What is Material Participation in a Business?
Any work you do in connection with an activity in which you own an interest is treated as participation in the activity. Whether your participation constitutes material participation depends on the facts and circumstances.
If you materially participate in your business it is not considered a passive activity. Therefore, net income or loss is classified as nonpassive.
This means you may deduct businesses losses of the activity from your other nonpassive income (e.g., a spouses income, interest, dividends, income from another business in which you materially participate).
The IRS has seven tests for determining material participation. You only have to meet ONE of them EACH YEAR to qualify for nonpassive treatment of income and losses.
Material Participation Tests
The seven material participation tests include:
- You work in the activity for more than 500 hours per year, or
- You worked at least 100 hours, if no other shareholder worked more than that.
- If you have several activities, and spend more than 100 hours in each activity and the total hours for all activities add up to more than 500 hours, you are treated as a material participant in each activity. This is called the significant participation test.
- Your participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals, including non-owners, for the year.
- The facts and circumstances show that you worked on a regular, continuous, and substantial basis (IRC Section 469 and Reg. 1.469).
- You materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in question. The five tax years do not have to be consecutive.
- In a personal service activity, you materially participated for any three tax years preceding the tax year in question. The three years do not have to be consecutive. Personal services include, accounting, law, health, engineering, actuarial science, architecture, the performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
If you're married and your spouse works in the activity, his participation is treated as participation by you, even if your spouse does not own an interest in the activity and you and your spouse do not file a joint return for the year.
Proof of Participation
Proof of participation may include an appointment book calendar, or narrative summary. Your records should show the services performed and the approximate number of hours spent.
You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way.
- Return to the Tax Basics for Startups Table of Contents to find related links.