When it comes to material participation, most business owners and investors become confused. These laws were put into place by the IRS, but they can be hard to understand. Often, your accountant is the first to bring it to your attention, which is usually around tax time.
What does it mean to materially participate in the business? We will define it and help you determine if you have done it the past year. That way, you’re more informed and can make the right choices for the next tax season.
What Does It Mean to Materially Participate?
The IRS (Internal Revenue Service) created passive activity laws and material participation rules. This was to prevent company owners from profiting from the tax losses if they didn’t help with daily operations. Usually, material participation for a business owner is determined each business year.
If you don’t materially participate for that business year, you might not be able to take business losses or deductions for that year. Therefore, it’s helpful to understand what it is and how not to do it. That way, you can get all the deductions to which you are entitled.
Material Participation in the Business World
The IRS makes all the rules when it comes to taxes and what you’ll pay. For business owners, it’s a little more complicated.
To materially participate in business activities, you have to do it on a substantial, continuous, and regular basis. That means you can’t deduct as many losses as an owner who doesn’t participate materially.
There are primarily two types of businesses where passive losses and activities can play a part. These include:
- Limited partnerships: Limited partners don’t participate much in the investment or handle day-to-day operations.
- Rental businesses: These include both real estate and equipment.
How to Determine if There Is Material Participation
Every year, you will have to establish whether or not you materially participated. There are seven tests that the IRS has come up with to determine this.
- You work 500 or more hours during the year on an activity to benefit the business.
- The activity you perform is considered an SPA (Significant Participation Activity). The sum of your SPAs is over 500 hours for the year, with between 100 and 500 being allocated to each activity.
- You have materially participated in one activity for any of the last five out of 10 years.
- A personal service activity was performed, and you also materially participated in that same activity within any of the last three years.
- You work over 100 hours in a particular activity during that year. Others may work on it, too, but not as much as you do.
- The taxpayer participates in a particular activity on a substantial, continuous, or regular basis throughout the year. This test will only apply if you work 100 or more hours in the action. No one else can receive compensation as a manager for the activity or work more on it than the taxpayer.
- You do almost all the work for the activity throughout the year.
It’s important to understand that you only have to meet one of the tests above. If you do, you have materially participated in the business and will need to adjust your taxes accordingly.
A Helpful Example
Let’s say that you and your spouse were owners or members of an LLC. You both have 50-percent ownership of the company, but your spouse does most of the work for the business.
You’ll share suggestions and comments and might fix something when it breaks. That means you’ll share in the losses and profits, but you don’t meet any of the "tests" provided by the IRS. Therefore, you’re not materially participating in the company.
Why It’s Important for Your Taxes
Determining whether or not your participation in the daily activities of the business can affect your personal taxes. They’re highly affected if your business suffered a loss throughout the years.
The IRS usually labels any loss to a business owner who doesn’t materially participate as a passive activity loss. Typically, the government takes the view that this is similar to putting money in your savings account and letting the interest grow. You don’t add any more money to the pot or do anything else to affect it.
Rental income can also be called passive unless you’re a real estate professional. You’re not just buying an investment property to house a tenant. Passive income isn’t treated the same at tax time as income earned through active efforts.
Owners can take the full loss amount on their personal tax returns if they materially participate in the company, and it suffers losses. However, the owner’s losses are more limited if they didn’t materially participate, and the business suffered a loss. As such, you’d only claim losses on the income you reported and can’t report on the company.
Example of a Loss
You and your spouse own a business and had a $10,000 loss for the year. This is the only income you both have. Plus, your LLC operating agreement allows you to split losses and profits equally.
Your spouse actively participates in the company, so she’s allowed to deduct her full share of the loss, which amounts to $5,000. On the other hand, you don’t materially participate in the business, so you can’t deduct any of your share of the $5,000 because there wasn’t other income to offset it.
The IRS is well-known for auditing people, especially business owners, so it’s essential that you have all of your ducks in a row. That means you’ll have to prove whether or not you materially participated in the business.
To do that, you need to keep records to prove how much time you’ve spent on various activities throughout the year. Calendars, timesheets, and work logs are all excellent sources of evidence. They can all prove how much work you did and when you did it.
From this information, you can make sure that you put in the number of hours necessary to materially participate. That said, some rules stipulate that you work more than others on the same task.
If you answered over 100 hours of calls throughout the year, but the co-owner answered the same or more, you may not qualify. It just depends on whether or not other rules come into play.
How It Works for Married Couples
The rules can become confusing when a couple is involved. If you own the business and your spouse doesn’t, they can help you materially participate. When your spouse works at the same activity as you, their participation is added to your time working on the same thing.
Your spouse doesn’t have to own the company to participate in it. This rule, though, only applies if you and your spouse plan to file separate tax returns for the year.
It’s also essential that your spouse keep track of what they did, when, and how long it took to complete. That way, you have proof if the IRS decides to audit you.
The Seven Tests
Earlier, we talked about the seven indications to determine if you had materially participated in the business. These material participation tests can help you see if you are entitled to claim the losses and profits of the company. You only need to meet one of the requirements to qualify.
Many of the tests require you to have 500 or 100 hours worth of work performing certain activities. Not all the time you spend working will count for those time requirements.
For example, the time spent working as an investor isn’t going to count unless you can show that it is directly related to the day-to-day management of an activity. Taxpayers who do work that isn’t usually done by an owner is also not counted as material participation hours.
Commute time is also not to be counted for the number of hours you need. Material participation also doesn’t include work that’s taken on to allow you to claim your losses utilizing the passive loss rule. Finally, involvement as a manager where the other participants don’t receive compensation can’t be counted, either.
With that said, if you’re a limited partner in an enterprise and you own it or part of it, your participation is likely passive. You have to participate for over 500 hours, participate in five out of 10 years, or perform personal service activities.
You may group activities together. This allows you to participate in two enterprises operated by the same pass-through entity. You can qualify for material participation if you can pass one of the tests for both activities.
LLCs and LLPs
If your business is an LLC (Limited Liability Company or LLP (Limited Liability Partnership), you already know you’ve got tax advantages coming to you. However, there can also be significant disadvantages.
In the past, the IRS treated all LLP and LLC owners as limited partners for the PAL rules, which often caused significant tax issues.
Nowadays, these owners are considered general partners. Therefore, they can be a material participant if they meet one of the seven material participation rules.
- PAL Rules
The Passive Activity Loss rules don’t let taxpayers offset losses from their passive business activities against nonpassive income. Passive activities can include rental properties and limited partnerships. Nonpassive income includes capital gains, wages, interest, and more.
Any losses that you can’t cover for one year can be rolled over to any future year. Then, they can be deducted from your passive income or recovered if you sell the passive interest.
How Material Participation Can Bring Tax Deductions
The tax law focuses on both active businesses and passive investments. Let’s say you own a condo and rent it out at a loss every year. This happens because you collect rent, but it doesn’t cover the real estate tax or your mortgage.
You can depreciate the condo and make the tax loss even bigger. The question becomes: "Can you offset that loss against your business income or salary?"
Primarily, it depends on whether your real estate is passive or active. Do you materially participate in the condo as a business? If so, then it is considered active, and you can use it against your other income as a tax loss.
What Happens if There Is No Material Participation?
If you don’t materially participate, you have to store up those losses until you have a passive income, such as when you sell the condo. Of course, you may review financial documents or finance an operation. That doesn’t qualify for material participation unless you handle daily management tasks, as well.
Management activities aren’t considered if someone else is paid to handle those activities, and you choose to do them yourself. Plus, you can’t claim an activity that another person manages more than you.
The rules are highly confusing, but that doesn’t mean they are impossible to understand. It just means you have to focus on what you’ve done throughout the year. This is where trouble can arise though.
Many times, people don’t keep records of what they do and how often. It’s essential to have proof. You don’t need itemized time reports and logs, but you should show how many hours you worked on a particular activity.
An Example of Not Getting “Paid” for Your Work
Think about this. A ranch owner did not get to claim their ranch losses because they couldn’t show that they materially participated in the daily operation or management of the ranch. Plus, there was a full-time manager on the payroll.
This ranch owner owned a medical-equipment business, as well. He bought his 14,000-acre ranch and hired someone to run it. Still, he was there about 11 times and spends over 20 days there.
He hosted clients, employees, and more, but he kept no records of what work he performed. The IRS objected to the losses and claimed the activity was passive. Since the rancher couldn’t prove he spent 500+ hours working, he lost the right to file and claim the loss.
It’s never easy to understand the legal and government terms, but it’s up to you to ensure that you file taxes correctly and get what’s due to you. What does it mean to materially participate in your business?
Generally, it means you perform work that directly relates to the daily operations of the business. If you come out at a loss, you can claim it against other earned income. Consider checking out some of the best investment magazines here for more related business topics.