Income that is not subject to federal tax withholding requires you to pay estimated taxes.
What is material participation?
Material participation refers to a set of criteria used of the IRS to determine if you actively participated in a business venture or if it’s a source of passive income.
To determine if you are a material participant in your business or merely a passive investor, the IRS uses seven tests. You only have to pass a single test to qualify as a material participant.
Tests include participating more than 500 hours in the business throughout the year, consistently participating in the business throughout the entire year or participating more than 100 hours during the year and the person’s participation is not less than that of any other person.
The distinction between passive participation and active participation is important for tax purposes. If you meet the qualifications for an active participant, you are allowed to use your business losses to offset other sources of business income or your salary.
Taxpayers can claim a passive loss only against income generated from passive activities. Any excess passive activity loss can be carried forward to future years until used, or until it can be deducted in the year when the taxpayer disposes of the passive activity in a taxable transaction.
If you feel like you meet the criteria to be a material participant, it is important to keep records that prove you meet the time requirements. Time sheets, calendars and work logs are all great sources of evidence to prove that you were an active participant of the business.
Material participation example
If you have your own business, you’ll need to determine if you are a material or active participant.
For example, assume that you open your own lawn care company. You start the business without any employees. In the first year, you log 800 hours of activity with the business and pass the test to be an active participant.
However, by your fourth year of business, you decide to open a tree-trimming business. You focus your efforts on the tree-trimming business and hire a project manager for your lawn-care company. Your participation drops to 200 hours for the entire year. Unless you satisfy one of the other IRS guidelines, you are now a passive participant in the lawn-care company.
Get a handle on your taxes with this self-employment tax calculator.