Material Participation for LLP and LLC Owners

The passive activity loss (PAL) rules can impact whether you’re able to deduct losses from a business set up as an LLC or LLP. Depending on how involved you are in the business, you may or may not be able to use those losses right away.

The Basics

PAL rules limit the use of passive activity losses to offset only passive income. Additionally, basis and at-risk rules may further restrict deductions.

So, what counts as a passive activity? There are two main types:

• Businesses where you’re not actively involved, and

• Rental activities (these are usually considered passive, even if you’re hands-on, unless you qualify as a real estate professional)

If your losses are limited under these rules, they aren’t lost forever. You can carry them forward to use in future years, or when you sell your interest in the business.

Why your Involvement Matters

If you actively participate in your LLC or LLP, your losses are generally not passive and can be used to offset other income, such as wages, interest, dividends, or capital gains.

“Material participation” basically means you’re regularly, consistently, and meaningfully involved in the business.

If you’re not treated as a limited partner, you can qualify by meeting one of several IRS tests, including:

• Spending more than 500 hours on the business during the year

• Doing most (or all) of the work yourself

• Working at least 100 hours and as much as (or more than) anyone else

• Spending significant time across multiple business activities (over 500 hours total)

• Having been materially involved for 5 of the last 10 years

• Meeting certain rules for personal service businesses

• Or simply being deeply involved based on all the facts and circumstances

If you’re considered a limited partner, you can only qualify under a few of these tests.

Track your Time

If you want to take advantage of these rules, good recordkeeping is a must. Keep track of the time you spend on your business activities throughout the year. And if your spouse is involved too, you can usually combine your hours to help meet the participation requirements.

Bottom Line — these rules can get complicated, but they can also create real tax-saving opportunities. A little planning and good documentation can go a long way.

If you need help with applying the PAL or determining if you meet the material participation criteria, talk to your CPA or tax advisor.