Material Participation Tests

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.

Understanding Material Participation Tests

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 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.

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.

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 one, three, four, or seven.

Time spent as an investor will not count unless they can show direct involvement in the day-to-day management of the activity. 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.