In my youth, I was fascinated by all things weird and wonderful. The natural wonders of the world, such as the Grand Canyon or Aurora Borealis, were impressive for their scale and beauty. However, the man-made wonders were impressive not only for their scale and beauty but also for the fact that they sprung from the minds of men and made real through years of hard work.
I was in awe and fueled my interests through the joy of reading. I always held a love for books and looked forward to trips to the local library, so I could find an armful of books that I could read and fill my book log during the annual summer reading program.
While surely not on anyone’s top seven list, the Internal Revenue Code is most definitely a man-made wonder. Few would agree that is it beautiful and, while it is incredibly massive compared to other texts, a walking tour of the printed code isn’t going to require you to bring a water bottle or sunscreen. However, what it lacks in beauty and physical presence is more than made up for by its complexity and the impact it has on taxpayers around the world.
One of the complex areas of the code are the material participation tests which impact many taxpayers, particularly those that generate income and losses from numerous business activities. If a taxpayer does not pass one or more of the material participation tests for an activity, it is considered a passive activity and is subject to the Passive Activity Loss (“PAL”) rules which determine the timing of tax deductions for losses generated by passive activities. In general, the PAL rules limit the deduction of passive losses to the extent you have passive income from other sources. A full discussion of the PAL rules and related tax planning, particularly in regards to rental real estate, are beyond the scope of this article which focuses solely on the material participation tests.
What are the material participation tests?
An individual is considered to materially participate in an activity, and therefore not subject to the PAL rules, if they meet any one of the following seven tests:
- More Than 500 Hour Test: The taxpayer participates in the activity for more than 500 hours during the year.
- Substantially All Test: The taxpayer’s participation in the activity during the year constitutes substantially all of the participation by all individuals, including non-owners.
- More Than 100 Hours Test: The taxpayer’s participation is greater than 100 hours during the year and no other individual participates more hours than the taxpayer.
- Significant Participation Activity (“SPA”) Test: The activity is an SPA in which the taxpayer participates more than 100 hours during the year and the taxpayer’s annual participation in all SPAs is more than 500 hours for the year. An SPA is an activity in which the taxpayer participates for more than 100 hours during the year and in which the taxpayer does not materially participate under any of the other six material participation tests.
- Prior-Year Material Participation Test: The taxpayer materially participated in the activity for any five of the preceding 10 tax years.
- Personal Service Activity Test: The activity is a personal service activity (e.g. healthcare, law, accounting, architecture, consulting, etc.) in which the taxpayer materially participated for any three tax years preceding the current tax year.
- Facts and Circumstances Test: Depending on the specific facts for the taxpayer, this test is met if they spent more than 100 hours on an activity in which they participate on a regular, continuous, and substantial basis during the year.
What hours count toward the material participation test requirements?
Unfortunately, not all hours count toward the requirements to meet the material participation tests. There are two main types of hours that do not count toward material participation:
- Hours spent as an investor for the taxpayer’s own benefit are not counted toward the hour requirements, unless the taxpayer is also directly involved in the day-to-day management or operations of the activity. For example, if you review the financial statements and analyze the data for your own use, not in a managerial role for the activity, the hours will not count.
- Hours spent performing work not customarily done by an owner when one of the principal reasons for performing the work is to avoid disallowance of a loss under the passive activity loss rules. For example, hours spent serving as a receptionist with a principal motive of avoiding disallowance of a loss under the passive activity loss rules would not be considered as participation hours since that work is not customarily performed by an owner of a business.
On a positive note, if a taxpayer’s spouse materially participates in an activity, the taxpayer is deemed to materially participate in the same activity. This applies even if the spouse does not own an interest in the activity. This is consistent with many other sections of the Internal Revenue Code which treat a married couple as a single taxpayer.
How do you substantiate participation in an activity?
The extent of an individual's participation in an activity may be established by any reasonable means. While contemporaneous daily time reports, logs, or similar documents are not required, if the extent of such participation may be established by other reasonable means, it is highly recommended that such records be maintained to support the taxpayer’s position. Reasonable means may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
I hope this quick tour around a tiny portion of the man-made wonder that is the Internal Revenue Code wasn’t too taxing and that you can walk away from it without any blisters on your feet.
If you have any questions about what other books I am reading this summer or the material participation tests, please feel free to contact me at email@example.com or any of the other Zinner & Co. tax professionals at 216-831-0733. We are ready to start the conversation.