardless of whether the person was compensated for the services).
Caveats
Material participation assumes that the work the taxpayer is doing is work that a business owner would customarily do in the same type of activity, as opposed to doing the work mainly to avoid the disallowance of losses or credits from the activity under the passive activity rules.
Work the taxpayer does as an investor in an activity is not treated as participation unless they were directly involved in the day-to-day management or operations of the activity. Work performed as an investor includes:
- Studying and reviewing financial statements or reports on the activity,
- Preparing or compiling summaries or analyses of the finances or operations of the activity for their own use, and
- Monitoring the finances or operations of the activity in a nonmanagerial capacity.
For married taxpayers, participation by one spouse during the tax year in an activity in which the other spouse owns an interest can be counted as the other spouse's participation in the activity. This rule applies even if (a) one spouse did not own an interest in the activity and (b) they don't file a joint return. However, this rule does not apply for purposes of determining whether they can elect to have their business treated as a qualified joint venture instead of a partnership.
For farming activity, a surviving spouse is treated as materially participating if (a) the surviving spouse actively manages the farm, and (b) the real property used for farming meets the estate tax rules for special valuation of farm property passed from a qualifying decedent.
Additional Information: