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materially participate

As a business partner or investor in a limited liability company (LLC) or limited liability partnership (LLP), you’ve likely heard the term “materially participate.” But what does material participation mean? If you don’t know and aren’t involved in your business, you could face consequences. 

In this article, we’ll discuss what material participation is and how it may affect you. More specifically, we’ll dive into the following topics:

  • How do I know if I materially participated in my business?
  • Why should I materially participate in my business? 
  • If I’m a limited partner do I still need to materially participate? 
  • How do I materially participate in my business?
  • Final thoughts

 

materially participate

How Do I Know if I Materially Participated in My Business?

According to the IRS, business owners who materially participate in a business do so on a regular, substantial basis. If you don’t actively participate in your business, your interest is a passive activity. Those with passive activity business relations face a different set of tax considerations. 

But, what does it mean to participate in a business on a regular basis? The IRS created a seven-part test to determine material participation. If you meet one or more of the following seven criteria, you materially participate in a business: 

  1. You participated in the activity for more than 500 hours. 
  2. Your participation was substantial compared to the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity. 
  3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year. 
  4. Your significant participation activities total more than 500 hours. 
  5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. 
  6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor. 
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

The IRS uses these seven tests to determine whether or not you materially participate in a business. These criteria can seem confusing for most business owners. If you’re not sure if you meet one of the material participation tests, contact us at Tax Hack. We’re happy to review your situation.

 

Why Should I Materially Participate in My Business? 

To answer this question, you need to look at the business you’re involved in and your financial situation. When you materially participate in your LLC or LLP, you can deduct the full amount of your business losses on your tax return. 

For example, assume you own a 25% share in an LLC that takes a $100,000 loss in a given year. Assuming your business allocates loss on a pro-rata basis, this means a material participant could deduct $25,000 on their tax return. This could potentially offset W-2 or other non-passive income. 

On the other hand, if you did not actively participate in the business and are a passive participant, you could only deduct that $25,000 against other passive income, generally speaking. 

While there are exceptions to the passive activity loss limitations, these go beyond the scope of this article. Once again, if you think you qualify for an exception, we’d be happy to review your situation.  

The incentive for material participation changes if your business interest generates a loss or if you have other non-passive income. If your business interest doesn’t generate a loss, you won’t reap the benefits from offsetting non-passive income. If you have other, non-passive income and still materially participate in a business, you could deduct your portion of that loss against your other income. 

Here’s an example to consider. Let’s say you had a full-time job with a W-2 salary while materially participating in a business with some friends. In that instance, you could deduct your portion of that loss against your salary. This could potentially save you thousands of dollars, or more, in income taxes. 

 

If I’m a Limited Partner, Do I Still Need to Materially Participate? 

Limited partners don’t need to materially participate in a business. In fact, if you seek passive income, you should not materially participate. Many investors become limited partners to generate passive income to offset other passive losses. 

But, as a limited partner, you may want to use partnership tax losses to offset other, non-passive income. For a limited partner to materially participate, they must meet one of the following three IRS participation tests: 

  1. […] You participated in all significant participation activities for more than 500 hours. 
  2. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. 
  3. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. 

 

How Do I Materially Participate in My Business?

For most people to materially participate in a business, you must pass one of the mentioned tests. However, as a limited partner, only three of these tests apply. 

Regardless of the situation, most business owners opt for the 500-hour material participation test. This is the simplest one to defend in case of an IRS audit. Business owners can use a simple Excel spreadsheet to record all hours and activities performed. If the IRS requests documentation, this information can justify your material participation claim.  

 

Final Thoughts

If you want to deduct all of your business losses, you must pass one of the IRS material participation tests. Doing so can potentially save you a significant amount of money when you file your taxes. 

But at Tax Hack, we understand how complicated this topic can be. Fortunately, we live and breathe small business tax treatment and material participation. So contact us to set up a tax planning strategy session. We look forward to helping you!

Book your session now!

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