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Passive Activity Loss ATG - Chapter 4, 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.

Chapter 4, Material Participation

In a Nutshell

A taxpayer materially participates in an activity if he or she works on a regular, continuous and substantial basis in operations (IRC § 469(h)(1)). If a taxpayer does not materially participate, losses are passive, which means they generally are not deductible in the absence of passive income. Material participation is time sensitive. A taxpayer materially participates in an activity only if he or she meets any one of the seven material participation tests in Reg. § 1.469-5T(a).

A taxpayer is required to identify the amount of his or her participation in a trade or business activity for each year. The type and quantity of time documented determines whether an activity should be treated by the taxpayer as passive or non-passive.  A taxpayer can have a significant financial interest in a business, and yet not materially participate.

Material participation is a year by year determination.  Consequently, it is conceivable that a taxpayer could be passive in one year and non-passive (in other words, materially participating) in the subsequent year.

It is essential for an examiner to determine if reported losses are classified properly on a given return.  Losses from businesses, whether conducted as a Schedule C, Schedule Form, partnership or S Corporation, are passive if the taxpayer does not materially participate.  See checksheet, decision tree and log at end of chapter.

The rules discussed in this lesson are applied at the Form 1040 level for individuals involved in partnerships and S Corporations.

Material participation does not apply to the following activities:

  • Rentals are generally passive, whether or not the taxpayer materially participates.  However, rental real estate interests of real estate professionals are subject to the material participation tests.  See Reg. § 1.469-9(e)(1).
  • Working interests in oil and gas activities are excepted from the passive loss limitations.  If liability is not limited, the taxpayer has a “working interest”.
  • Income from a partnership or S Corporation that trades in stocks, bonds or securities for the accounts of the partners or shareholders is non-passive. Income or losses, even from a limited partnership interest, may be deducted as non-passive.   See Reg. § 1.469-1T(e)(6).

Activity Defined

Regulation § 1.469-4 provides the definition of an activity.

A trade or business activity is an activity that:

  • Involves the conduct of a trade or business (within the meaning of IRC § 162);
  • Is conducted in anticipation of starting a trade or business; or,
  • Involves research & development expenditures that would be deductible under IRC § 174.

There are only two business activities that are excepted from the passive loss rules:

  1. working interests oil  and gas activities;[1] and,
  2. traders in stocks & bonds[2].

Grouping of Activities

Related businesses that form an appropriate economic unit are treated as a single “activity”.  Related businesses conducted via a Schedule C, partnership, C or S Corporation, or limited liability company may be grouped into one activity.  An “activity” is not constrained by entity lines.  See Reg. § 1.469-4(c) and 1.469-4(d)(4).

It is also possible that several different activities may exist within a single entity:  two unrelated businesses, or a business and a rental activity.

By grouping related businesses as a single activity, the taxpayer can more easily meet the 500-hour test for material participation discussed below.  Before considering the material participation tests, the examiner should identify related businesses and determine if the taxpayer has grouped any to form a specific “activity”.  Ask- or Issue an IDR - asking if the taxpayer has grouped any activities under Reg. § 1.469-4; to explain why the grouping is appropriate; and when the grouping decision was made.   See Chapter 8.

A trade or businesses is a passive activity if the taxpayer does not materially participate.  The taxpayer materially participates if and only if he or she meets one of the following seven tests provided in Reg. § 1.469-5T(a).  See checksheet and log at end of chapter.

  1. The taxpayer works 500 hours or more during the year in the activity.
  2. The taxpayer does substantially all the work in the activity.
  3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  4. 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.
  5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
  6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
  7. 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.[3]

Note: The first four tests look to a set number of hours of participation in the tax year.  The next two tests look to material participation in prior tax years.  The final test looks to the facts and circumstances, but is highly restrictive.

Material participation applies to income as well as to losses.  One of the purposes of the last four material participation tests is to prevent the taxpayer from “failing” material participation when the activity generates income instead of losses. 

For tiered entities, the look-through rule in Reg. § 1.469-2T(e)(3)(ii)(D)(3) treats the taxpayer as holding an interest in a subsidiary entity.  In other words, the examiner will look to the lowest tier for participation by the individual taxpayer.  Thus, for example, if the individual taxpayer fails to materially participate in a partnership which flows losses to an S Corporation in which he is a shareholder, losses are generally passive to him.

500 Hours

If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive.  Participation of both spouses is counted, but not participation of the children or employees.

Participation in operations must be regular, continuous, and substantial. The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.

Examination Techniques:

  • Review W-2s and other non-passive activities.  Does it seem likely that the taxpayer could spend 500 hours on the activity in light of other employment obligations?
  • Ask questions on taxpayer activity time early in the examination.  Establish time the taxpayer spends on all activities during the initial interview if possible.  See exhibit with log at the end of the chapter.
  • Determine the location of each activity.  If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?

Substantially All

Stated simply, if the taxpayer does most of the work,  income or loss will be  non-passive.  The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test.

Note: There is no specific number of hours associated with this test.  In addition, the term “substantially” is not defined in the regulations.

100 Hours

If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.

Examination Techniques:

  • Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C & F).
  • When reviewing taxpayer hours, watch for “investor” activities (Reg. § 1.469-5T(f)(2)(ii)).  The taxpayer must be involved in the activity’s day-to-day management or operations.  Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.

Significant Participation Activities (SPA)

The term significant participation activity is unique to Reg. § 1.469-5T.   If the sum of the taxpayer’s time in all SPAs is more than 500 hours for the year, then income or losses from the businesses are non-passive.  For each SPA, the regulations require:

  • The taxpayer to participate more than 100 hours during the year.
  • The activity must be a business, i.e. it cannot be a rental or investment activity.
  • The business must be a passive activity. Thus, if the taxpayer works more than 500 hours in the business, it is not a SPA as 500 hours is one of the qualifying tests for material participation.  Similarly, if the taxpayer does most of the work in the business, it cannot be a SPA as Reg. § 1.469-5T(a)(2) holds that performing substantially all the work qualifies for material participation.

Any 5 of the Last 10 Years

An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive).  This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity.

Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

Any 3 Years in a Personal Service Activity

If a taxpayer materially participated for any three prior taxable years in a personal service activity the current year income or loss will be treated as non-passive.  It does not matter whether those three prior taxable years were consecutive.

Personal service activity means services performed 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.

Facts and Circumstances

The facts and circumstances test may apply if none of the other tests are met.  This test does not apply unless the taxpayer worked more than 100 hours a year.  Furthermore, the taxpayer’s time spent managing will not count if:

  • Any person received compensation for managing the activity; and,
  • Any person spent more hours than the taxpayer managing the activity.

Examination Techniques:

  • Taxpayers may argue the facts and circumstances test when they fail the others.  However, due to the stringent limitations, few taxpayers can meet the facts and circumstances standard.  If there is paid on-site management, the facts and circumstances test cannot be used.


Indicators that the taxpayer did not materially participate:

  • The taxpayer was not compensated for services.  Most individuals do not work significant hours without expecting wage or commissions.
  • The taxpayer's residence is hundreds of miles from the activity.
  • The taxpayer has a W-2 wage job requiring 40+ hours a week for which he or she receives significant compensation.
  • The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
  • There is paid on-site management/foreman/supervisor and/or employees who provide day-to-day oversight and care of the operations.
  • The taxpayer is elderly or has health issues.
  • The majority of the hours claimed are for work that does not materially impact operations.
  • Business operations would continue uninterrupted if the taxpayer did not perform the services claimed.

What are My Issues?

  • Does the taxpayer work on a regular basis in the operations of the partnership, S Corporation, Schedule C, or farm?  If not, losses generally are not deductible.
  • Has the entity been grouped by the taxpayer with another related entity as a single activity?  If grouped with a business where the taxpayer works regularly, losses will be deductible.
  • Is the entity a significant participation activity (SPA)?  If so, are there other SPAs (passive businesses) with which it can be grouped, and does the sum of all SPA hours exceed 500 hours for the tax year?  If activity is a SPA and there are other SPAs with time over 500 hours, losses are deductible.
  • Is the time claimed plausible in terms of the taxpayer’s other commitments or from a common sense standpoint? Should portions of time be discounted as they are investor-type hours or work not customarily done by an owner?

Limited Partners The IRC § 469(h)(2) presumes that limited partner interests are per se passive, and losses are therefore not deductible unless the taxpayer has passive income reported on the return.

There are three exceptions to the limited partner passive taint[4]:

  • The taxpayer works 500 hours or more in the trade or business activity.
  • 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.

If a taxpayer holds both a general and a limited partnership interest all year, he may use any one of the seven tests to qualify for material participation.[5]

Examination Techniques:

  • Scrutinize losses claimed in the non-passive column of Schedule E.  Is the employer identification number out of state?
  • Review Schedule K-1s.  Is the taxpayer a limited partner?  Does he have a small ownership interest?
  •  A 3-year comparative analysis of passive and non-passive losses using current, prior and subsequent year data may reveal inconsistencies.
  • It is critical that you consider what is reasonable.  The taxpayer’s total time commitments should be considered.  Consider the taxpayer’s W-2 job, the commute, the travel and out-of-town requirements, in addition to personal commitments to children or other special circumstances.
  • When examining a partnership or S Corporation, question the level of participation of each investor.  You may want to focus on those who are limited partners or who have a small ownership interest or who live out of town, as they are most likely to be passive.

Reminder:  If the activity of the entity is equipment leasing or rental real estate, losses are generally passive to the investor.

Treatment of Former Passive Activities

A former passive activity is an activity that is non-passive in the current year, but was a passive activity in prior years.  If the former passive activity generates net income, suspended passive losses from prior years can offset that net income.  Remaining suspended losses are treated like any other passive loss.  Passive losses can only be offset against passive income.  Unused suspended losses may be carried forward indefinitely.  Change in status does not constitute a qualifying disposition.

Methods of Proof

To meet the recordkeeping requirements of Reg. § 1.469-5T(f)(4), the taxpayer must establish his participation by reasonable means.  Reasonable records may include:

  • An identification of the services provided; AND,
  • The approximate number of hours spent, based on appointment books, calendars, or narrative summaries.

Contemporaneous daily records are not required if the taxpayer’s participation can be reasonably established.  If records provided are not reasonable, i.e. there is a credibility issue, you may request contemporaneous records.  The courts have repeatedly taken a dim view of self-serving guesstimates of time.  See Scheiner, Tax Court Memo 1996-554, 72 T.C.M. (CCH) 1532 and Carlstedt Tax Court Memo 1997-33, 74 T.C.M. (CCH) 170.

Examination Techniques:

  • Questions regarding material participation should be asked as early in the examination process as possible, preferably during the initial interview. The log in the exhibit at the end of the chapter is a good document to give to the taxpayer to establish his services and hours.
  • Time claimed should be scrutinized for investor-type time and work not customarily performed by an owner, which are specifically excluded in the hourly tests for material participation.  See Reg. 1.469-5T(f)(2)(ii).
  • If hours provided are suspicious, appear inflated, or there is a credibility issue, be sure to state so in your report with examples.

Qualifying Participation

Once the taxpayer provides the type of participation and the approximate hours spent performing that participation, a determination can be made as to whether that participation qualifies.

General Rule

Work performed by an individual or the spouse will be considered unless it falls in one of the exceptions listed under "Non-qualifying Time." 

Work performed by either spouse will be considered even if the spouse does not own an interest in the activity.[6]

Non-Qualifying Time

While the taxpayer may have spent time working on various aspects of the activity, certain hours do not count in the tests for material participation:

Investor-type activities do not count unless the taxpayer is directly involved in day-to-day management or operations.  The Reg. § 1.469-5T(f)(2)(ii)(B) provides that the following types of activities do not count unless the taxpayer is directly involved on a day-to-day basis in management or operations:

  • Studying or reviewing financial statements or reports.
  • Preparing or compiling summaries or analyses for the individual’s own use.
  • Monitoring finances or operations in a non-managerial capacity.

The above list is not all inclusive.  Other activities could be investor-type activities such as organizing records, preparing taxes, and paying bills[7].

Work not ordinary done by an owner is not counted if it is claimed in an effort to avoid the passive loss limitations.  This would be work performed by an owner that would normally be assigned to an employee.  Generally the taxpayer/owner has no reason to include these services in the hourly computations other than in an attempt to avoid disallowance of losses under IRC § 469[8].

Travel Time generally should not be considered in computing the hourly tests for material participation, particularly if other factors indicate the taxpayer is not participating in the activity on a regular, continuous and substantial basis.[9].  Legislative history provides that "services must be integral to operations".  It is somewhat difficult to construe that travel constitutes "services" or "participation" as contemplated by Congress or the Regulations.  More importantly, travel is not integral to operations in most cases.

Supporting Law

  • IRC § 469(h):  The taxpayer materially participates if he is involved in the operations of an activity on a regular continuous and substantial basis.
  • IRC § 469(h)(5), Reg. 1.469-5T(f)(3), Reg. 1.469-1T(j):  Participation of both spouses counts.  Income or losses for both spouses are non-passive, even if only one spouse rises to any of the seven tests for material participation.
  • IRC § 469(h)(4):  Material participation rules for closely held C- Corporations and for personal service corporations.
  • Reg. § 1.469-5T(a):  The taxpayer materially participates if and only if he or she meets one of 7 tests in each separate tax year.
  • Reg. § 1.469-5T(a)(7) & 1.469-5T(b):  Facts and circumstances test is not applicable unless the taxpayer works more than 100 hours and more than anyone else does.  This test is also not applicable if anyone, other than the taxpayer, is paid compensation for managing the activity.
  • Reg. § 1.469-5T(e):  A taxpayer is excepted from the limited partner taint if he works 500 hours during the year or materially participated 5 of the prior 10 years or materially participated in a personal service activity for any three prior years.
  • Reg. § 1.469-5(f)(1):  The taxpayer must own an interest in the activity at the time the work is done  (See Example 6 in the regulations).
  • Reg. § 1.469-5(f)(2)(i):  Work not customarily done by an owner is not counted.
  • Reg. § 1.469-5T(f)(2)(ii):  Investor-type activities are not counted unless the taxpayer  is directly involved in day-to-day management or operations of the activity.
  • Reg. § 1.469-5T(f)(4):  Reasonable means for proving hours requires:
    1. an identification of services provides; and,
    2. hours spent performing those services during the year based on appointment books, calendars, narrative summaries.
  • Reg. § 1.469-4 Related business may be grouped as a single activity, making it easier to meet the 500-hour test.  Rentals, however, may not be grouped with businesses unless they are insubstantial or owned in the same percentage as the business[10]


  • Related businesses may be grouped as a single activity, making it easier to meet the 500 hour test for material participation.
  • A taxpayer materially participates if and only if he meets one of seven tests for material participation.
  • While limited partners are presumptively passive[11], there are three exceptions to the limited partner taint[12], the most common being that the taxpayer works more than 500 hours during the year in the business.
  • Net income from a former passive activity, even though non-passive, may offset prior year losses from the same activity.
  • If the taxpayer has not provided both services performed and hours attributable to those services, he does not meet the record-keeping requirements of IRC § 469.
  • Certain hours, even if performed, are not counted in the hourly tests for material participation, most notably time spent performing activities typical of an investor.

[1] IRC § 469(c)

[2] Reg. § 1.469-1T(e)(6) 

[3] Reg. § 1.469-5T(b)  

[4] Reg. § 1.469-5T(e)(2)   

[5] Reg. § 1.469-5T(e)(3)(ii) 

[6] IRC § 469(h)(5) and Reg. § 1.469-5T(f)(3) 

[7] W.A. Barniskis, 78 TC Memo 226, December 53,486(M), TC Memo 1999-258

[8] Reg. § 1.469-5T(f)(2)(i) 

[9] We have no express statutory guidance on travel.  While not precedent setting and just a summary opinion, the following case provides guidance on travel time:  Thomas E. Truskowsky, T.C. Summary Opinion 2003-130

[10] Reg. § 1.469-4(d)(1) 

[11] IRC § 469(h)(2)

[12] Reg. § 1.469-5T(e)(2), Reg. § 1.469-5T(e)(3)(ii)   

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