What is Material Participation?
Material participation is a set of criteria the Internal Revenue Services (IRS) uses to determine taxpayers’ level of participation in their income-producing activity.
The IRS uses the Material Participation test to determine whether a taxpayer’s source of income is generated by actively participating in a business venture or through passive income.
There are seven tests the IRS set to scrutinize taxpayers. To qualify as a material participant, a taxpayer needs to pass only one out of the seven tests. The test is as follows:
- Engagement in the activity for more than 500 hours during the tax year.
- You did most of the work involved in the business.
- At least 100 hours more than any other individual were spent in the activity.
- Participation in the activity is significant, and the total value of all the activities you participated in exceeds 500 hours.
- You participated in the activity during any five of the preceding ten taxable years.
- Your income-producing activity is a personal service, and you materially participated during the three years before the current tax year.
- Regular participation in the activity for more than 100 hours during the tax year.
Meeting one of the seven tests in a tax year qualifies a taxpayer to deduct the full amount of losses on their tax returns. However, a drawback to the test is that it is applicable for only a tax year. For instance, if you pass the test this year, next year you still need to retake it.
Generally, any income-generating activity where one’s participation is regular, continuous, and substantial is Material participation. While any income-generating where one’s participation is non-regular, continuous, and substantial is passive participation.
Material Participation Example
If you were to start a car washing business alone. In the first year, you log 700 hours of activity. That qualifies you as a material participant. If in the third year of the business, you decide to hire people to help you, and you log 200 hours, you do not qualify as a material participant.« Back to Glossary Index