Passive Activity Loss ATG - Exhibit 4.1: Material Participation
Publication Date - December 2004
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Exhibit 4.1: Material Participation
ISSUE: Are losses limited, as taxpayer is not materially participating?
Is taxpayer materially participating in the activity; therefore, income is non-passive and cannot be used on FORM 8582 to offset passive losses?
ACTIVITY: If the return reflects several related businesses, particularly for income issues, the examiner should consider whether they should be grouped as a single activity under Reg. § 1.469-4. The grouping rules are also a position the taxpayer may raise in loss situations. The time for the taxpayer to group is when the first return with the entity was filed.
To determine material participation in an activity, the taxpayer must meet ONE of the following:
1.____ Does taxpayer and/or spouse work more than 500 hours a year in the business?
2.____ Does taxpayer do most of the work? Even if taxpayer does not meet 500 hour test, but his participation is the only activity in the business, he materially participates. Example: sole proprietor with no employees.
3.____ Does taxpayer work more than l00 hours and no one (including non-owners or employees) works more hours? Example: If owner puts in l75 hours a year and an employee works 190 hours a year, taxpayer would not meet material participation test.
4.____ Does taxpayer have several passive activities in which he participates between 100-500 hours each, and the total time is more than 500 hours? The following activities should not be included in the above test: rental activities: activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.
5.____ Did taxpayer materially participate in activity for any 5 out of l0 preceding years (need not be consecutive)? Example: taxpayer who retired and his children now run business, but he stills owns part of partnership.
6.____ Did taxpayer materially participate in a personal service activity for any 3 prior years (need not be consecutive)? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
7.____ Do the facts and circumstances indicate taxpayer is materially participating? Test does not apply unless taxpayer worked more than 100 hours a year. Furthermore, it does not apply if:
- any person, other than the taxpayer, received compensation for managing the activity; or,
- if any person spent more hours than taxpayer managing the activity.
REMINDER: Limited partners under IRC § 469(h)(2) are generally passive. The exceptions to the limited partner rule are tests 1, 5 and 6 above. If taxpayer holds both a general and limited partner interest, he will have all seven tests available.
If the answer to any of the above questions is YES the taxpayer meets the material participation standard. Losses or income should not be reflected on Form 8582, and the taxpayer may generally deduct in full the amount of the loss in the current year. If the taxpayer materially participated, losses or income are reflected on the return as non-passive.
If the answer is NO to all seven tests, the material participation standard is not met, and losses are passive. Taxpayer will be allowed losses only to the extent of passive income.
CONCLUSION: Under IRC § 469, it has been determined that the taxpayer is /is not materially participating.
Reminder: If the taxpayer does not materially participate, credits arising from the business are generally passive. In the absence of passive income, a passive activity credit is nondeductible in the current year.
Examples: investment credit, rehabilitation credit, work opportunity, disabled access, credit for employer social security and medicare taxes on employee tips, etc. See Instructions for Form 8582-CR for a list.
ADJUSTMENT: Generally, the adjustment is the full amount of the loss disallowed, unless the taxpayer has remaining passive income which has not been used to trigger other passive losses. Passive income is net income from a rental or from a business in which the taxpayer does not materially participate. Losses belong on Form 8582 line 3b (2b for years prior to 2002). As a practical matter, there is often no need to compute Form 8582 if there is no remaining passive income.