Many businesses have suffered losses during the COVID-19 pandemic. The ability to deduct these losses can provide a silver lining, but the federal tax rules regarding passive activity losses and material participation may mean the losses can’t be deducted in the year they occurred.

PAL Limitation

A passive activity loss (PAL) is the amount by which your aggregate losses from all passive activities for the tax year exceed the aggregate amount of your income from those activities. A passive activity is a trade or business in which you have an ownership interest but don’t materially participate — for example, limited partnerships and rental or leasing businesses. Material participation requires regular, continuous and substantial involvement in the business’s operations.

Generally, a PAL can be used only to offset passive income. So, if you’ve had passive losses without passive income during the pandemic, you can’t benefit from those losses yet. You’ll have to carry them forward until a tax year when you have passive income or dispose of the activity.

Material Participation Tests

In general, subject to limitations, you can immediately deduct losses from businesses in which you materially participate. However, different rules apply to certain real estate activities.

You’ve materially participated if you can satisfy any of the following tests established by the IRS:

1. You participated in the business for more than 500 hours.
2. Your participation was substantially all of the participation in the business by anyone for the tax year, including the participation of individuals who didn’t own an interest in the business (for example, employees).
3. You participated in the business for more than 100 hours during the tax year and at least as much as any other individual, including those with no ownership interest, for the year.
4. The activity is a “significant participation” activity, and you participated for more than 500 hours. A significant participation activity is any business activity in which you participated for more than 100 hours during the year — but didn’t, according to the other six tests, materially participate.
5. You materially participated in the business, according to at least one of the other tests, for any five of the 10 immediately preceding tax years.
6. The business is a personal service activity in which you materially participated for any three preceding tax years. A personal service activity involves the performance of services in the fields of:
   -Health, including veterinary services,
   -Law,
   -Engineering,
   -Architecture,
   -Accounting,
   -Actuarial science,
   -Performing arts,
   -Consulting, or
   -Any business in which capital isn’t a material factor in producing income.
7. You participated in the business on a regular, continuous and substantial basis during the year based on all of the facts and circumstances (assuming you participated for more than 100 hours). Managing it doesn’t count if a) any other person received compensation for managing the activity, or b) any person spent more hours during the tax year managing the business than you did (whether compensated or not).

Important note: Limited partners must pass either the first, fifth or sixth item on this list.

Most work you do in connection with a business you own is treated as participation, as long as the work is customarily done by owners of such businesses. Your participation includes your spouse’s participation, even if he or she doesn’t have an ownership interest.

Work done in the capacity of an investor (for example, studying financial statements) isn’t participation, though, unless you’re also directly involved in the daily management or operations of the business.

Now or Later?

Your level of participation in your business will play a large role in the timing of your loss deductions. Our tax specialists can help you determine and document whether your participation qualifies your losses as deductible non-passive losses.