What is the Material Participation Test?

Material participation tests refer to a criterion set by the Internal Revenue Service (IRS) used to evaluate whether or not a business is a passive activity. The activity may include something like a business, trade, or any other activity that generates income. Generally, material participation consists of the activity's operations on a continual, standard, and significant basis. To participate in the material tests, you must be involved in business operations.

How Do Material Participation Tests Work?

Note that when you are actively participating in your business, it is taken to be a non-passive activity. Therefore, any net income or loss the business generates becomes a non-passive income. This means that you can deduct business activity's losses from your other active income. Examples of other income include dividends, spouses income, interests, and income from your other business where you are an active participant. Passive income occurs when a taxpayers participation does not meet any of the seven material participation tests. Rules to do with passive activity do limit the deductions made from active losses.

Tests for Determining Material Participation

The IRS has seven tests it uses to determine whether or not you are a passive investor in your material participation. For you to qualify as a material participant, you have to pass one of the seven tests each year. The tests are as follows:   

You should have participated in the activity for over 500 hours in the tax year  

Participation in the activities must be regular, constant, and significant. The person evaluating should be able to determine whether the quantity of time recorded makes sense with regard to the obligations.   

Your participation in the activity for the year was substantial and all the participants including the activity of all individuals who earned nothing in the activity   

It means that if the taxpayer did most of the work, the classification of his income or loss will be non-passive. Note that if a non-owner or an employee takes part in the activity, it may cause that person to fail the test. Also, the test has no time allocation   

During the tax year, you should have participated in the activity for not less than 100 hours, and your involvement was more than the rest of the individuals   

The test requires that as a participant, your involvement in the activity or work should exceed that of other participants. It means that for more than the 100 hours you have been able to work, no one else managed to exceed this target. In a nutshell, for you to qualify, the hours you worked should be more than the rest.   

Your participation in the activity should have been significant during the tax year, and the activities you participated in lasted for more than 500 hours   

Under these tests, the regulation requires the participant to engage in activity for not less than 100 hours during the tax year. Also, the activity should not be an investment or a rental but a business with passive activity. All the activity hours should total to 500 hours.   

The events in the records should show that your participation in the activity was regular, continuous, and significant   

The test requires that you participate in the activity for 5 years (not necessarily consecutive) out of the previous 10 years. The test applies where a taxpayer stops taking part in material participation but continues to own interest in the activity.   

You must have materially participated for 3 years (not necessarily consecutive) preceding the tax year in a personal service activity.   

An activity is considered a personal service activity when there is a performance of personal services in the following fields:

• Health (this includes veterinary services)
• Consulting
• Performing arts
• Engineering
• Law
• Accounting
• Architecture
• Actuarial science

  Basing on the entire circumstances and facts, you must have on a continuous, regular, and considerable basis participated in the activity during the tax year   

The tests on facts and circumstances apply where the participant has not been able to meet the requirements of the other six tests. However, this one applies only if the taxpayer was able to work for more than 100 hours every year. Also, the time of the taxpayer spent will not count if:

• Any individual who received compensation form managing the activity
• Any individual spent extra hours that the taxpayer managing the activity

About Married Couples

Note that if you are married and your partner participates in the activity, his or her participation becomes your participation too. It happens even if your spouse does not own a share of interest in the activity. Also, if both of you (you and your spouse) don't file tax returns jointly.

Proof of Participation

As a taxpayer, you can present proof of your participation using various records. The records should be able to demonstrate the services you performed, including the number of hours spent. Generally, it crucial to always keep the requirement records once you feel that you qualify to be a material participant. The records will act as proof to show that you were an active participant in the business. Some of these records include the following:

• Timesheets
• Work logs
• Calendars

Active Participation vs. Passive Participation

For tax purposes, it is good if you are able to distinguish between passive and active participation. If you qualify in becoming an active participant, you can use losses from your business to offset your salary or your other business income sources. According to the IRS, the following are indications for both active and passive participation:   

Active Participation  

• Awarding and terminating employees employment contracts (hiring and firing)
• Managing activities or making decisions in the task
• Personally participating and performing some of the activity's services

Passive Participation  

• Where the manager is an independent contractor
• Where a taxpayer is not authorized to operate the activity but only have the authority to remove the manger and not the employees

Note that as a taxpayer, you can claim a passive loss against the income from passive activities only. In case there is any other passive activity loss, it is carried forward to the years that follow until it is used. Another alternative is that it is deducted in the year when the taxpayer gets rid of the passive activity in a taxable transaction.

The Bottom Line

Most business owners look forward to disengaging themselves from the daily running of a business and instead enjoy the earnings from the business without being actively engaged in work. A good example is the real estate investors. For maintenance of their real estate, they will always outsource a profession or a firm that can manage and maintain their estates. As much as it sounds like a good idea, this situation is likely to lead to high taxes. However, most investors avoid such high taxes through material participation. Note that for any money you make from a business must pass any of the SECs tests for your income to be subject to deductions. If you are not participating in your business, then you may lose the tax deductions you used to enjoy while you were an active participant. In addition, your income is likely to be categorized as unearned so that it can be taxed. Generally, how your income is classified makes a big difference. For high earners, there are surtax charges amounting to 3.8 percent on any unearned income. So, if your business happens to be in this class of income, then you are likely to owe more taxes. The only way to avoid this is when you pass any of the material test participation tests.