What Are Material Participation Examinations?

Material involvement tests are a collection of factors established by the Internal Revenue Service (IRS) to determine whether a taxpayer has materially participated in a trade, company, rental, or other income-producing activity. A taxpayer participates materially if they meet one of the seven material involvement standards. However, the deductibility of losses is limited when taxpayer participation fails to fulfill at least one of the seven material participation requirements.

Understanding Material Participation Examinations

Material participation in income-producing activities is generally defined as regular, continuous, and considerable. Active income or loss generates income in which the taxpayer has a significant stake. An active loss is deductible but is subject to the Internal Revenue Code’s (IRC) at-risk provisions and other limits.

Participation that fails to meet one of the material participation standards is subject to passive activity restrictions. A passive investment in an income-producing endeavor is not regular, continuous, or large. Passive income and loss are income-producing activities in which the taxpayer engages passively. Passive activity restrictions place a limit on the deductibility of any passive loss.

Material Participation Tests and Their Varieties

A taxpayer or their spouse qualifies as materially participating in a venture for any tax year if they meet any of the seven material participation requirements.

• Test one: You put in more than 500 hours.
• Test number two: Your activity constituted the majority of all involvement.
• Test three: You participated for more than 100 hours, more than any other person.
• Fourth test: The activity is a significant participation activity in which you participated for more than 500 hours, along with all other significant participation activities. A considerable participation activity is one in which the taxpayer works for more than 100 hours without qualifying for the other six tests.
• Fifth test: You participated in five of the previous ten taxable years.
• Sixth test: The activity is a personal service activity in which you engaged in any of the previous three taxable years. Health, legal, engineering, architecture, accounting, actuarial science, performing arts, or consultancy are examples of personal service activities in which capital is not a material income-producing aspect.
• Test seven: You participated for more than 100 hours regularly, continuously, and substantially (based on all facts and circumstances).

Material Participation Tests Have Limits

Specific activities will not count against the 100-hour or 500-hour thresholds of tests one, three, four, or seven.

Time spent as an investor will not be considered unless you demonstrate direct engagement in the activity’s day-to-day management.1 Work that an owner does not typically perform is not counted as material involvement hours or time spent commuting. Material participation does not include work to avoid loss disallowance under the passive loss rule. Finally, participation in exclusively managerial activities for which other managers are not compensated cannot be counted.

Unless limited partners pass material participation tests one, five, or six, their participation in firms held by them is passive. When a taxpayer participates in two enterprises run by the same pass-through corporation, at least one of the seven conditions for each endeavor must be met for the taxpayer to be considered to have significantly participated in both operations.

Material Participation Tests: Special Considerations

Taxpayers who possess a stake in a business earn participation credit for labor done for it. They demonstrate their engagement by stating the number of hours spent and the type of task completed. Participation is based on records kept by taxpayers, such as appointment books, calendars, narrative summaries, or any other reasonable means.

How Does the IRS View Active vs. Passive Income-Generating Participation?

Material participation in an income-generating activity is considered active if assessed as regular, continuous, and considerable. This type of engagement must pass the IRS’s material participation standards. Passive engagement that generates revenue is the polar opposite of active participation—it is activity that is not regular, continuous, or substantial.

How Do You Prove Material Involvement?

Taxpayers must keep track of the number of hours they spend on material participation in an activity and be able to provide written proof if necessary. An investor may typically perform tasks like reading stock charts but would not fulfill the participation burden unless the taxpayer was heavily involved in managing a specific activity.

What effect does material participation have on taxes?

A taxpayer materially involved in an activity may deduct the complete loss amount from their taxes. The deductibility of losses for a taxpayer passively participating in an income-generating activity is limited under passive activity regulations.

Conclusion

The type of income-generating activity you engage in, whether active or passive, can impact your tax payments. The IRS has devised seven measures you can use to evaluate your involvement to help you determine which it is. If your action qualifies as material participation, you can usually deduct the complete amount of losses; in the event of passive engagement, your deductions are limited.