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Whether a taxpayer materially participates in an activity has primary relevance to two important tax issues. First, an activity in which the taxpayer materially participates avoids the passive activity loss (PAL) limitation rules of Section 469.1 Second, if the activity produces income, that income is exempt from the Section 1411 net investment income tax (NIIT) if the income is derived from a trade or business in which the taxpayer materially participates.2 For both provisions, material participation is defined generally in Section 469(h) and in more detail in Reg. 1.469-5T.3 The reach of both provisions extends to individuals, estates, and trusts. The Section 469(c)(7) qualified real estate professional (QREP) test, which allows the taxpayer to avoid the automatic passive status of rental properties,4 adds another reason to test for material participation. A QREP is a person who spends more than one-half of their time in real property trade or business activities in which they materially participate, and who spends more than 750 hours in such activities during the year.5
The material participation issue is also relevant to a determination of whether a joint venture conducted by a husband and a wife satisfies the Section 761(f) definition of a "qualified joint venture" (QJV). A QJV may elect to report as a disregarded entity rather than as a partnership. A QJV is a trade or business activity in which the husband and wife are the only owners, and both husband and wife materially participate within the meaning of Section 469(h).6 If the QJV test is satisfied for the first year of operations, and if the spouses choose to treat the arrangement as a disregarded entity, it would appear that the status of the trade or business arrangement as a partnership would be based on the Tower analysis if one of the spouses fails to materially participate in a subsequent year.7
Finally, while it does not specifically use the material participation definitions, Prop. Reg. 1.1402(a)-2(h)(2)(iii) extends the self-employment tax to a partner who participates for more than 500 hours during the year. This proposed regulation, released in March 1997, has never been issued in temporary or final form and is therefore not authoritative. However, the IRS has informally stated that it will not challenge a taxpayer who relies on...