Defining Material Participation

If you haven’t looked at last week’s blog (“Reclassifying Non-Passive Income”), we suggest you do that first. Last week, we focused on classifying activities as either passive or non-passive. This week, we want to look at the rules of material participation. When intentionally trying to recharacterize income from non-passive to passive, we need to prove a lack of material participation.

Why? This is covered more fully in last week’s blog. In summary, if you materially participate in an activity, it’s considered to be non-passive and subject to ordinary tax. Now, let’s outline the Six Criteria of Material Participation. We’ll list them below and then discuss each one…

Criteria for Material Participation
The individual…

  • …participates for more than 500 hours in the year
  • …participation in the activity constitutes substantially all of the participation in the activity
  • …participates for at least 100 hours during the year and it is more than any other individual’s participation
  • …materially participated in any of the 5 preceding 10 years
  • …participated in the activity for any of the preceding 3 years if the activity is a personal service activity
  • …participates in the activity on a regular, continuous, and substantial basis

#1. The most common criteria is the 500 hours per year threshold. The concept is simple, but from an audit perspective, how would you substantiate that? You need a way to document your clients activity within the business. As you’ll notice with a number of these criteria, the key challenge is how you proactively collect proof throughout the year to substantiate your claims.

#2. How do you make sure your client fails this criteria? Obviously, someone else would need to be doing the majority of the work. Keep in mind, it doesn’t have to be an employee; it could be an independent contractor. Either way, if your client doesn’t have anyone else working within the business, this is going to be a tricky one to prove.

#3. There are two ways to fail this criteria. First, you can communicate with your client and make sure their participation is less than one hundred hours a year. Or second, if your client breaks the 100 hour threshold, make sure they’re working less than anyone else. To prepare for an audit, you’re going to need some sort of log to properly represent and substantiate your case.

#4&5. Both of these involve a look-back period, and so they are easy to fail. You are recharacterizing and redefining an activity. If a chiropractor removes massage from his chiropractor business, that becomes a brand new activity, with no look-back period.

#6. In my opinion, if you fail the first three, you fail number six as well. If you’re participating less than 100 hours a year or less than any other individuals, for example, how can this participation be classified as regular, continuous, or substantial?

Remember, our objective here is to help our clients intentionally fail these tests for purposes of converting non-passive income to passive income. Want to learn more? Find out how to become a Certified Tax Planner!

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