Material Participation Tests: Definition & Overview

KEY TAKEAWAYS

• The IRS created material participation tests. They get used to determine if a taxpayer is materially participating in an income-producing activity.
• Material participants can deduct the total amount of losses on their tax returns.
• It’s important to consider that passive activity rules can limit the deductibility of a passive loss.

What Are Material Participation Tests?

Material participation tests are tests that the IRS uses to determine whether an individual is a material participant in a business activity that would be normally considered a passive activity.

Passive activities are activities in which you don’t participate materially as well as rental activities, even if you participate materially, unless you are a real estate professional (as defined by the IRS).

Being a material participant allows you to deduct more of your passive loss than otherwise allowed. This is important, because usually losses from passive activities are limited to your passive income. There is one exception for losses derived from passive rental real estate activity. The exception will allow you to deduct up to $25,000 of passive losses against your active income (e.g. wages). .

How to Determine Material Participation

To determine material participation, you must meet one of the seven material participation tests. Satisfying the requirements of at least one of them will make you a material participant in your business activity.

They seven test are: 

1. You participated in the business activity for more than 500 hours during the year.
2. Your participation in all the business activities was substantially all of the participation from individuals.
3. You have participated in the business activity for more than 100 hours during the year and no one else must have participated more hours than you.
4. The activity is a significant participation activity, and you participated in all other significant participation activities for more than 500 combined hours. You must have participated in the other significant activities for at least 100 hours and you didn’t materially participate under any of the material participation tests, other than this test.
5. You materially participated in the business activity for any 5 of the 10 last tax years. The 5 years don’t have to be consecutive.
6. The activity is a personal service activity in which you participated for any 3 preceding tax years. Personal service activities can be in the fields of health, law, engineering, accounting, consulting or any other businesses in which capital isn’t a income-producing factor.
7. You participated in the activity on a regular, continuous and substantial basis for at least 100 hours and no one else was paid for managing the activity or spent more time on it than you. This test is based on all the facts and circumstances of an activity.

What Are the Benefits of Material Participation Tests?

The main benefit of material participation is the possible deduction of additional passive losses against your active income. 

If you are married, your spouse’s participation counts towards the material participation hours even if they don’t any interested in the business.

Different passive business activities can be grouped together to be able to meet one of the material participation tests. Those groups have to be combined in appropriate economic units. Those units can be based, for example, on the similarities of the business, the geographic location or the extent of the common control or ownership.

What Are the Drawbacks of Material Participation Tests?

One of the drawbacks is that the IRS didn’t word the tests exactly and you will need good interpretation skills to distinguish the nuances in each of them.

Also, not all activities will qualify towards the hours counted towards material participation. For example, a real estate investor cannot count hours they used to analyze the financial statements or hours spent looking for new deals. Also, work that is customary not performed by the owner doesn’t count either. For example, an out of state owner wouldn’t usually fly to the business to clean the office building.

Summary 

Material participation tests were created by the Internal Revenue Service (IRS). Their purpose is to determine if a taxpayer is materially participating in an income-producing activity, which will allow him to deduct some of their passive loss against their active income.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.