For income tax purposes, business income and losses are categorized as either passive or non-passive. If you do not materially participate in a business, income and loss from the business are treated as passive. Losses from passive activities are only deductible against income from passive activities. Any excess passive loss is suspended and must be carried forward to future years. Also, upon a complete taxable disposition of the activity, you will be able to utilize the suspended losses.
You determine material participation during the tax year based on the time you spend in a business activity. For most business owners, the issue rarely arises for your primary source of income since you probably spend more than 40 hours per week working on that business. However, when you have secondary businesses or investments, you will need to determine if you materially participate in the business or investment to determine whether it is a passive activity. In addition to passive loss limitations, these rules are also applied in determining net investment income for the 3.8% Medicare tax.
Material Participation Tests
Material participation requires that you must spend time on an activity on a regular, continuous, and substantial basis.
You must also generally meet one of the following tests for material participation. In some cases you may be able to aggregate certain activities to meet these rules:
You work more than 500 hours during the year in the activity,
Your participation in the activity constitutes substantially all of the participation in the activity during the year (including non-owners),
You participate in the activity for more than 100 hours during the year, with no one else working more than you (including non-owners),
You participate in significant business activities for more than 100 hours during the year. If the total hours spent in all significant business activities exceeds 500 hours, each significant activity of more than 100 hours will be treated as a material participation activity.
- You materially participate in the activity for any five taxable years during the 10 tax years immediately preceding the taxable year (the participation does not have to be consecutive),
- The activity is a personal service activity and you materially participated in the activity for any three taxable years preceding the tax year (the participation does not have to be consecutive),
- Activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or
- Any other trade or business in which capital is not a material income-producing factor, or
- Based on all of the facts and circumstances (with limitations imposed by the IRS), you participate in the activity on a regular, continuous, and substantial basis and participate for more than 100 hours during the year.
Rental activities are generally considered passive activities, but there are circumstances where you may claim material participation. You must generally work more hours and meet additional tests.
You should maintain adequate records of your participation in the activity to prove your material participation. A good, contemporaneous diary or log of your activities and time spent should provide appropriate evidence to rebut an IRS challenge.
Passive activity losses are a complicated area of the tax code so, if you have questions contact me at HZemel@berdonllp.com or your Berdon advisor.
Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.