Determining a Member’s Participation in LLC Activities

Editor: Albert B. Ellentuck, Esq.

Any trade or business activity of a limited liability company (LLC) in which a member materially participates is not considered a passive activity. Material participation is a year-by-year determination, and a member meets the material participation standard if he or she is involved in the operations of the activity on a regular, continuous, and substantial basis.

According to Temp. Regs. Sec. 1.469-5T, a member is treated as materially participating in an activity if one of the following seven tests is met. The first four are objective tests based on the current year. The next two tests are based on participation in prior years, while the last one is a broad “facts and circumstances” test based on the statutory definition of material participation.

  1. Hourly safe harbor: The member participates in the activity for more than 500 hours during the current year.
  2. Primary participant: A member’s participation in the activity for the current year constitutes substantially all of the participation of all individuals in the activity (including individuals who are not owners of interests in the activity).
  3. Maximum participant: A member participates in the activity for more than 100 hours during the current tax year, and this is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity).
  4. Significant participation activity aggregation: The activity is a significant participation activity (SPA), and the member’s aggregate participation in all SPAs during the current year exceeds 500 hours. (An SPA, generally, is an activity in which the member participates for more than 100 hours during the year but which does not qualify as a material participation activity under any of the other six tests.)
  5. Historical participation: The member materially participated in the activity for any five years (whether or not consecutive) during the 10 years immediately preceding the current year.
  6. Personal service activity: The activity is a personal service activity (professions and trades in which capital is not an income-producing factor), and the member materially participated in the activity for any three years (whether or not consecutive) preceding the current year.
  7. Facts and circumstances: If a member is not a material participant under tests 1–6, but based on all of the facts and circumstances the individual participates in the activity on a regular, continuous, and substantial basis during the year, then the member is considered to materially participate. The temporary regulations require the member to participate in the activity for at least 100 hours a year. However, the member’s time spent managing will not count toward the 100 hours if any person receives compensation for managing the activity and if any person spent more hours than the member managing the activity.

Example: C spent 300 hours participating in his baking business (F LLC) and 250 hours participating in his restaurant business (B LLC). C owns 40% of each LLC and is a named manager of each one. Since he participates more than 100 hours in each activity, each activity is an SPA. Because his participation during the year in all SPAs is more than 500 hours, C is deemed to materially participate in both activities.

Exceptions to Material Participation Rules

Generally speaking, any participation by an LLC member, in any capacity, counts as participation for Sec. 469 purposes (Regs. Sec. 1.469-5(f)(1)). However, there are exceptions to this rule:

  1. Work not customarily performed by an owner: The first exception is for work not customarily performed by an owner. If the work performed by the member is not of a type customarily done by an owner of the activity, and one of the principal purposes of performing the work is to avoid the passive activity loss rules, the member’s work does not count as participation (Temp. Regs. Sec. 1.469-5T(f)(2)).
  2. Participation as an investor: The second exception excludes work done as an investor from the definition of participation. Participation as an investor includes (a) studying and reviewing financial statements or operation reports; (b) preparing summaries or analyses of the finances or operations of the activity for the investor’s own use; and (c) monitoring the activity in a nonmanagerial capacity (Temp. Regs. Sec. 1.469-5T(f)(2)(ii)). In Jende , T.C. Summ. 2011-82, taxpayers owned several vacation condos they rented out on a short-term basis. They paid others to manage the properties. Accordingly, the time they spent “managing” the activities was spent as an investor and did not satisfy the material participation tests.
  3. Limited partners: Under this exception, partners are treated as not materially participating in any activity they hold through a limited partner interest (Sec. 469(h)(2)). However, a limited partner is treated as materially participating if he or she (a) participates in the activity for more than 500 hours during the year (i.e., meets the hourly safe-harbor test); (b) materially participated in the activity for any five of the 10 immediately preceding tax years (i.e., meets the historical participation test); or (c) materially participated in a personal service activity for any three prior years (i.e., meets the personal service activity test) (Temp. Regs. Sec. 1.469-5T(e)(2)).

Proper Treatment of LLC Members

Uncertainty has existed about the proper treatment of LLC members under the material participation rules. According to the IRS Passive Activity Loss Audit Technique Guide , an LLC member (even a member-manager) can be a material participant only by meeting the limited partner hourly safe-harbor test, historical participation test, or personal service activity test. However, a number of commentators do not share this view. They point out that while there are similarities between limited partnerships and LLCs (e.g., limited liability), an LLC member can participate in management (while, under state law, limited partners are often prohibited from actively participating in the business). Furthermore, the courts have not agreed with the IRS’s position regarding application of the limited partner material participation rules to LLC members. For example, in Gregg , 186 F. Supp. 2d 1123 (D. Ore. 2000), a district court held that an LLC member was not subject to the higher material participation standard applicable to limited partners but only had to satisfy one of the regular seven material participation tests.

In November 2011, the IRS released proposed regulations changing its position to more narrowly provide that an interest in an entity will be treated as an interest in a limited partnership if the entity is classified as a partnership for federal tax purposes, and the holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement (Prop. Regs. Sec. 1.469-5(e)(3)(i)). This means that the rules would no longer rely on limited liability, but would rely instead on the member’s right to participate in the management of the LLC. Consequently, for members who participate in management, the determination of material participation could be made using any of the seven tests, not just the three tests available for limited partners.

Under the proposed regulations, a limited partner who also has a general partner interest in the same partnership during the entire year would be considered a general partner for determining material participation (Prop. Regs. Sec. 1.469-5(e)(3)(ii)). Presumably, a member in an LLC who holds interests as a manager and a nonmanager would be treated as a manager for determining material participation.

The proposed regulations are scheduled to apply to tax years beginning on or after their publication as final regulations in the Federal Register.

Documenting Participation

Participation by a member in an LLC classified as a partnership is based on the LLC’s tax year, not the member’s tax year. Under Temp. Regs. Sec. 1.469-5T(f)(4), proof of an individual’s participation in an activity can be established by any reasonable means, including appointment books, calendars, or narrative summaries. However, oral testimony, post-event “ballpark guesstimates,” and a calendar maintained in advance, are not reasonable methods for documenting participation .

When hours of participation may be questioned, practitioners should recommend that clients maintain a contemporaneous log.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 18th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, James A. Keller, and Linda A. Markwood, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724;



Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va..


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