Material participation

Material participation occurs when a taxpayer is involved in a business on a regular, continuous, and substantial basis. If so, the taxpayer can check off a "material participation" box on his Form 1040. An outside investor in a business is probably not engaged in material participation in the business, since he is merely providing funds to the entity. Conversely, the general manager of a business is engaged in material participation, being actively involved in any number of business decisions.

Tasks commonly associated with an investor do not qualify a person for material participation. Thus, reviewing financial statements, providing advice, or monitoring operations without any active engagement in the business are not sufficient. Instead, the person is considered to be a passive investor.

The key difference between material participation and passive investing is that a passive investor can only deduct passive activity losses from passive activity income. Passive activity income is the proceeds from financial investments where the person is not actively involved in the business. The outcome of this distinction is that a passive loss that exceeds the amount of passive income cannot be used as a deduction until a later tax year in which there is more passive income available to use as an offset.

The IRS has set up several criteria that a taxpayer can use to see if he has materially participated in a business. Some of these criteria are:

  • The taxpayer worked at least 500 hours in the business during the tax year; or
  • The taxpayer did nearly all of the work in the activity; or
  • The taxpayer worked more than 100 hours in the activity and no one else worked more hours; or
  • The taxpayer has materially participated in the activity in any 5 of the last 10 years.

The IRS is less likely to allow a claim of material participation if the taxpayer lives a considerable distance from the place of work, or oversees a number of businesses or investments, or was not compensated by the business.