Materially Participate in the Business to Avoid the Passive Activity Loss Rules

Kevin Burkett, Extension Associate
College of Agriculture, Clemson University

Introduction

Beginning farmers and ranchers frequently establish their agricultural business by starting small and having an off-farm job. This is a common pattern and allows the operation to scale up over time. However, farming business activities must meet certain threshold tests to be considered active rather than passive activities. The passive activity loss rules apply to farm businesses, including partnerships, Limited Liability Companies (LLCs), C Corporations, and S Corporations.

Generally, a passive activity is any activity that involves: (1) the conduct of a business in which the operator does not materially participate, or (2) is a rental activity. Should a loss occur in such a business, the passive activity loss rules limit an operator’s ability to deduct losses. When an operator does not materially participate or it is a rental activity, losses generated from passive activities, as a general rule, can only offset income from passive activities.

There are some exceptions to this. One exception, which is discussed later, is rented farm property where the landowner participates in the business with the tenant. Second, a retired or disabled farmer can be considered a material participant if they were materially participating five or more of the eight years before their retirement or disability. Additionally, a less stringent threshold of actively participating can allow passive losses to be deducted up to $25,000.

In the case of farming or ranching, material participation is looked at in relation to the business activities. Material participation requires an operator to be involved in the operation of a trade or business activity on a regular, continuous, and substantial basis. This rule was set in place so that taxpayers with large amounts of income could not merely invest in business ventures and be able to deduct significant passive activity losses against their other (more profitable) activities.

In agriculture, ownership and management structures vary because of the capital required for farm businesses, estate and transition issues, and meeting the wishes of various stakeholders. There can be two common issues with passive activity rules for agriculture. One, when an operator is trying to get the business started, i.e. the example mentioned earlier, but may be lacking in time or opportunity to devote to the business. The other, a landowner that rents property to a tenant but has participation in the farming of the land as well.

Activities associated with material participation (especially for farm rental landlords) are those things that, considered in their totality, show that the operator was significantly involved in the production of farm commodities. Examples include but are not limited to:

• Paying at least half the direct production costs (operating expenses),
• Furnishing at least half the tools, equipment, and/or livestock,
• Advising the tenant, and/or
• Regularly and frequently making or taking part in management decisions.

Tests to Determine Material Participation

There are seven tests used by the Internal Revenue Service to determine whether or not an operator materially participates in a business activity. An operator who meets any one of these seven tests is deemed to be materially participating in the business activity. It is also important to note the activity of an operator’s spouse can count toward the material participation requirements listed here, even though the spouse themselves may not be an operator of the business.

The first four tests for material participation look for a set number of hours in the current tax year. The next two tests look at participation in previous tax years. The final test examines the facts and circumstances from a restrictive point of view.

Test 1. Participation Exceeds 500 Hours

The operator participates for more than 500 hours in the specific activity during the taxable year. If both spouses participate in the farm business, the participation of both spouses is counted; the participation of children and employees is not counted.

Test 2. Substantially All of the Activity for the Year

If the operator is the sole participant in an activity or performs substantially all of the services in the activity for the tax year, that person’s participation is material. This test does not specify a number of hours, just that the operator does most of the work.

Test 3. More than 100 Hours and No One Else Spends More Time

A third test of material participation requires that the operator participate more than 100 hours and not less than any other individual involved in the activity. Participation by employees as well as operators must be considered.

Test 4. Significant Participation: Multiple Activities Combined

The requirements of the 500-hour test can be met by combining different and distinct activities in which the person participates for more than 100 hours each. These activities are known as significant participation activities, a term that has no legislative history but has materialized in the regulations. For each significant participation activity, the tax regulations require:

• the operator to participate more than 100 hours per year;
• the activity must be a business, not a rental or investment activity;
• you were not considered materially participating under any other test;

Several aspects of significant participation activities can lead to some strange results, so be sure to consult with your tax advisor.

Test 5. Material Participation for 5 of Last 10 Years

An individual who has materially participated (by Tests 1 through 4) in an activity for five of the last ten years will be considered a material participant in the current year. This test typically applies when the taxpayer retires from material participation but retains an ownership interest.

Test 6. Material Participation in Personal Service Activity for 3 Years

An individual who has materially participated in a personal service activity for at least three years will be treated as a material participant for the rest of his or her life. A personal service activity includes any trade or business in which capital is not a material income-producing factor, such as fields of health, law, accounting, consulting, etc.

Test 7. Facts and Circumstances

An individual who participates in an activity for more than 100 hours may be treated as a material participant if, based on all the facts and circumstances, he or she participates on a regular, continuous, and substantial basis. The regulations set out the following rules regarding the facts and circumstances test:

1. The fact that an individual satisfies a material participation test under another section of the Code, such as I.R.C. sec 1402 (self-employment) or I.R.C. sec 2032A (special-use valuation) has no bearing on the material participation test for passive activities.
2. Management activities of the producer are not counted if:
   • anybody other than the taxpayer is compensated for management services; or
   • anybody provides more hours of management services than the taxpayer.
3. If the taxpayer participates for 100 or fewer hours, he or she cannot be treated as materially participating under the facts and circumstances test.

Best Practices

A log should be kept to substantiate the involvement in a business activity, notating dates, hours spent, and descriptions of the work or service performed by the operator. This is important, for instance, if both spouses have non-farm jobs and are getting started in farming. The following examples depict situations applicable to beginning farmers and ranchers.

Frequently, a beginning farmer will rent land from a landowner due to financial constraints that prohibit the purchase of enough land for a viable farm or ranch. The rental arrangement can be either cash rent or crop-share rent. In either case, the beginning farmer or tenant is generally materially participating in the activity while the landlord, in the case of a cash rental agreement, is not materially participating. In a crop-share rental arrangement, the facts and circumstances of the rental agreement should be examined to determine whether the landlord is materially participating. Generally, the tenant is materially participating; however, the seven tests must be applied to determine whether the crop-share landlord is involved in a passive activity. 

Disclaimer

This information is provided to educate beginning farmers and ranchers as well as other taxpayers about the income tax consequences associated with passive activities. You are encouraged to contact your income tax preparer to discuss your unique facts and circumstances.

IRS Publications

To access IRS Publications go to www.irs.gov and click on “Forms and Publications.” Then click on “Publication number” under “Download forms and publications by.” Type the publication number in the find box to search for the publication. Publications may be viewed online by double clicking on the publication or downloaded.

IRS Publication 925: Passive Activity and At-Risk Rules. This publication specifically covers passive activities and income tax treatment of income and losses.

IRS Form 8582 and Instructions: Passive Activity Loss Limitations. This form is to figure and report passive activity loss.

Additional Topics

This fact sheet was written as part of Rural Tax Education, a national effort including Cooperative Extension programs at participating land-grant universities to provide income tax education materials to farmers, ranchers, and other agricultural producers. For a list of universities involved, other fact sheets, and additional information related to agricultural income tax, please see RuralTax.org. 

Fact sheets that might be of interest include:

• Farm Losses versus Hobby Losses: Farmers Must Plan Ahead to Avoid Adverse Tax Consequences
• How Do the At-Risk Rules Apply to a Farm Business?

Sources:

IRS Pub 925:  https://www.irs.gov/pub/irs-pdf/p925.pdf

IRS Form 8582 and Instructions:  https://www.irs.gov/pub/irs-pdf/i8582.pdf

IRS Schedule C and Instructions:  https://www.irs.gov/pub/irs-pdf/i1040sc.pdf

IRS Schedule F and Instructions:  https://www.irs.gov/pub/irs-pdf/i1040sf.pdf

 

This information is intended for educational purposes only. You are encouraged to seek the advice of your tax or legal advisor, or other authoritative sources, regarding the application of these general tax principles to your individual circumstances. Pursuant to Treasury Department (IRS) Circular 230 Regulations, any federal tax advice contained here is not intended or written to be used, and may not be used, for the purpose of avoiding tax-related penalties or promoting, marketing or recommending to another party any tax-related matters addressed herein.

USDA is an equal opportunity provider, employer, and lender. Rural Tax Education is part of the National Farm Income Tax Extension Committee.  The land-grant universities involved in Rural Tax Education are affirmative action/equal opportunity institutions.

This material is based upon work supported by the U.S. Department of Agriculture, under agreement number FSA21CPT0012032. Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the author(s) and do not necessarily reflect the views of the U.S. Department of Agriculture. In addition, any reference to specific brands or types of products or services does not constitute or imply an endorsement by the U.S. Department of Agriculture for those products or services.

Published March 2024

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