Active or Passive Participant in a Partnership?

A partnership represents a business or investment structure where multiple owners share in the profits and losses. For federal tax purposes, the Internal Revenue Service (IRS) mandates that each partner’s involvement be classified as either “active” or “passive.” This distinction dictates how a partner’s portion of the entity’s income or loss is reported and taxed on their individual income tax return. The classification hinges on a set of specific tests measuring a partner’s engagement with the business’s operations during the tax year.

The determination of whether a partner is active or passive has financial consequences, as it directly impacts the ability to deduct losses and the application of self-employment taxes. Understanding this classification is a foundational element of a partner’s personal tax planning and compliance.

Determining Your Participation Status

A partner’s classification as active is established by meeting at least one of seven specific “material participation tests” outlined by the IRS for a given tax year. These tests quantify a partner’s involvement in a trade or business activity. The prior year tests, for example, prevent partners from easily switching to passive status after years of active involvement. If a partner’s engagement satisfies any single test, they are considered to have materially participated and are classified as an active participant for that activity for that year. Failure to meet any of these tests results in a passive participant classification.

• The 500-Hour Test: The partner participated in the activity for more than 500 hours during the tax year.
• Substantially All Participation Test: The partner’s participation constituted substantially all of the participation in the activity by anyone for the year. This prevents a sole operator from being classified as passive if the business does not require 500 hours of work.
• The 100-Hour Test: The partner must participate for more than 100 hours, and that participation must be at least as much as any other individual involved in the activity.
• Significant Participation Activity (SPA) Test: An SPA is a business where an individual participates for more than 100 hours but does not meet other tests. If the partner’s combined time in all SPAs exceeds 500 hours, they are a material participant in each activity.
• Prior Year Test (5 of 10 Years): The partner materially participated in the activity for any five of the ten immediately preceding tax years.
• Prior Year Personal Service Test: The partner materially participated in a personal service activity, such as law or accounting, for any three prior tax years.
• Facts-and-Circumstances Test: This allows for material participation based on regular, continuous, and substantial involvement, even if hourly thresholds are not met. This test cannot be used if the individual participated for 100 hours or less.

Limited Partner Rules

The rules for material participation are more stringent for limited partners, who are presumed to be passive. To be classified as an active participant, a limited partner must satisfy the 500-hour test, the five-out-of-ten-prior-years test, or the three-prior-years in a personal service activity test.

Tax Treatment of Active Participation

When a partner is classified as an active participant, their share of the partnership’s business income or loss receives a distinct tax treatment. If the partnership generates a loss, an active partner can deduct their share of that loss against other forms of income, such as wages, interest, or dividends.

These loss deductions are not unlimited. The amount of loss a partner can deduct is first limited by their tax basis in the partnership. After the basis limitation, losses are also subject to at-risk rules, which limit deductions to the amount the partner stands to lose financially.

Another implication of active status for a general partner is the treatment of their income for self-employment tax purposes. A general partner’s distributive share of income from a partnership’s trade or business is considered self-employment income. This income is subject to both Social Security and Medicare taxes, paid via their personal Form 1040.

Tax Treatment of Passive Participation

For partners who do not meet any of the material participation tests, their involvement is classified as passive, which triggers a different set of tax rules. The Passive Activity Loss (PAL) rules under Section 469 of the tax code stipulate that losses from a passive activity can only be used to offset income from other passive activities. They cannot be used to reduce non-passive income, such as wages or portfolio income.

If a partner’s passive losses for a year exceed their passive income, the excess loss is suspended and carried forward to future tax years to offset future passive income. The full value of any remaining suspended losses is realized when the partner disposes of their entire interest in that specific passive activity in a taxable transaction. For example, if a partner sells their entire stake in the partnership to an unrelated party, all suspended losses from that activity are released and can then be used to offset any type of income.

Partners with passive income may also face an additional tax. Net income from passive partnership activities is included in the calculation of Net Investment Income and may be subject to the 3.8% Net Investment Income Tax (NIIT). The NIIT applies to individuals, estates, and trusts that have net investment income and a modified adjusted gross income (MAGI) exceeding certain thresholds.

Special Considerations for Real Estate Activities

The tax code applies unique rules to real estate investments. The IRS automatically classifies any rental real estate activity as a passive activity, regardless of how many hours the partner participates, so losses are subject to the PAL limitations. However, there are two exceptions.

One exception allows a partner who “actively participates” in a rental real estate activity to deduct up to $25,000 of rental losses against non-passive income. The “active participation” standard is less stringent than “material participation” and requires management decisions, such as approving tenants or authorizing repairs. This allowance is phased out for taxpayers with a modified adjusted gross income (MAGI) between $100,000 and $150,000.

A second exception exists for individuals who qualify as a “real estate professional.” To meet this standard, a taxpayer must spend more than half of their personal service time in real property trades or businesses and perform more than 750 hours of service in those activities during the year. If a partner qualifies, their rental real estate activities are no longer automatically passive and are instead evaluated individually using the seven material participation tests.