As I recover from the latest busy season, I took time to reflect on what was the most common question I was asked. Not surprisingly, it dealt with the material participation standards under Section 469 and the interplay with the net investment income tax under Section 1411
Although material participation rules are hardly new, they were given added importance with the introduction of the new net investment tax this filing season. This new tax forced many of us to reexamine with our clients, their participation throughout the year in business entities in which they own an interest. To complete the new Form 8960 we needed to go through the exercise of putting various ownership interests into separate buckets of nonpassive activities and passive activities, that is, activities in which the taxpayer materially participates or does not materially participate. This lead to further discussion on issues that we have always had to deal with such as passive loss limitations, grouping elections, self-rental rules and the real estate professional exception. Various common questions arose and are discussed in general below:
Is this activity passive or nonpassive? Usually this question arose in the context of whether or not the activity was subject to the new net investment tax. But, the answer tends to be more important for the reason for which the rule was first enacted: to limit the allowance of passive losses to the amount of passive income for the year. A passive activity is defined in IRC 469(c) as the conduct of a trade or business in which the taxpayer does not materially participate. A nonpassive activity is one that is not passive, and, therefore, one in which the taxpayer materially participates. So, meeting the requirements for material participation is key to this determination. Material participation is briefly defined in IRC Section 469(h) as involvement in the operations of an activity on a basis which is regular, continuous and substantial. The Temporary Regulations under Reg. 1.469-5T enumerate seven tests, any one of which can be met to satisfy material participation in an activity:
1) The individual participates in the activity for more than 500 hours during such year.
(2)The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3)The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4)The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5)The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6)The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7)Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
Stay tuned for more in part 2 next week…