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Material Participation Rules

(a) IN GENERAL

A taxpayer's interest in a trade or business activity is not treated as an
interest in a passive activity for a taxable year if the taxpayer
materially participates in the activity throughout that year on a regular,
continuous, and substantial basis. Material participation is not
determinative in certain instances. For example, working interests in oil
and gas properties generally are treated as active, and interests in
rental activities are treated as passive, without regard to a taxpayer's
level of participation. In general, however, whether a taxpayer has
materially participated in an activity will determine whether the interest
is treated as passive.


(b) PARTICIPATION DEFINED

Participation in an activity means any work done in connection with an
activity by an owner of an interest in the activity, without regard to the
capacity in which the individual does the work. Reg. Section 1.469-
5(f)(1).

The participation of an individual's spouse in an activity is attributed
to the individual for purposes of determining the individual's
participation. This attribution is made regardless of whether the spouse
owns an interest in the activity or whether a joint return is filed for
the year.

Certain work done in connection with an activity is not treated as
participation in the activity. Work done by an owner not customarily done
by an owner of such an activity is not treated as participation if one of
the principal purposes of the performance of the work is to avoid
disallowance of a loss from the activity. <82>

Work done by an investor in her capacity as an investor is not treated as
participation unless the investor is involved in the day-to-day management
or operations of the activity. Reg. Section 1.469-5T(f)(2)(ii)(A). Work
done in the capacity of an investor includes studying and reviewing
financial statements or reports on operations of the activity, preparing
or compiling summaries or analyses of the finances or operations of the
activity for the individual's own use, and monitoring the finances or
operations of the activity in a non-managerial capacity. Reg. Section
1.469-5T(f)(2)(ii)(B).

If a taxpayer provides legal, tax, or accounting services as an
independent contractor, or the taxpayer commonly provides these services
as an independent contractor, the provision of these services will be
considered material participation only in the activity of providing those
services to the public. Thus, for example, a lawyer who invests in a
general partnership engaged in research and development is not treated as
materially participating in the research and development activity by
reason of providing legal services. S. Rep. 313, 99th Cong., 2d Sess. 735
(1986).

The extent of a taxpayer's participation in an activity may be established
by any reasonable means. Contemporaneous daily time reports, logs, or
similar documents are not required if the extent of the taxpayer's
participation may be established by other reasonable means. For these
purposes, reasonable means include, but are not limited to, the
identification of services performed over a period of time and the
approximate number of hours spent performing the services during that
period, based on appointment books, calendars, or narrative summaries.
Reg. Section 1.469-5T(f)(4).


(c) TESTS FOR MATERIAL PARTICIPATION

In general, an individual is treated as materially participating in an
activity during the taxable year only if any one of seven tests is met.
<83> These tests are described in the following Sections.


(c)(1) The 500-hour test

An individual who participates in an activity for more than 500 hours
during the year is treated as materially participating in such activity.
<84>

EXAMPLE: Sally spends 20 hours per week operating an interior design
business. Since she spends more than 500 hours during the year
participating in the activity, she is treated as materially
participating in such activity.


(c)(2) The substantially all test

An individual whose participation in an activity for the taxable year
constitutes substantially all of the participation in the activity by all
individuals for the year (including individuals who are not owners of
interests in the activity) is treated as materially participating in the
activity. Reg. Section 1.469-5T(a)(2).

EXAMPLE: Bill is employed full time as an accountant. Bill also is
engaged in a construction activity that is a trade or business
activity conducted entirely on Saturdays. Bill is the only
participant in the activity for the taxable year. Each Saturday
throughout the taxable year, Bill works for six hours in the
activity. Although Bill does not participate in the activity for more
than 500 hours during the taxable year, he is treated as materially
participating in the activity because his participation is
substantially all of the participation of all individuals in the
activity for the year.


(c)(3) The not less than others test

An individual who participates in an activity for more than 100 hours
during the taxable year and whose participation in the activity is not
less than the participation in the activity of any other individual for
the year (including individuals who are not owners of interests in the
activity) is treated as materially participating in the activity. Reg.
Section 1.469-5T(a)(3).

EXAMPLE: Bill is employed full time as an accountant. Bill also owns
an interest in a partnership that is engaged in a construction
activity, which is a trade or business activity conducted entirely on
Saturdays. Bill and the other partners -- Mark and David -- are the
only participants in the activity for the taxable year. Each Saturday
throughout the taxable year, Bill, Mark, and David all work for six
hours in the activity. Although Bill does not participate in the
activity for more than 500 hours during the taxable year, Bill is
treated as materially participating in the activity because he
participates in the activity for more than 100 hours during the
taxable year, and Bill's participation in the activity is not less
than the participation of any other individual in the activity for
the year.


(c)(4) Significant participation activities test

An individual is treated as materially participating in an activity if the
activity is a significant participation activity for that individual for
the taxable year, and his aggregate participation in all significant
participation activities exceeds 500 hours for the year. Reg. Section
1.469-5T(a)(4). A significant participation activity is a trade or
business activity in which the individual participates for more than 100
hours during the taxable year but does not otherwise materially
participate within the meaning of any other test. <85>

EXAMPLE 1: Diana is employed full time as a paralegal. Diana also
owns an interest in a restaurant and a shoe store. The restaurant and
shoe store are trade or business activities that are treated as
separate activities under the passive activity rules. Each activity
has several full time employees. During the taxable year, Diana works
in the restaurant for 400 hours and in the shoe store for 150 hours.
Both the restaurant and the shoe store activities are significant
participation activities for Diana in the taxable year. Accordingly,
since Diana's aggregate participation in the restaurant and shoe
store activities during the taxable year exceeds 500 hours, she is
treated as materially participating in both activities.

EXAMPLE 2: Paul participates in five trade or business activities in
which he owns an interest: restaurant (120 hours), shoe store (75
hours), construction (140 hours), insurance (300 hours), and van
conversions (550 hours). The shoe store and van conversions are not
significant participation activities for Paul because his
participation in them is under 100 hours and over 500 hours,
respectively. These hours are not counted for purposes of the
substantial participation activity test. The restaurant (120 hours),
construction (140 hours), and insurance (300 hours) activities are
significant participation activities. Paul is treated as materially
participating in all three of these activities since the total of 560
hours (120 + 140 + 300) exceeds 500 hours. Note that Paul is
considered to have materially participated in the van conversion
activity because he participated in the activity for more than 500
hours.

EXAMPLE 3: Kevin participates in the following trade or business
activities during the taxable year: imports (300 hours) and insurance
(600 hours). Since Kevin participates in the insurance activity for
more than 500 hours during the taxable year, the activity is not a
significant participation activity (although Kevin is considered to
have materially participated in the insurance activity since he
participated in the activity for more than 500 hours). With respect
to the import activity, Kevin does significantly participate (i.e.,
he participates for more than 100 hours), but he is not considered to
have materially participated in the activity because he does not
satisfy the more than 500-hour requirement for all significant
participation activities.


(c)(5) The five of ten preceding years test

An individual is treated as materially participating in an activity for
the current taxable year if the individual materially participated in the
activity for any five taxable years (which do not need to be consecutive)
during the ten taxable years that immediately precede the current taxable
year. Reg. Section 1.469-5T(a)(5). Only the 500- hour test is applied in
any case in which it is necessary to determine whether an individual
materially participated in any activity for a taxable year beginning
before January 1, 1987 (other than a taxable year of a partnership, S
corporation, estate, or trust ending after 1986). Reg. Section
1.469-5(j)(2). The purpose of this rule is to prevent a retiring taxpayer
from converting active income into passive income.

EXAMPLE 1: In 1992, John acquired stock in an S corporation engaged
in a trade or business activity. For every taxable year from 1992
through 1996, John participated in the activity for more than 500
hours. John retires from the activity at the beginning of 1997 and
does not materially participate in the activity in 1997 and
subsequent years under any other test. John will be treated as
materially participating in the activity for taxable years 1997
through 2002 because he materially participated in the activity for
five taxable years during the ten taxable years that immediately
precede each of those years. John will not be treated as materially
participating in the activity for taxable years after 2002 because
for those years John has not materially participated in the activity
for five of the ten immediately preceding taxable years.

EXAMPLE 2: Assume the same facts as Example 1, except that John does
not acquire any stock in the S corporation until 1996. John will not
be treated as materially participating in the activity for any
taxable year before 1996 because John did not own an interest in the
activity for any of the preceding taxable years. Accordingly, John
materially participates in the activity for only one taxable year
before 1997, and John will not be treated as materially participating
in the activity for 1997 or subsequent taxable years.


(c)(6) Personal service activities test

An individual is treated as materially participating in an activity for
the current taxable year if the activity is a personal service activity,
and the individual materially participated in the activity for any three
taxable years (need not be consecutive) preceding the current taxable
year. <86> An activity is considered a personal service activity if it
involves the performance of personal services in the field of health, law,
engineering, architecture, accounting, actuarial science, performing arts,
consulting, or any other trade or business in which capital is not a
material income producing factor. Reg. Section 1.469-5T(d).

EXAMPLE: In 1994, Oz acquired stock in an S corporation engaged in
the performance of personal services in the field of dentistry. For
every taxable year from 1994 through 1996, Oz materially participates
in the activity under the 500-hour test. Oz retires from the activity
at the beginning of 1997 and is not treated as materially
participating in the activity for 1997 and subsequent taxable years
under the 500-hour test. Oz is treated as materially participating in
the activity for 1997 and all subsequent taxable years because he
materially participated in the activity for three taxable years.


(c)(7) Facts and circumstances test

If a taxpayer does not satisfy any of the other tests, he can be
considered to materially participate in an activity for the taxable year
if, based on all of the facts and circumstances, the individual
participates in the activity on a regular, continuous, and substantial
basis for such taxable year. Reg. Section 1.469-5T(a)(7). For this test
to be satisfied, however, the individual must participate in the activity
for more than 100 hours during the taxable year. Reg. Section
1.469-5T(b)(2)(iii). The fact that the taxpayer satisfies the requirements
of any participation standard (whether referred to as material
participation) under Code Section 1402 (relating to self-employment) or
Code Section 2032A (relating to the valuation of farm property for
purposes of the estate tax) or any other provision (other than Code
Section 469) is not taken into account in determining whether the
taxpayer materially participates in an activity for purposes of the facts
and circumstances test.

For management activities to constitute participation under the facts and
circumstances test, there can be no individual other than the taxpayer who
receives compensation (which is earned income) for management services and
no other individual can put in more hours than the taxpayer in performing
management services.

The regulations do not address what facts and circumstances are to be
taken into account for purposes of this test. Reg. Section 1.469-
5T(b)(1) (Reserved). However, the legislative history to the 1986 Act
discusses several factors to be considered in determining material
participation. S. Rep. 313, 99th Cong., 2d Sess. 733-735 (1986). None of
these factors alone is to be considered conclusive in determining
material participation. These factors are:

(1) Principal Business Factor -- A taxpayer is more likely to
materially participate in an activity that is her principal business
and less likely to materially participate in an activity that is not
her principal business.

(2) Regular Presence Factor -- A taxpayer is more likely to
materially participate in an activity where the taxpayer is regularly
present at the place where the principal operations of the activity
are conducted. However, a taxpayer can materially participate in the
operation of an activity without being present at the activity.

(3) Knowledge or Experience Factor -- A taxpayer who has little or no
knowledge or experience in an activity is less likely to materially
participate in the activity.

(4) Management Factor -- If a taxpayer merely approves or ratifies
decisions made by others, the taxpayer's participation is not
substantial. The degree of a taxpayer's knowledge or experience as to
an activity is significant in determining whether the participation
of the taxpayer and management amounts to material participation.


(d) TREATMENT OF LIMITED PARTNERS

A taxpayer who owns an interest in a limited partnership as a limited
partner generally will not be treated as materially participating in the
limited partnership's activities.  A limited partner's distributive
share of the income, gain, loss, deductions, or credits from an activity
in which she owns a limited partnership interest and any gain or loss
recognized from the sale or exchange of the partnership interest are
presumed to be passive.

OBSERVATION: The IRS has directed its examiners to treat limited
liability company members, including member managers, as limited
partners for purposes of the passive activity rules. IRS Audit
Guidelines on Passive Activity Losses (February 1996).

A partnership interest is a limited partnership interest if the interest
is designated a limited partnership interest in the agreement or
certificate of limited partnership. This characterization applies whether
the liability of the holder of the interest is in fact limited under
applicable state law. Reg. Section 1.469-5T(e)(3)(i)(A). Thus, if an
individual who is designated as a limited partner participates in the
affairs of the partnership to a degree that his liability as to the
partnership is no longer limited, the individual is nevertheless still
considered a limited partner for purposes of the passive activity
rules.

A partner is also a limited partner if her liability for partnership
obligations is limited by state law to a determinable fixed amount. For
example, a partner is a limited partner if her liability is limited to the
sum of capital contributions to the partnership plus any additional amount
that the partner is required to contribute under the terms of the
partnership agreement. Reg. Section 1.469-5T(e)(3)(i)(B).

In certain circumstances, a partner who is both a general partner and a
limited partner in a partnership is not treated as a limited partner. For
this rule to apply, however, the individual must be a general partner in
the partnership at all times during the partnership's taxable year ending
with or within the individual's tax year. In the situation where a general
partner is also a limited partner for only part of the partnership's
taxable year, the individual must be a general partner during that portion
of the partnership's taxable year that he directly or indirectly owns the
limited partnership interest. Reg. Section 1.469-5T(e)(3)(ii).


A limited partner may nevertheless be treated as materially participating
in a partnership if he satisfies certain participation exceptions provided
in the regulations. These exceptions are: the 500-hour test, the five of
ten preceding years test, or the personal service activity test. Reg.
Section 1.469-5T(e)(2).


(e) MATERIAL PARTICIPATION IN A FARMING ACTIVITY

If an individual is treated as having self-employment income with respect
to a farm under Code Section 1402 (i.e., the individual files a Schedule
F), such individual generally will be treated as materially participating
in the farm activity regardless of whether she performs any actual labor
on the farm. S. Rep. 313, 99th Cong., 2d Sess. 733-734 (1986).

This issue arises most frequently when a farmer leases land and has an
arrangement with the tenants to participate in the farming activity. A
farmer will be treated as materially participating if:

(1) the farmer performs any three of the following four functions:

(a) paying or standing good for at least half of the direct work
of producing the crop;

(b) furnishing at least half of the tools, equipment, and
livestock used in producing the crop;

(c) consulting with the tenants; or

(d) inspecting the production activities;

(2) the farmer regularly and frequently makes management decisions
that contribute substantially to the success of the enterprise;

(3) the farmer works 100 or more hours over a period of five weeks or
more in activities connected with the production of the crop; or

(4) the farmer's activities demonstrate that the farmer is materially
and significantly involved in the production of the farm products.
IRS Publication 225, Farmer's Tax Guide.

A retired or disabled farmer and a surviving spouse of a farmer can
qualify as materially participating in a farm activity under the material
participation rules for farm property to qualify for the special use
alternate valuation election under Code Section 2032A. <92> An individual
who is retired or disabled is treated as materially participating in a
farm activity under Code Section 2032A if that individual or a member of
his family materially participated in the operation of the farm for an
aggregate of at least five years during the eight-year period ending
during the taxable year. <93> For purposes of Code Section 2032A, the
eight-year period ends on the date of death. Code Section
2032A(b)(1)(C). For Code Section 469 purposes, the farmer is deemed to
have died during the taxable year for which material participation is to
be determined. Code Section 469(h)(3). The five of eight year test must
be satisfied each year. Thus, material participation by a member of the
taxpayer's family must continue following the taxpayer's retirement or
disability.

Under Code Section 2032A, an individual is retired if the individual is
receiving old age benefits under social security. Code Section
2032A(b)(4)(A). An individual is disabled if he has a mental or physical
impairment that renders the individual unable to materially participate
in the operation of the farm. Code Section 2032A(b)(4)(B).


In the case of a surviving spouse whose deceased spouse could have
qualified to make the special use election as to the farm property under
Code Section 2032A, the five of eight year rule for retired or disabled
person applies to determine the material participation of the surviving
spouse. Code Section 2032A(b)(5)(C). Active management of the farm by the
survivor is treated as material participation. Code Section
2032A(b)(5)(A). Active management means the making of management decisions of the farm (other than daily operating decisions).


(f) MATERIAL PARTICIPATION BY ESTATES AND TRUSTS

The participation of the fiduciary (i.e., executor or trustee) determines
whether there is material participation by an estate or trust. S. Rep.
313, 99th Cong., 2d Sess. 735 (1986). A trust may be treated as an
association taxable as a corporation if it is a joint enterprise for the
conduct of business for profit. Reg. Section 301.7701-4(b). Thus, a trust
that is directly conducting a business normally is treated as an
association taxable as a corporation and might be subject to the passive
loss rules as they apply to closely held corporations. However, it is
unlikely that a trust, as such, will materially participate in a trade or
business activity.

In the case of a grantor trust, to the extent the grantor or beneficiary
is treated as the owner for tax purposes,  the material participation
of the person treated as the owner is used to determine whether income or
loss from an activity owned through the grantor trust is treated as
passive in the hands of the owner. S. Rep. 313, 99th Cong., 2d Sess. 735
(1986). In the case of a qualified Subchapter S trust,  which is
treated as a grantor trust (i.e., the beneficiary is treated as the owner
for tax purposes), the material participation of the beneficiary is used
to determine whether the S corporation's activity is passive activity with
respect to the beneficiary.


(g) MATERIAL PARTICIPATION BY CORPORATIONS

Certain closely held C corporations and personal service corporations are
subject to the passive activity rules, unless the corporation materially
participates in the activity.  Material participation of a corporation
generally is determined by reference to the participation of its
shareholders. Code Section 469(h)(4). A closely held C corporation or a
personal service corporation materially participates in an activity only
if one or more of its individual shareholders who hold directly or
indirectly in the aggregate more than 50 percent (by value) of the
outstanding stock of such corporation materially participate in the
activity.  In addition, if a corporation is a closely held C
corporation but is not a personal service corporation, the corporation's
participation through the involvement of its employees may also be
considered in determining active participation.

Whether an individual shareholder or employee materially participates is
determined under the rules that determine individual material
participation.  Thus, for example, if a 60 percent shareholder spends
more than 500 hours participating in a corporate activity, the
shareholder, and thus the corporation, has materially participated in the
activity.

The significant participation test is applied differently for corporations
than for individuals. Reg. Section 1.469-1T(g)(3)(ii). For individuals, a
significant participation activity is one in which the individual
participates in for more than 100 hours (but not more than 500 hours).
The individual materially participates in significant participation
activities if the total participation in all significant participation
activities exceeds 500 hours.  For a corporation, however, an
activity is a significant participation activity (i.e., the corporation
participates in the activity for more than 100 hours during the taxable
year) if one or more individuals, each of whom is treated as
significantly participating in such activity under Reg. Section
1.469-1T(g)(3)(iii), directly or indirectly hold (in the aggregate) more
than 50 percent (by value) of the outstanding stock of such corporation.
Reg. Section 1.469-1T(g)(3)(ii). Under Reg. Section 1.469-1T(g)(3)(iii),
all activities of a corporation are treated as activities in which the individual holds an interest when determining whether the individual participated in the activities of the corporation, and the individual's non-corporate activities are disregarded in determining whether the individual has met the more than 500 hour test for significant participation activities.

A closely held C corporation that is not a personal service corporation
can establish its material participation through the involvement of its
employees.  In order to establish material participation through
employee involvement, the closely held C corporation must be engaged in an
activity that is a qualifying business. If a closely held corporation is a
corporate partner in a partnership, the corporation must be a qualified
corporate partner, and the partnership's activity must be a qualified
business. Reg. Section 1.469-1T(g)(3)(i)(B).

The qualified business definition revolves around the involvement of the
corporation's employees in the business activity. A qualifying business
means any active business if (1) for the twelve-month period ending on the
last day of the taxable year, the corporation had at least one full-time
employee substantially all of the services of whom were in the active
management of such activity, (2) during the same twelve-month period, such
corporation had at least three full-time non-owner employees substantially
all of the services of whom were services directly related to the
activity, and (3) the amount of the corporation's business deductions
attributable to the activity exceeded 15 percent of the gross income from
the activity for the taxable year. Code Section 465(c)(7)(C).


A corporation's proportionate share of the active business of a
partnership is a qualified business, and the corporation is considered to
materially participate in that qualified business for the taxable year, if
the corporation is a qualified corporate partner and (1) during the entire
twelve-month period ending on the last day of the partnership's taxable
year, there was at least one full-time employee of the partnership (or of
a qualified corporate partner) and substantially all of the services
provided by that employee were in the active management of the business,
(2) during the same twelve-month period, at least three full-time non-
owner employees provided services directly related to the activity, and
(3) the amount of the corporation's business deductions attributable to
the activity exceeded 15 percent of the gross income from the activity for
the taxable year. Code Section 465(c)(7)(D).

A qualified corporate partner is any corporation that is a general partner
with an interest of 10 percent or more in the profits and losses of the
partnership and has contributed property to the partnership in an amount
not less than the lesser of $500,000 or 10 percent of net worth of the
corporation. Code Section 465(c)(7)(D)(ii).

EXAMPLE: Phoebe, a calendar year taxpayer, owns all the stock of C
Corporation. C is the general partner, and Phoebe is the limited
partner in P, a calendar year partnership. P has a single activity, a
restaurant that is a trade or business activity. During the taxable
year, Phoebe works an average of 30 hours per week in connection with
P's restaurant activity. Phoebe is treated as materially
participating in the activity for the taxable year because she
participates in the restaurant activity during the year for more than
500 hours. In addition, her participation causes C to be treated as
materially participating in the restaurant activity.


(h) MATERIAL PARTICIPATION BY PASS-THROUGH ENTITIES

In the case of a partnership or an S corporation, material participation
is determined at the partner or shareholder level. The participation of
each partner or shareholder must be examined as to each of the activities
conducted by the entity. Participation is determined for the entity's
taxable year, not the taxable year of the partner or shareholder. Reg.
Section 1.469-2T(e)(1).

EXAMPLE: Henry, a calendar year taxpayer, is a partner in a
partnership with a taxable year ending January 31. During its taxable
year ending on January 31, 1997, the partnership engages in a single
activity. For the period from February 1, 1996, through January 31,
1997, Henry does not materially participate in the activity. On
Henry's calendar year 1997 return, his distributive share of the
partnership's gross income and deductions from the activity must be
treated as passive, regardless of any participation by him in the
period of February 1, 1997, through December 31, 1998.

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