Material Participation

Material participation is the most important factor in determining if an income or loss is considered passive or active. If you materially participate, the resulting income/loss is generally classified as active (or non-passive) and is not subject to the PAL limitations.

The IRS provides seven tests to determine if a taxpayer materially participates in a trade or business activity

If a taxpayer meets any one of these seven tests for a trade or business activity, they are deemed to have materially participated, and the income/loss is classified as Active (not subject to the PAL limitations).

The 500-Hour Test

The taxpayer participates in the activity for more than 500 hours during the tax year.

Note: This is the most common and definitive test.

The Substantially All Test

The taxpayer's participation in the activity constitutes substantially all of the participation in the activity of all individuals (including non-owners and employees) for the tax year.

Example: A sole proprietor who runs a small business and does all the work himself.

The 100-Hour/No One Else Test

The taxpayer participates for more than 100 hours, AND no other single individual participates in the activity for a greater number of hours than the taxpayer.

Purpose: This test ensures a modest time commitment still qualifies if the taxpayer is the primary participant.

The Significant Participation Activity (SPA) Test

The activity is an SPA, AND the taxpayer's aggregate participation in all SPAs exceeds 500 hours.

Definition of SPA: A trade or business activity in which the taxpayer participates for more than 100 hours but does not otherwise meet any of the other six tests.

Purpose: This test allows taxpayers to aggregate several smaller activities to reach the 500-hour threshold.

The Prior Participation (5-Out-of-10) Test

The taxpayer materially participated in the activity (by meeting any of the other six tests) for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.

Purpose: Designed for activities where the taxpayer has a long-term, established history of participation.

The Personal Service Activity Test

The activity is a personal service activity, and the taxpayer materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.

Definition: An activity principally involving the performance of personal services in fields like health, law, accounting, consulting, etc.

The Facts and Circumstances Test

Based on all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.

Constraint: The taxpayer's participation for the tax year must be more than 100 hours. Also, management services only count if specific conditions are met (e.g., no one else is compensated for managing, and no one else's management time exceeds the taxpayer's).