What Qualifies as Material Participation?
For purposes of the passive loss rules (including the special relief provision for real estate professionals), a taxpayer is normally consider to materially participate in an activity if any of the following tests are met (Temp. Reg. § 1.469-5T(a)):
- The taxpayer participates in the activity for more than 500 hours during the year.
- The taxpayer's participation in the activity for the tax year constitutes substantially all of the participation by all individuals in the activity.
- The taxpayer's participation is more than 100 hours during the tax year, and no other individual participates more hours than the taxpayer.
- The activity is significant participation activity for the taxpayer for the tax year and the taxpayer's participation in all significant participation activities for the tax year is more than 500 hours. (A "significant participation activity" is basically one in which the taxpayer participates for more than 100 hours during the tax year.)
- The taxpayer materially participated for any five tax years during the 10 immediately preceding tax years.
- If the activity in question is a personal service activity, the taxpayer materially participated in the activity for any three tax years preceding the current tax year. (Personal service includes the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.)
- Based on all the facts and circumstances, the taxpayer participates on a regular, continuous, and substantial basis during the year. Future regulations are to provide further guidance for this test. However, the temporary regulations indicate that if an individual participates in an activity for 100 hours or less during the year, the "facts and circumstances" test is not available to qualify for material participation. Also, services in the management of the activity are not to be taken into account for this test unless no person (other than the taxpayer) who performs services in connection with the management of the activity receives fees or compensation for such services, and no individual performs management services that exceed (by hours) the amount of management services performed by the individual (Temp. Reg. § 1.469-5T(b)(2)).
In determining if tests five and six are met, any pre-1987 years are considered "materially participating" only if more than 500 hours during the year are spent in the activity. Furthermore, participation is counted only for periods when the individual has an ownership interest in the activity (Reg. § 1.469-5(f)(1) and (j)(2)).
Limited partners have a tougher standard for determining if they materially participate in the partnership's activities. Instead of satisfying one of the seven tests listed above, they must satisfy either test 1, 5, or 6. However, in the case of rental real estate activities, effectively only test 1 and 5 are available for limited partners because rental real estate is not a personal service activity. According to the IRS Audit Manual, members of an LLC are treated as limited partners. (But see Gregg v. Comm'r, 2001-1 USTC ¶ 50,169 (D.C. Ore. 2000) where a member was treated as a general partner for purposes of applying the PAL rules.)