For many taxpayers with multiple active business interests, the material participation test can be a significant tax trap. If the elements of that test are not met, the impact could be that the taxpayer is limited in how the income/loss from that business is recognized on their personal tax return. A recent decision in the United States Tax Court (Court) may have expanded the definition for material participation.
Pursuant to Internal Revenue Code (I.R.C.) Sections 162(a) and 212(1), a taxpayer can deduct certain business and investment expenses. However, I.R.C. Section 469 limits those deductions if a taxpayer does not materially participate in the trade or business.
I.R.C. Section 469(h)(1) provides that a taxpayer materially participates if such participation is regular, continuous, and substantial. According to Treasury Regulation 1-469-5T(a), there are seven tests to determine whether a taxpayer has materially participated in an activity. Perhaps the most common test is defined as follows:
1. The taxpayer participates more than 100 hours in the activity in the given year; and,
2. The facts and circumstances show that the participation was regular, continuous, and substantial. In Barbara v. Comm’r of Internal Revenue, TC Memo 2019-50, (2019), the taxpayer, Mr. Barbara, ran a lending business based out of Chicago, Illinois. He spent approximately 40% of his time in the Chicago office. On days when he was in Chicago, he would spend approximately 5 3/4 hours a day working on the lending business. When not in Chicago, Mr. Barbara spent the remaining 60% of his time in Florida. On days when he was in Florida, he would spend approximately 2 hours a day working on the lending business. While Mr. Barbara, he was in regular communication with his two full-time employees in Chicago.
The business had losses in all three tax years at issue in this case. The Internal Revenue Service determined that Mr. Barbara did not martially participate in his lending business and, therefore, those losses would have to be passive activity losses. The Court determined that, at least in part, because he was spending approximately 700 hours a year on his business, Mr. Barbara was materially participating in his lending business.
There are a couple of interesting notes that arise from this determination. First, Mr. Barbara was materially participating in the lending business from a remote location. That is uncommon, though, might be a reflection of the times. It is easier than ever to remain connected to a business from a remote location and taxpayers are able to maintain regular and continuous activity in their business even if they are not in the office every day. Second, there is an alternative test in Treas. Reg. 1-469-5T(a) that states that if a taxpayer spends more than 500 hours on an activity, they will have been deemed to materially participate in that activity. The Court did not reference that alternative rule, instead, focusing on the time spent by Mr. Barbara on his lending business.
Ultimately, it is good to know that you do not always have to be physically in the office to meet the material participation test. Instead, remote participation, assuming it is continuous and regular, may be enough to carry the day.