Taxpayers who run up tax losses in a business must be prepared to prove that one of the material participation tests was passed to avoid having the losses characterized as a passive activity loss (PAL) that cannot be currently deducted. Adequate contemporaneous records that detail the taxpayer’s tasks and time spent in the activity are crucial in attempting to sidestep the PAL rules. Records created after-the-fact are better than nothing, but they are much less believable than contemporaneous records. If losses are disallowed by the IRS, interest and penalties may be added to the unpaid taxes.
In general, an individual taxpayer can meet the material participation standard by passing one of the following seven tests outlined in the regulations:
- More-than-500 hours. This test is passed if the taxpayer spends more than 500 hours in the activity during the tax year in question.
- More-than-100 hours and more-hours-than-anyone-else. This test is passed if the taxpayer participates in the activity for more than 100 hours during the tax year and no other taxpayer participates more, including taxpayers who are not owners.
- Substantially all. This test is passed if the individual’s participation in the activity for the year constitutes substantially all of the participation in the activity for all individuals (including nonowners).
- Significant participation activity. This test is met if the individual’s aggregate participation in all activities in which he or she participated for more than 100 hours during the year (significant participation activities) exceeds 500 hours for the year.
- Material participation in the last five years. This test is passed if the individual materially participated in the activity for any five tax years during the 10 immediately preceding years.
- Personal service activity. This test is passed if the individual materially participated for any three preceding tax years by performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
- Facts and circumstances. This test is passed if, based on all facts and circumstances, the taxpayer is found to have participated in the activity on a regular, continuous, and substantial basis during the year in question.
In attempting to pass the material participation tests, taxpayers can prove their participation levels by any reasonable means. This can include identifying the types of work performed and the approximate number of hours spent performing such work with contemporaneous appointment books, calendars, narrative summaries, and the like. Several court decisions have said that, while the regulations permit flexibility regarding what it takes to prove material participation, courts are not required to accept after-the-fact “ballpark guesstimates” or a taxpayer’s unverified, undocumented, and presumably self-serving testimony.