Material Participation Is a Records Question

What turns on it

Section 469 divides activities into passive and non-passive. A loss from a passive activity can generally only offset passive income. It cannot reduce your salary, your bonus, or income from a business in which you materially participate.

Which means the entire value of a structured position frequently turns on a single determination: did you materially participate. Get it right and the loss reaches your actual liability. Get it wrong and you hold a suspended loss that waits, possibly for years, for passive income that may never arrive.

The seven tests

The regulations provide seven. Satisfying any one is sufficient.

1. 01More than 500 hours in the activity during the year. The workhorse test and the one most positions are built around.
2. 02Your participation constitutes substantially all of the participation by anyone in the activity, including non-owners.
3. 03More than 100 hours, and not less than the participation of any other individual.
4. 04The activity is a significant participation activity, meaning more than 100 hours, and your aggregate significant participation across all such activities exceeds 500 hours.
5. 05You materially participated in any five of the prior ten years.
6. 06The activity is a personal service activity in which you materially participated in any three prior years.
7. 07Facts and circumstances demonstrating regular, continuous and substantial participation, with a 100-hour floor.

The tests are evidentiary, not aspirational

Here is the part that decides outcomes. The regulations permit participation to be established by any reasonable means, which sounds generous and is not.

What survives examination is a contemporaneous record: a log kept as the work was done, with dates, duration, and a description specific enough that somebody else can tell what was actually performed. What does not survive is a reconstruction produced after a notice arrives, however sincerely it was compiled.

Where it commonly fails

• Investor hours. Time spent reviewing financials or monitoring performance in a non-managerial capacity generally does not count, which removes a large part of what many holders were counting.
• Work not customarily done by an owner. Activity undertaken mainly to clear an hours threshold can be disregarded.
• Travel. Frequently counted by taxpayers and frequently challenged.
• Someone else does more than you. The 100-hour test fails the moment a manager or contractor exceeds your hours, and nobody checks until it is too late.
• Grouping assumed rather than elected. Whether activities can be treated as one is a formal question, not a convenience.

Where this lands

1. 01Decide which test you are relying on before the year starts. Different tests require different evidence and different behavior.
2. 02Keep the log as you go, weekly at worst. This is the whole ballgame and it costs minutes.
3. 03Find out how many hours everyone else puts in, if you are relying on the 100-hour test. That number is not yours to control and it decides the test.
4. 04Be sceptical of any structure where participation is asserted in the marketing rather than evidenced in your calendar. If the sponsor cannot tell you precisely what you will do and for how long, they are describing an outcome they cannot deliver.