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.
Material participation may or may not be worse than passive participation in any given situation. It is recommended that a financial advisor assists in making that decision.
How Material Participation Tests Work
Material participation in an income-producing activity is, generally speaking, an activity that is regular, continuous and substantial. Income-producing actions, in which the taxpayer materially participates is an active income or loss. An active loss is deductible but subject to at-risk rules or other limitations imposed by the Internal Revenue Code (IRC).
Passive activity rules apply to participation that fails to meet one of the material participation tests. A passive participation in an income-producing venture is participation that is not regular, continuous and substantial. Income-producing actions, in which the taxpayer passively participates is passive income and loss. Passive activity rules limit the deductibility of any passive loss.
- Material participation tests help determine whether a taxpayer has materially participated in business, rental or other income-producing activity.
- A material participant can deduct the full amount of losses on their tax returns.
- Only one requirement of the seven material participation tests need to be met in order to qualify.
- Passive activity rules limit the deductibility of any passive loss.
- The IRS requires documentation to prove participation is material.
Types of Material Participation Tests
For any tax year, a taxpayer, or their spouse, qualifies as materially participating in a venture if they satisfy any one of the seven material participation tests.
- Test 1: participation for more than 500 hours.
- Test 2: activity that constituted all participation substantially.
- Test 3: involvement for more than 100 hours and not less than the participation of any other individual.
- Test 4: which is a significant participation activity, combined with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
- Test 5: participation during any five (5) of the preceding ten (10) taxable years.
- Test 6: which is a personal service activity, for any three (3) prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
- Test 7: partaking for more than 100 hours and based on all the facts and circumstances, on a regular, continuous, and substantial basis.
Pros and Cons of Material Participation Tests
Not all time spent in certain activities will count toward the 100-hour or 500-hour thresholds of Tests 1, 3, 4 or 7.
Time spent as an investor will not count unless they can show direct involvement in the day to day management of the activity. Taxpayers who do work, not customarily done by an owner, is not counted towards material participation hours, nor is time spent commuting. Work undertaken for the primary purpose of avoiding the disallowance of losses under the passive loss rule is not material participation. And finally, participation in a purely managerial activity where other managers receive no compensation cannot be counted.
The participation of limited partners in enterprises owned by them is passive participation unless they pass material participation tests one, five or six. When a taxpayer participates in two enterprises operated through the same pass-through entity, at least one of the seven tests for each venture must be met to be considered to have materially participated in both activities.
Special Considerations for Material Participation Tests
Taxpayers with an ownership interest in a venture receive participation credit for work done for it. By identifying the hours spent and the nature of work done, a taxpayer establishes their participation. A taxpayer bases participation on records they maintain such as appointment books, calendars, narrative summaries, or any other reasonable means.
For further information see the "Material Participation" section at pages 5 to 6 of the Internal Revenue Service (IRS) Publication 925.