Meeting the 100-Hour Significant Participation Activity Test

By Brenda M. Graat, CPA, MBA, Milwaukee, and James J. Malczewski, CPA, Appleton, Wis.

Editor: Mark Heroux, J.D.

Effective beginning in 2013, the Health Care and Education Reconciliation Act, P.L. 111-152, created the 3.8% net investment income tax imposed by Sec. 1411 to fund health care reform. Since this tax came into effect, taxpayers and their advisers have considered income tax planning methods to alleviate the additional tax due. Because passive activity income is generally subject to the net investment income tax, one strategy is to focus on the taxpayer's level of participation in an activity so that income may be characterized as nonpassive and thus not subject to the tax.

As defined under the passive loss rules, according to Regs. Sec. 1.469-5(f)(1), participation is considered to be any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity, where the individual owns (directly or indirectly) an interest in the activity at the time the work is done. The regulations have defined three levels of participation: active, significant, and material.

Levels of Participation

Active participation is the least-stringent test, in which the taxpayer does not need to have regular, continuous, and substantial involvement in the operations. Instead, a taxpayer is considered to actively participate if he or she makes management decisions in a significant and bona fide sense. This level of participation is beneficial for taxpayers who have a greater than 10% interest in rental real estate activities, with an opportunity to claim a loss of up to $25,000 from those activities (subject to phaseout based on adjusted gross income).

A harder-to-achieve standard is material participation. To be considered as materially participating in an activity, an individual must, under Sec. 469(h)(1), have "regular, continuous, and substantial" involvement in the activity. Temp. Regs. Sec. 1.469-5T(a) provides seven tests by which taxpayers can meet the material participation standard, one of which is that the taxpayer participates more than 500 hours in the tax year in the activity. Where taxpayers can meet the material participation standard for an activity (and, for rental real estate activities, where the taxpayer meets the real estate professional requirements of Sec. 469(c)(7) and the activity is a trade or business), their income will be characterized as nonpassive and not subject to the net investment income tax.

In between these two levels is significant participation, defined in Temp. Regs. Sec. 1.469-5T(c)(2) as a trade or business activity in which the taxpayer participates for more than 100 hours during the tax year, with the level of participation not qualifying as material. The income from a significant participation activity is subject to recharacterization rules under Temp. Regs. Sec. 1.469-2T(f)(2). While losses from a significant participation activity are considered passive activity losses, if passive activity gross income from all of a taxpayer's significant participation activities for the tax year exceeds the taxpayer's passive activity deductions from all such activities for the year, a ratable portion of the net passive income from each significant participation activity is recharacterized as nonpassive income and, as such, is not subject to the net investment income tax. In addition, a taxpayer can establish material participation in a significant participation activity if the taxpayer participates in more than one significant participation activity and the taxpayer in total participates in the significant participation activities for more than 500 hours for the tax year (Temp. Regs. Sec. 1.469-5T(a)(4)).

Although the definition of "significant participation activity" appears relatively straightforward in comparison to the material participant requirements, it can be deceiving. Taxpayers should take great care to understand which work activities qualify as "participation."

Work That Qualifies as Participation

The type of work that will qualify as participation is broadly defined. Regs. Sec. 1.469-5(f)(1), states:

except as otherwise provided . . . any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity in which the individual owns an interest at the time the work is done shall be treated for purposes of this section as participation of the individual in the activity.

The meaning of "without regard to the capacity" is illustrated in Temp. Regs. Sec. 1.469-5T(k), Example (2), where individual A's work as an employee of corporation X counted as participation in an activity of partnership P. Partnership P contracted with corporation X for managerial services at a time when A had a direct ownership interest in P. A's only other involvement in P was in the capacity of an employee of X, under terms of a contract for services between X and P. This example goes out of its way to make it clear that even if X had no ownership in P, A could count his hours as participation while working on P's activity as an employee ofX.

Exception to Participation Rules

Temp. Regs. Sec. 1.469-5T(f)(2) provides two specific exceptions from work activities considered participation for application of these rules: "certain work not customarily done by owners" and "participation as an investor."

Certain work not customarily performed by owners: As indicated in Temp. Regs. Secs. 1.469-5T(f)(2)(i), a taxpayer's hours in an activity do not count as participation if the work is of a type that is not customarily done by an owner and "[o]ne of the principal purposes for the performance of such work is to avoid the disallowance, under Section 469 and the regulations thereunder, of any loss or credit from such activity."

Stated differently, as long as none of the principal purposes for performing the work are to avoid disallowance of losses or credits under the passive activity rules, then the work would be counted as participation.

Temp. Regs. Sec. 1.469-5T(k), Example (7), gives a simple example of an attorney who set up his wife to work as a receptionist for the football team in which he had a passive ownership interest and did no work himself in connection with the activity. He made this arrangement so he could claim a loss for that tax year. Under Temp. Regs. Sec. 1.469-5T(f)(3), any participation by his wife is treated as participation by the lawyer. However, this type of activity is disallowed as participation because, presumably, owners typically do not perform receptionist services, and the taxpayer's wife was only doing so to avoid loss disallowance.

Assume the same facts, except the football team activity is certain to generate gross income significantly in excess of deductions. Avoiding loss disallowance is not a principal purpose of the wife's working as a receptionist, since no loss is expected. Therefore, the Temp. Regs. Sec. 1.469-5T(f)(2)(i) exception should not apply. Moreover, the exception does not explicitly include a principal purpose of avoiding the application of Sec. 1411. As a result, her work as a receptionist (even though a type of work not customarily done by an owner) should qualify as participation.

The tax implications of the above fact pattern could be significant. If the wife's hours are treated as participation and they exceed 500 in the tax year, she and her husband would be considered as materially participating in the football team activity. As such, the income would not be subject to the net investment income tax. For that matter, even if she worked just over 100 hours in the year, the significant participation activity recharacterization rules would apply. Either way, the joint taxpayers' football team activity net income would be nonpassive and not subject to the net investment income tax. Depending of the level of profitability generated by this activity, saving net investment income tax could make the 100 hours of work quite valuable.

It is interesting to note that the qualifiers of "regular, continuous, and substantial" are mentioned in Sec. 469(h)(1) and Temp. Regs. Sec. 1.469-5T(a)(7) only for purposes of meeting the material participation standard, a higher level of participation than significant participation. Given the absence of any reference to "regular, continuous, and substantial" in either Temp. Regs. Sec. 1.469-5T(c), Regs. Sec. 1.469-5(f), or Temp. Regs. Sec. 1.469-2T(f), one might conclude those qualifiers are not necessary to meet the 100-hour test to recharacterize income as nonpassive.

Work performed as an investor: The second participation exception is work performed as an investor. It prevents taxpayers from counting time worked in their capacity as investors "unless the individual is directly involved in the day-to-day management or operations of the activity." Some examples of investor activities include: (1) studying and reviewing financial statements or reports on operations of the activity; (2) preparing or compiling summaries or analyses of the financial reports or operations of the activities for the individual's own use; and (3) monitoring the finances or operations of the activity in a nonmanagerial capacity. Taxpayers should be careful not to rely on investor hours in trying to meet the 100-hour test. A review of relevant case law is advisable (see, e.g., Lamas,T.C. Memo. 2015-59; Tolin,T.C. Memo. 2014-65; and Williams,T.C. Memo. 2014-158).


It should not be thought taxpayers can avoid the net investment income tax on otherwise passive activity income simply by performing 100 hours of meaningless work in the activity. However, Treasury did exercise its Sec. 469(l) authority in drafting these regulations. Thus, the specific and limited exceptions of Temp. Regs. Sec. 1.469-5T(f)(2) to the kinds of work that can be counted as participation suggest that a broad scope of work will qualify.

Nevertheless, there is no clear-cut answer on what work should be considered as participation, specifically for purposes of meeting the significant participation test, and all the facts and circumstances regarding the work performed should be considered. By avoiding the participation exceptions, in many cases, taxpayers can meet the 100-hour significant participation activity rule and thereby create significant tax savings by recharacterizing passive income as nonpassive and avoiding the 3.8% net investment income tax.


Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.

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