How Material Participation Works in a Business Loss

Owner Participation in a Business When the Business has a Loss

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When your business has a loss, your participation in your business may limit your ability to take that loss and reduce your taxes. The key to being able to take the full amount of the tax loss on your tax return is what the Internal Revenue Service (IRS) calls material participation.

Key Takeaways

  • The IRS may limit how much of your business losses you may take as a tax loss in a given tac year.
  • There are two sets of rules that apply when determining your ability to claim a loss: At-Risk rules and Passive Activity rules.
  • At Risk limits come first and they are based on the investment you have in the business for which you are personally liable. You cannot deduct more than this.
  • Passive Activity rules relate to your participation in the business, day-to-day, and the IRS has several tests to determine whether or not your activity is material.

IRS Rules for Business Losses

Two sets of rules apply when determining your ability to take a loss in your business:

At-Risk Rules

You have a risk in your business based on your investment in the business or for amounts you borrowed for the business for which you are personally liable or for which you pledged personal property. You can't deduct more than the amount you have at risk for a year.

Passive Activity Rules

These rules relate to your activity, and whether you have materially participated in the business or you have a passive role in the business.

You must apply the at-risk rules before the passive activity rules.

The IRS limits the amount of losses that business owners can take on their tax returns. It looks first at the amount of an owner's investment in the business and then the owner's activity in the business to determine the owner's share of business losses. In any one year, either or both of these factors can limit the owner's tax situation.

Material Participation and Business Owners

The IRS has determined that an individual materially participates in business activities if they do so on a "regular, continuous, and substantial basis." An owner who doesn't participate in the business can't deduct losses to the same extent as a business owner who does materially participate in the business.

Material participation is determined on an individual basis, and it's determined each tax year. The opposite of material participation is called passive activity. If you haven't materially participated in the business during the year, your share of any business deductions for the year is limited.

Although any business owner can be affected by this regulation, owners of two types of businesses are especially affected:

  • Limited partners in a partnership whose participation is limited to their investment and who don't materially participate in day-to-day business activities.
  • Rental businesses, of both equipment and real estate. Generally, rental activities are considered passive activities, even if you materially participated in them. The exception is real estate professionals if they meet certain IRS criteria.

How Material Participation Is Determined 

Material participation is determined separately for each tax year. The IRS has several tests to determine material participation in the activities of the business, using both time worked and type of work.

These material participation rules apply to individual owners of businesses, not to the business entity (partnership or S corporation).

  • Time Worked: You can be considered to materially participate in the business if you work on a regular, continuous, and substantial basis during the year, at least 100 hours in the activity, if no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
  • Type of Work: The work you do on your business should be work usually done by a business owner, in the day-to-day management of the business, but not as an investor.

The IRS wants to make sure your main reason for doing the work isn't to avoid the passive activity rules. It also can't be work as an investor.

You will need to find a way to establish your participation in a reasonable way, to satisfy the IRS. You don't have to keep a daily time report, but you could use your appointment book, calendar, or narrative summary to show the amount and type of your participation in your business during the year.

How To Report Losses on Your Tax Return

Depending on your situation in your business, your loss for the year might be limited by (a) the at-risk rules and/or (b) the passive activity limits. The forms you file depend on the specific situation. For example, you must use Form 6198 to report at-risk loss limits and Form 8582 to report passive activity loss limitations. You may need to file other forms, based on your specific situation.

Note

Both limited partners and owners of real estate businesses file business taxes on Schedule E of their personal tax returns. Other types of business owners who have losses file business taxes on Schedule C or other schedules, depending on their business type or activity for the year.

Why Material Participation Is Important for Taxes 

Determining whether a business owner's participation in the day-to-day activities of the business affects that owner's personal taxes. The owner's taxes are particularly affected if the business has a loss in any given year.

The IRS looks at both at-risk limits and passive-activity limits (material participation) to see if these business losses are in excess. An excess business loss is an amount by which the total deductions for a business are greater than the gross income (as calculated by the IRS) and gains (capital gains) plus $270,000 (or $540,000 in the case of a joint return).

Note

The tax regulations for business losses, these excess loss calculations, and the reporting of losses are complicated. If your business has a loss for the year, be sure to get help from a tax professional to make sure you get the full amount of any tax deductions you're entitled to, but not more than you can take.

For more information on at-risk rules and more detailed information about material participation and passive activity rules, see IRS Publication 925 Passive Activity and At-Risk Rules.

Frequently Asked Questions (FAQs)

Are losses from passive activities deductible?

In general losses from passive activities that exceed income from those activities are not allowed (although losses can be carried forward to another tax year). Passive activities are businesses in which you do not materially participate.

What is a material participation test?

A material participation test is one of seven tests the IRS uses to determine a business owner's activity in an enterprise for tax purposes. The tests involve the type of work performed and the number of hours spent carrying out those tasks. A taxpayer need only meet one of the tests to qualify.

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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. IRS. "Publication 925 Passive Activity and At-Risk Rules."

  2. IRS. "Excess Business Losses."

  3. IRS. "Rev. Proc. 2021-45," Page 19.

  4. IRS. "Topic No. 425 Passive Activities – Losses and Credits."

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