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Are You the Partner With 'Material Participation'?

By Elizabeth Rosen

NEW YORK ( IRS.com) -- When it comes to your income taxes, U.S. tax law makes a distinction between different types of income -- including income from passive investments and active businesses in which the taxpayer "materially participates." The issue of material participation can be extremely important for you as a business owner or investor. Whether you qualify as a material participant determines the extent to which you are allowed to deduct losses on your tax return.

For example, let's say you are completing Schedule C of Form 1040 (the U.S. Individual Income Tax Return) to report your business' profits and losses. You will have to check a box indicating whether you materially participated in the business during the tax year. Generally, you are eligible to claim material participation if you participated in a business on a "regular, continuous and substantial basis." To claim material participation, check "yes" on your tax form.

Most sole proprietors are qualified to claim material participation because they typically spend substantial amounts of time running their business. Merely having a financial interest in a business (even if it is significant), though, is not enough to meet the material participation criteria -- unless you also handle the day-to-day management of the business. This means your managerial tasks do not qualify you for material participation if you are simply reviewing financial statements, monitoring operations or providing business advice.

SLIDESHOW: Is it worth it? To spend or not to spend

On the other hand, if you check "no," the business counts as a passive activity. This limits the losses you are permitted to deduct, since passive activity losses can only be deducted against passive activity income. Passive income refers generally to the proceeds from a financial investment, such as a business or rental property, that does not require significant time or effort to manage after the investment is made. This question is posed because the federal government does not want taxpayers to try to claim losses on passive investments as regular business losses, which are deductible against their ordinary income. If you do not have sufficient passive income to deduct passive income losses, the deductions must be suspended and claimed in a year when you have more passive income or when you sell the investment.

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