The The IRS has determined that an individual materially participates in business activities if he or she participates on a "regular, continuous and substantial basis." If it is determined that an individual's participation is not material, he/she cannot deduct losses to the same extent as a business owner who does materially participate in the business.
Material participation is determined each year. The IRS has seven tests to determine material participation:
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
Determination of "material participation" is complicated, and lack of material participation can result in passive loss rules. If you think lack of material participation may be an issue in your business, check with your tax adviser.
An example for clarification:
Joe and Sally Cotler are a husband and wife who are members of an LLC. Each of them has a 50% membership percentage. Sally does the majority of the work in the business; Joe offers comments and suggestions, and he occasionally helps with fixing things. He does not work over 100 hours a year, so he is not materially contributing to the business. In this case, his lack of participation would not allow the Cotlers to elect to be a Qualified Joint Venture.