If you are a sole proprietor and must file Schedule C to report your business income, you'll notice that the top section of the Schedule C form asks you to answer yes or no to the question, "Did you materially participate in the operation of this business during 200X?"
Most sole proprietors can safely check the box marked "yes," since owners typically expend much more time and effort on their operations than an employee might. Their participation in the business is not only material, it's absolutely crucial!
The IRS asks this question chiefly to screen out businesses that are really passive, investment activities for their owners instead of actively managed businesses. Passive activities are the classic vehicles for tax shelters, and they are now subject to strict rules regarding deduction of losses.
If your business is a partnership, limited liability company, or S corporation you'll also need to be concerned about this issue, since any passive activity income, losses, or credits passed through to you by the business must be treated as such on your own income tax return. For partnerships and limited liability companies, any passive activity tax items must be determined by the business and reported as such on the business's Form 1065, U.S. Partnership Return of Income, and on the Schedule K-1s given to partners or LLC members.
What's the big deal about passive activities? Essentially, the IRS does not want you to try to disguise passive activity losses as regular business losses that are deductible against your ordinary income. The rule is that passive activity losses can only be deducted against passive activity income.
Furthermore, if you are involved in any passive activities, the IRS does not want you to call a profitable business a "passive activity" just so that you can deduct some passive losses against it.
Real estate rentals will almost always be considered a passive activity that should be reported on Schedule E, not Schedule C or another business return, regardless of whether the owner materially participates. (An exception exists for certain real estate professionals who materially participate in the real estate rental activities.)
Beyond that important distinction, the IRS has devised a seven-step test for material participation in a business. If you meet any of seven requirements, you have materially participated for the year, and you should check the "yes" box in answer to the question on Schedule C, or treat the income or loss items as nonpassive if your business is a partnership, LLC, or S corporation.
If you are married, your spouse's work in the business can be counted towards your own participation hours whether or not you file a joint tax return, and whether or not your spouse is a co-owner of the business.
However, work done primarily as an investor in the business (such as reviewing or analyzing financial statements, or monitoring the finances or operations in a nonmanagerial capacity) does not count toward these tests.
If you do not meet any of these tests, you must treat the activity as a passive activity, and if you have a loss, you may have to complete Form 8582, Passive Activity Loss Limitations.
There is an exception for those who own working interests in oil or gas wells - they may check the "yes" box and complete Schedule C whether or not they meet any of the seven tests.
The seven-part test does not apply to C corporations, including personal service corporations. These corporations face a different set of rules, and we suggest that you consult your tax advisor for more details.