Material Participation Tests
Candlefocus EditorAn activity is considered passive if the taxpayer's involvement is limited to management activities, such as collecting rents, and if there is no material participation in an activity. To be considered a material participant, a taxpayer must meet at least one of the seven criteria laid out in the MPT.
The seven material participation tests are:
1. Significant participant test: The taxpayer spends more than 500 hours in the business activity during the year;
2. Regular and continuous participation test: The taxpayer participates in the business activity at least 100 hours in the year and the business activity takes place extensively and regularly;
3. Material participation test: The taxpayer participates in the business activity for more than 500 hours in the year and participates with more than any other similar activity;
4. Working owner test: The taxpayer owns and operates a business as an proprietor, partner, member of an LLC, or fellow shareholder;
5. Real estate professional test: The taxpayer spends more than 50% of the deduction expenses in the year on real estate activities and more than 750 hours on real estate activities.
6. Limited partner test: The taxpayer's interest in a limited partnership is classified as a limited partnership for federal tax purposes;
7. Self-rental test: The taxpayer earns income from renting activities or equipment to their own business.
In addition to the seven MPT tests, taxpayers must meet the guidelines set forth in Internal Revenue Service (IRS) Circular 230. Circular 230 provides numerous requirements, including laws concerning conflicts of interest, independent practice, improper tax advice, and criminal penalties.
The MPT are designed to be comprehensive and can be applied to numerous activities. However, it is the responsibility of the taxpayer to prove that they are a material participant. If a taxpayer fails to prove material participation, the taxpayer will be subject to the passive loss rules and will be unable to deduct the entire amount of the passive losses. It is therefore essential for taxpayers to understand and be aware of the MPT rules before engaging in income-producing activities n order to ensure their eligibility for tax deductions.