Active vs. Passive Participation in a Partnership

For federal tax purposes, the Internal Revenue Service (IRS) classifies a partner’s involvement in a partnership as either active or passive. This classification directly impacts how income and losses from the partnership are treated on a personal tax return. The level of a partner’s participation can alter their tax liability, affecting the deductibility of losses and the obligation to pay certain federal taxes.

Defining Material Participation in a Partnership

A partner’s status as active or passive depends on the concept of “material participation.” To be classified as a material participant for the tax year, a partner must satisfy at least one of seven tests defined by the IRS that measure regular, continuous, and substantial involvement.

• The 500-Hour Test: The partner participates in the business for more than 500 hours during the tax year. For example, a partner in a consulting firm who spends over 10 hours per week on client work and business development would meet this threshold.
• Substantially All Participation: The partner’s involvement constitutes substantially all of the participation in that activity for the year. If a partner in a small retail shop is the only person working in the business, they meet this test regardless of total hours.
• The 100-Hour Test: The partner participates for more than 100 hours, and their participation is not less than that of any other individual. For instance, if one partner works 120 hours on bookkeeping while no other person works more than that, they would materially participate.
• Significant Participation Activity (SPA): An SPA is a business where an individual participates for more than 100 hours but doesn’t meet other tests. If a partner’s combined time in all their SPAs exceeds 500 hours, they materially participate in each one.
• Five-of-Ten-Year Test: The partner materially participated in the activity for any five of the ten immediately preceding tax years.
• Three-Year Personal Service Test: The activity is a personal service business (e.g., law, health), and the partner materially participated for any three prior tax years.
• Facts and Circumstances Test: Based on a broad view of the partner’s role, they participated on a regular, continuous, and substantial basis during the year, even if no other test is met.

Limited partners are presumed to be passive because their involvement is often restricted to a financial investment. However, a limited partner can be classified as a material participant if they satisfy the 500-hour test, the five-out-of-ten-year test, or the three-year personal service activity test.

Tax Consequences of Passive Participation

When a partner does not meet any material participation tests, their involvement is classified as passive. This triggers the Passive Activity Loss (PAL) rules, which prevent taxpayers from using losses from passive investments to shelter other forms of income, such as wages or portfolio income. The core principle is that losses from passive activities can only be used to offset income from other passive activities.

If a partner’s share of losses from a passive activity exceeds their total income from all passive sources, the excess loss is not deductible in that year. For example, if a partner has a $20,000 passive loss but only $5,000 of passive income, they can only deduct $5,000 of the loss. The remaining $15,000 is disallowed for the current tax year.

These disallowed losses are suspended and carried forward to future tax years to offset passive income. Upon a complete and taxable disposition of the partner’s interest in the activity, all suspended losses from that activity are freed up to offset any type of income.

Tax Consequences of Active Participation

For a partner who materially participates, the tax treatment of losses is different. Losses from an active partnership are not subject to the Passive Activity Loss limitations, meaning a partner can deduct these losses against other sources of income, such as their salary or dividend income. The ability to deduct these losses is still subject to other tax provisions, such as the basis limitation and the at-risk rules, which limit deductible losses to the amount the partner has personally invested.

A defining consequence of active participation is that a partner’s share of income is generally considered net earnings from self-employment and is subject to self-employment taxes. Court rulings have established that partners who are “limited” in name only but are actively involved in operations may still be subject to this tax. An active partner can deduct one-half of their self-employment tax payments, which helps to partially offset this liability.

Special Rules and Related Taxes

Real Estate Professional Exception

The tax code provides an exception for qualifying real estate professionals, allowing them to treat otherwise passive rental real estate activities as non-passive. To qualify, an individual 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 these tests are met, the individual can deduct rental losses against non-passive income, provided they also materially participate in the rental activity itself.

Activity Grouping Election

Taxpayers have the option to group multiple trade or business activities into a single activity for applying the material participation tests. This election can be advantageous when a partner participates in several related ventures but does not meet the hour requirements for any single one. By combining the hours spent on all grouped activities, a partner may exceed the 500-hour threshold and qualify as a material participant for the entire group. This election is formal and requires filing a statement with the tax return for the first year the grouping is made.

Net Investment Income Tax (NIIT)

A partner’s participation status also has direct implications for the 3.8% Net Investment Income Tax (NIIT). This tax applies to individuals, estates, and trusts with income above certain thresholds. For individuals, the thresholds are $200,000 for single filers and $250,000 for those married filing jointly. Net investment income includes interest, dividends, and income from passive business activities. Consequently, income passed through to a passive partner is generally subject to the NIIT, whereas income earned by a partner who materially participates in the business is typically excluded from this tax.