Income and Losses in a Side Business: Is Your Participation “Material?”

Business Income Atttorneys Serving the Sugarland and Houston Areas

It is quite common for “high net worth” individuals (e.g., physicians, landowners, developers, and those with significant investment portfolios) to invest in side businesses or enterprises. The investment decision might be prompted by a specific hobby or interest – say, in classic automobiles – or it may be rooted in a desire to help a fledgling entrepreneur. Often, particularly in the early years, these side businesses generate losses instead of actual income. The IRS has a vested interest in limiting the ability of an investor to reduce his or her taxable income by what it labels as “passive” losses. What sort of participation in the business is required to characterize the loss as “active” rather than “passive?”

Material Participation

Generally speaking, the Internal Revenue Service requires “material participation” in the business in order for losses to be considered active and not passive. Investors are sometimes surprised that having a financial interest in a business – even when it is a significant one – is insufficient to meet the Tax Code’s material participation criteria. According to the IRS, an individual materially participates in a business activity when his or her participation is on a “regular, continuous and substantial basis” [see the recent case of Escalante, T.C. Summ. 2015–47].

The IRS Seven-Part Test

In most cases, the IRS uses a seven-part test to determine if an investor’s participation is material. The taxpayer need not meet all parts in the test; the IRS gauges participation on an overall score. It assesses whether:

  • The taxpayer works 500 hours or more during the year in the activity.
  • The taxpayer does substantially all the work in the activity.
  • The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  • The activity is a “significant participation activity,” and the sum of such activities in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
  • The taxpayer materially participated in the activity in any five of the prior 10 years.
  • The activity is a personal service activity and the taxpayer materially participated in that activity in any three prior years.
  • Considering all facts and circumstances related to the taxpayer’s involvement in the business, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this part of the seven-part test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

Consider the IRS Test When Negotiating the Investment Agreement

In many cases, material participation is easier to establish where the issue isn’t merely an afterthought. It is important to give careful attention to the detail at the time the investment is made. For example, the investment might designate the number of hours each month that the investor is to devote to the business. It might designate not only a time frame for participation, but specify the actual duties that are contemplated. The investor should also give attention to documenting his or her time spent on the side business after the investment is made. It will do little good to craft an investment agreement that calls for material participation if the agreement is then ignored.

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