But first a bit of background about what material participation is and why it matters. And then I’ll talk about how grouping activities sometimes makes a giant difference on your tax return.
Why Material Participation Matters
Okay, so here’s the main thing: You can’t deduct losses from a business venture or hands-on investment except if you materially participate in the activity.
Example 1: Two brothers, Pete and Tom, invest in a new venture. Say a restaurant. The brothers agree to each invest $100,000 and will proportionally share the losses and the profits. Tom will also receive a salary from working in the business. Pete won’t work in the business. He’s keeping his regular job. If the first year, the business loses $100,000, each brother suffers a $50,000 loss. Tom, because he materially participates, can deduct that loss on this tax return. Pete, because he doesn’t participate at all, can’t.
That’s the basic concept.
The Seven Material Participation Recipes
Next question: How does someone materially participate? Well, tax law provides seven recipes:
- You spent more than 500 hours on the activity.
- You spent more than 100 hours but nobody else spends more time.
- In essence? You were the only person who spent any time in the activity.
- You spent more than 100 hours in the activity, also spent more than 100 hours in some other activities, somehow fail to materially participate in any of these activities using some other recipe, but in total, your hours spent in all of these “significant participation activities” exceed 500 hours.
- For five of the last ten years, you materially participated (for example, using more than 500 hours recipe) .
- You materially participated in a personal service activity for any three years. (Again, for example, by spending more than 500 hours those years.)
- You’ve been involved in an activity on such a “regular, continuous and substantial basis” that you material participated even if one of the other six material participation recipes doesn’t work. (This is an impractical recipe. Too vague. Please don’t think you can use it.)
And one important wrinkle to this discussion for married people. Spouses combine hours to determine material participation. For example, if two spouses each spend 300 hours, the total material participation hours equals 600 hours.
Grouping Activities: Backdoor Material Participation
If you don’t materially participate using one of those seven recipes just listed, however? You have one other gambit you can maybe use: Grouping activities.
The best way to understand grouping is to copy and paste an example from the relevant Treasury regulations at 1.469-4(c)(3):
Example 2: Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C‘s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities. Moreover, once C groups these activities into appropriate economic units, paragraph (e) of this section requires C to continue using that grouping in subsequent taxable years unless a material change in the facts and circumstances makes it clearly inappropriate.
I boldfaced key part of the copied text above. But let me summarize how I think you read this. A taxpayer invested in and works in four activities. Possibly she or he doesn’t materially participate in an activity at least using one of the usual recipes. But the taxpayer can combine activities in any reasonable method. And once activities get aggregated? Probably, the taxpayer does materially participate.
For example, maybe the taxpayer in Example 2 doesn’t qualify as materially participating in the bakery in Philadelphia. And maybe she doesn’t qualify as materially participating in the bakery in Baltimore either. But if she or he combines the Philadelphia bakery with the Baltimore bakery? Maybe that works.
Rules for Grouping Activities
As noted earlier, you can use “any reasonable method.” The Treasury regulations flesh out what that means. And they provide some logical instructions.
You need to look at all the relevant facts and circumstances. Further, a logical handful of factors should be given the “greatest weight” in determining whether it’s reasonable to treat “more than one activity as a single activity:”
I’m going to again copy and paste the actual language from the regulations. (See the bulleted list below.) But think about how these apply to the fictional business owner with bakeries and movie theaters in Baltimore and Philadelphia.
- Similarities and differences in types of trades or businesses
- The extent of common control
- The extent of common ownership
- Geographical location; and
- Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).
Limitations on Grouping Activities
Because grouping activities is so potentially powerful, limitations exist.
You can’t group a rental activity with a non-rental trade or business except in usual situations. (We’ve described those situations in another blog post here: A Dozen Ways to Deduct Passive Losses. But the common exception to this limitation: You can ignore this limitation when one of the activities is insubstantial in relation to the other. Another common exception: Self-rental situations.)
You can’t group real property rentals with personal property rentals.
You can’t group limited partner and limited entrepreneur activities except when the activities are in the same type of business. (This limitation applies to farming; movie and video production, distribution and holding; leasing Section 1245 property (so mostly depreciable personal property); oil and gas exploration; and geothermal exploration.)
But other than these limitations? In many cases, business owners should be able to group activities to achieve material participation. If they need to.
Grouping Activities Paperwork
You or your tax advisor need to add some paperwork to your tax return to group activities. For example, you include a grouping election with the first tax return you combine activities.
If facts and circumstances change and the original grouping no longer makes sense? You regroup and disclose that action on the first affected tax return.
If you haven’t made a grouping election but should have? Yeah, you should talk to your tax advisor about that. Typically, you can make a “backdated” grouping election.
One predictable and fair caveat? The IRS may regroup activities if (1) a group is “not an appropriate economic unit” and (2) a “principal purpose” of the grouping was to “circumvent” Section 469’s passive loss limitation rules.
Crazy Grouping Activities Examples That Work
Let me share three example groupings that probably work.
Example 3: A contractor works full-time in his own construction business. His spouse spends 50 hours a year on a short-term rental business—which tax law doesn’t consider a rental activity. But the short-term rental housekeeper spends 80 hours a year. Thus, without grouping the businesses? The taxpayers can’t deduct short-term rental losses. However, if the couple groups the activities, they achieve material particpation. Note that it should be reasonable to group these activities. In addition to the common ownership and control, the husband maybe does construction and repair work in both activities. And then the wife may do the accounting in both activities.
Example 4: A real estate broker qualifies as a full-time real-estate professional, and also spends 75 hours per property per year managing two rental properties. But if he uses separate landscapers for each property and the two landscapers each spend 100 hours a year? He doesn’t materially participate and won’t be able to deduct rental losses. Unless he groups. And in that case, bingo, he material participates. Because his 150 hours exceeds the 100 hours spent by either of the landscsapers. (As mentioned earlier, you can’t group his real estate sales activity with the rental activity.)
Example 5: A taxpayer rides horses professionally (one activity) and operates an interior design business that specializes in equestrian-themed home interiors (another activity). Very possibly, she can group the horseriding with the interior design. Risk exists here that the IRS might see the horse business as a hobby, something I discussed here: What Ms. Topping Learned. But ignoring the hobby loss issue, if someone owns and operates two businesses that together create synergies? Grouping might be reasonable. (Be sure to consult your tax advisor if you want to try something like this.)
A Final Caution Here
And let me end with a caution. The IRS regularly rejects taxpayers grouping an airplane business with another business. Which maybe doesn’t seem to matter to you if you don’t own an airplane. But the rejected airplane activity groupings highlight a risk.
The pattern that seems to show up when the IRS removes an airplane business from grouping? Common ownership and control isn’t enough. You need more than that. You want interdependencies or similarities in the activities. Probably some synergy. And then you don’t want huge differences in the activities. (Grouping a doctor’s office with an airplane charter, for example? Yeah, that’s stretch.)
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