Taxpayers who run up tax losses in a business must be prepared to prove that one of
the material participation tests was passed to avoid having the losses characterized
as a passive activity loss (PAL) that cannot be currently deducted. Adequate
contemporaneous records that detail the taxpayer's tasks and time spent in the
activity are crucial in attempting to sidestep the PAL rules. Records created
after-the-fact are better than nothing, but they are much less believable than
contemporaneous records. If losses are disallowed by the IRS, interest and penalties
may be added to the unpaid taxes.
In general, an individual taxpayer can meet the material participation standard by
passing one of the following seven tests outlined in the regulations:
- More-than-500 hours. This test is passed if the taxpayer spends
more than 500 hours in the activity during the tax year in question.
- More-than-100 hours and more-hours-than-anyone-else. This test
is passed if the taxpayer participates in the activity for more than 100 hours
during the tax year and no other taxpayer participates more, including taxpayers
who are not owners.
- Substantially all. This test is passed if the individual's
participation in the activity for the year constitutes substantially all of the
participation in the activity for all individuals (including nonowners).
- Significant participation activity. This test is met if the
individual's aggregate participation in all activities in which he or she
participated for more than 100 hours during the year (significant participation
activities) exceeds 500 hours for the year.
- Material participation in the last five years. This test is
passed if the individual materially participated in the activity for any five tax
years during the 10 immediately preceding years.
- Personal service activity. This test is passed if the individual
materially participated for any three preceding tax years by performing services
in the fields of health, law, engineering, architecture, accounting, actuarial
science, performing arts, or consulting.
- Facts and circumstances. This test is passed if, based on all
facts and circumstances, the taxpayer is found to have participated in the
activity on a regular, continuous, and substantial basis during the year in
In attempting to pass the material participation tests, taxpayers can prove their
participation levels by any reasonable means. This can include identifying the types
of work performed and the approximate number of hours spent performing such work with
contemporaneous appointment books, calendars, narrative summaries, and the like.
Several court decisions have said that, while the regulations permit flexibility
regarding what it takes to prove material participation, courts are not required to
accept after-the-fact "ballpark guesstimates" or a taxpayer's unverified,
undocumented, and presumably self-serving testimony.
This publication is distributed with the understanding that the author, publisher and
distributor are not rendering legal, accounting or other professional advice or
opinions on specific facts or matters, and, accordingly, assume no liability
whatsoever in connection with its use. The information contained in this newsletter
was not intended or written to be used and cannot be used for the purpose of (1)
avoiding tax-related penalties prescribed by the Internal Revenue Code or (2)
promoting or marketing any tax-related matter addressed herein. © 2015