Material Participation Test: Are You Involved in Your Business?

by Miranda Marquit

One of the goals that many business owners have is to slowly disengage themselves from the day to day running of the business and eventually just enjoy the income from the business without needing to do a whole lot of active work. While this is admirable goal, this situation could actually lead to some thorny tax issues — and increase the amount that they owe.

Material Participation TestWhen you make money from a business, one of the tests associated with the deductions you can take, as well as how your income is classified, is “material participation.” If you aren’t participating materially in your business, that could mean that you don’t get all of the same tax deductions that you used to enjoy. On top of that, you might find your income classified as unearned for tax purposes, which means a different sort of tax treatment.

With the 2013 changes resulting from health care reform, the classification of your income makes a difference, since there is a 3.8% surtax charged to unearned income for high earners. If your business income falls into this category, you might end up owing more in taxes this year — unless you can pass the material participation test.

What is Material Participation?

If you own a business, and receive income from that business, and you want your income to be considered earned, rather than passive or unearned, you need to materially participate in the business. There are 7 different ways that the IRS outlines that you can show your material participation. Meet any one of these 7 tests, and you are considered to be a “material participant”:

  1. Work more than 500 hours or more during the year doing a significant participation activity for the business.
  2. If you are involved in one activity, you can do substantially all the work involved in that activity that is necessary for the business.
  3. Work more than 100 hours doing a significant business activity for the year — as long as no one else works more than you.
  4. If you work on several significant participation activities during the year, putting in at least 100 hours on each, but others work on the activities more, you can count those activities, as long as the sum of all of your activities adds up to a total of 500 hours for the year.
  5. Material participation in the business activity for any 5 of the 10 prior years.
  6. Provide personal service activity through material participation in any of the three prior years.
  7. If you can look at all of the facts and circumstances, and show that you participate in an activity on a regular, continuous, and substantial basis throughout the year, you might be able to count it as material participation. However, you need to work on it for at least 100 hours, and no one else can work more on it than you, and no one else can receive compensation for managing the activity.

These tests are, like so many other tests offered by the IRS, a little vague at times. The important point, though, is that you need to take some time to be involved in the running of your business, to some degree, if you want to be able to take something other than a passive loss as part of your deduction, or if you want to avoid having your business income seen as unearned and subject to the 3.8% surtax (assuming you make more than the threshold).

Check with a trusted business tax professional to figure out what you can do to ensure that you are materially participating in your business this year. Not only might you find you enjoy being involved, but you might also save money in taxes.

Image creditDave Dugdale

Published or updated May 13, 2015.
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