J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

10.6 Material Participation Tests for Business

The IRS has seven tests for determining material participation in a business. Some tests require only a minimum amount of work, such as 500 hours a year, and others only 100 hours. You need to meet only one of the seven tests to qualify as a material participant. If you do, then the income and loss from that business is treated as nonpassive.

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Caution

Overcoming Investor Status

The IRS will not recognize time spent as an investor as “participation” unless you can show you are involved in daily operations or management of the activity. According to the IRS, this requires you to be at the business site on a regular basis. Even if you do appear daily, the IRS may ignore such evidence if there is an on-site manager or you have full-time business obligations at another site. Activity of an investor includes the studying and reviewing of financial reports for your own use that are considered unrelated to management decisions. If you invest in a business that is out of state or a distance from your home, you may also find it difficult to prove material participation.

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The tests apply whether you do business as a sole proprietor or in an S corporation or partnership. Losses and credits passed through S corporations and partnerships are subject to passive activity rules.

If you are a limited partner, ...