An activity that meets the 5/10 material-participation test cannot also be a significant participation activity

Plain-English summary

A taxpayer owned an S corporation (through grantor trusts) that conducted many separate business activities, and wanted to avoid the passive activity loss limits of section 469 by showing "material participation" in each activity. For activities where the taxpayer spent between 100 and 500 hours, the taxpayer grouped them as "significant participation activities" (SPAs) and, by adding up more than 500 total hours across all of them, claimed material participation under Treas. Reg. § 1.469-5T(a)(4). On audit, the examiners found that some of those activities already counted as material participation under a different test, the 5/10 test (material participation in five of the preceding ten years), and under the regulation an activity that meets another material-participation test cannot be a SPA. Removing those activities dropped the taxpayer's total SPA hours below 500, so the remaining activities became passive. The National Office technical advice sided with the examiners: an activity cannot be both a SPA and satisfy another material-participation test, so once the 5/10 test is met the activity shifts out of the SPA bucket. This matters to serial entrepreneurs and owners of multiple pass-through businesses, because it can reclassify long-held activities as passive and disallow their losses.

Ruling snapshot

• Question: Can an activity qualify as a significant participation activity under § 1.469-5T(c) in a year when the taxpayer already meets material participation for it under the 5/10 test of § 1.469-5T(a)(5)?
• Outcome: advice given (no; the activity is not a SPA, agreeing with Exam)
• Key authorities: IRC § 469; Treas. Reg. § 1.469-5T(a)(4), (a)(5), and (c)

Full text (IRS public release)

                            INTERNAL REVENUE SERVICE
                  NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                                 April 19, 2022

                                                      Third Party Communication: None
                                                      Date of Communication: Not Applicable
Number:                     202229036
Release Date:               7/22/2022
Index (UIL) No.:            469.00-00, 469.03-00, 469.08-00
CASE-MIS No.:               TAM-114797-21

Branch Chief
Passthroughs & Special Industries

          Taxpayer's Name:                             --------------------------
          Taxpayer's Address:                          ---------------------------------------------
                                                       --------------------------------
          Taxpayer's Identification No                 -----------------
          Year(s) Involved:                            -----------------------
          Date of Conference:                          -----------------



LEGEND:

Corp =             -------------------------------------------------
-----------------------------------------

Year 1 =          -------

Year 2 =          -------

ISSUE(S):

Whether an activity qualifies as a significant participation activity (SPA), as defined in
§ 1.469-5T(c), in a taxable year where the Taxpayer meets the requirement for material
participation in an activity under § 1.469-5T(a)(5) (5/10 test) by previously having
satisfied the SPA test under § 1.469-5T(a)(4) for material participation in five of the
preceding ten taxable years.
TAM-114797-21                                         2

CONCLUSION(S):

Section 1.469-5T(c)(1)(ii) provides that an activity is a significant participation activity
only if such activity would be an activity in which the individual does not materially
participate for the taxable year if material participation is determined without regard to
the SPA test in § 1.469-5T(a)(4). Under this rule, where an activity satisfies one of the
other six tests for material participation under § 1.469-5T(a) (excluding § 1.469-
5T(a)(4)), the activity does not satisfy the requirements to qualify as a SPA under
§ 1.469-5T(c)(1), even though the remaining requirements (trade or business and
hours) are met.

FACTS:

Taxpayer, through multiple grantor trusts, wholly owns Corp, an S corporation.
Taxpayer reported each trusts’ allocable share of Corp’s income on ---- individual
income tax return. Corp owned multiple entities, the activities of which are treated as
separate ungrouped activities for purposes of § 469. For Year 1 through Year 2,
Taxpayer reported the activities as nonpassive. For those activities in which Taxpayer
asserts ----- participated more than 100 hours and less than 500 hours, Taxpayer
reported these activities as having satisfied the SPA requirements under §1.469-5T(c)
and, based on the aggregate of all time Taxpayer spent on SPA activities, Taxpayer
claims to have materially participated in those activities under § 1.469-5T(a)(4). For the
remaining activities, Taxpayer acknowledges having participated less than 100 hours in
each of the activities but reported them as nonpassive based on the 5/10 test in
§ 1.469-5T(a)(5).1

During an examination, Exam concluded that certain activities of Taxpayer, which
Taxpayer classified as SPAs, instead met the 5/10 test for material participation in the
reviewed year by virtue of these activities having satisfied § 1.469-5T(a)(4) (SPA test) in
five of the preceding ten years. Based on this conclusion, Exam reclassified these
activities because the activities no longer satisfied the SPA requirements under § 1.469-
5T(c). This reclassification reduced the number of SPAs in the audit year, such that
Taxpayer’s aggregate hours for the remaining SPA activities failed to meet the 500 hour
requirement of § 1.469-5T(a)(4). Thus, Taxpayer was no longer treated as materially
participating in those activities and they were passive activities under section 469.

Exam’s Position

Exam bases their adjustment on the language of § 1.469-5T(c)(ii). Exam’s position is
that an activity cannot be a SPA if it meets any of the other six tests for material
participation in § 1.469-5T(a). Here, because Taxpayer is treated as materially
participating under the 5/10 test (§ 1.469-5T(a)(5)) for those activities that were SPAs in
five prior years, the same activities are not SPAs in the audit year.

1 Activities that Taxpayer claims met the 5/10 test did not do so by virtue of meeting the SPA test in prior

years.
TAM-114797-21                                 3

Taxpayer’s Position

Taxpayer argues that the language in § 1.469-5T(c)(1)(ii) turns on the meaning of the
phrase “if material participation for such year were determined without regard to
paragraph (a)(4) of this section.” Taxpayer states that this phrase requires a
hypothetical determination of whether a taxpayer would be treated as materially
participating in an activity in a given year if the material participation tests for such year
were applied without regard to the SPA test in § 1.469-5T(a)(4). Taxpayer’s asserts
that for purposes of the hypothetical determination, material participation for the taxable
year must be determined without regard to the application of § 1.469-5T(a)(4) in the
taxable year and any other year that is relevant to determining material participation for
the taxable year at issue. Taxpayer advocates that because the activities were SPAs
and together satisfied the SPA test for material participation under § 1.469-5T(a)(4) in
prior years, Taxpayer’s prior year material participation is not relevant.

Taxpayer argues that Exam’s position leads to the undesired result of having SPAs
alternate between the SPA test and the 5/10 test and would create difficulties and
inconsistencies for serial entrepreneurs with long standing businesses.

Taxpayer states that the Service’s interpretation of § 1.469-5T(c)(1)(ii) asks whether the
activity is an activity in which the taxpayer materially participates for the year, where the
regulation asks whether the activity would be an activity in which the taxpayer materially
participates if determined without regard to (a)(4). Taxpayer believes that the word
choice used in § 1.469-5T(c)(1)(ii) demonstrates that the drafters believed that there
would be a situation in which the taxpayer materially participated in the activity under
another test but would not materially participate if the determination was made without
regard to (a)(4).

Taxpayer also cites to the preamble to the regulations, which provides, with respect to
the SPA test, that

       [t]his rule is included because the Service believes that an individual who
       devotes more than 500 hours during a taxable year to several activities, each of
       which is a significant activity of such individual, should be treated similarly to an
       individual who devotes an equivalent amount of time to a single activity.

T.D. 8175, 1988-1 C.B. 194. Thus, Taxpayer reasons, it is inconsistent with the intent
of the regulation to use another test to prevent a taxpayer from being treated as
materially participating under the SPA test, as the tests were created to assist taxpayers
who would have difficulty demonstrating material participation under one of the other
tests. Taxpayer also argues that because 500 plus hour activities can qualify under both
§ 1.469-5T(a)(1) and (a)(5) in the same year, treating SPAs differently frustrates the
intent by treating a taxpayer engaged in multiple activities in a different manner than a
taxpayer involved in a single activity. To demonstrate this frustration, TP cites to the
TAM-114797-21                                           4

preamble to the regulations in discussing the 5/10 test, which provides that the 500 hour
test of § 1.469-5T(a)(5) was included because

        … the Service believes that an activity in which an individual has materially
        participated over a long period of time or a personal service activity in which an
        individual has participated for a substantial period of time is likely to represent the
        individual's principal livelihood rather than a passive investment...

T.D. 8175, 1988-1 C.B. 194. Taxpayer also argues that the 5/10 test was intended to
cause a taxpayer to be treated as materially participating in a longstanding activity in
order to prevent such activity from being characterized as passive after the taxpayer
ceases to materially participate in the activity.

Taxpayer further points out that in the few reported court opinions which analyze
whether a given activity is a SPA, the courts have looked at whether the taxpayer was
otherwise treated as materially participating in the activity under § 1.469-5T(a)(1)
through (a)(3), but no court has deemed it relevant to discuss whether the taxpayer in
such cases was also treated as materially participating in the activity for the year at
issue under the 5/10 test. Taxpayer infers from this that the courts did not deem such
analysis as relevant to the inquiry because the 5/10 test did not apply. Taxpayer argues
that its position is further supported by Example 4 in the regulations which fails to
provide facts to exclude material participation under the 5/10 test.2

LAW AND ANALYSIS:

Section 469(a) of the Code disallows the passive activity loss or passive activity credit
for the taxable year of any taxpayer subject to § 469.

Section 469(c) provides that, for purposes of § 469, the term “passive activity” means
any activity (A) which involves the conduct of any trade or business, and (2) in which the
taxpayer does not materially participate.

Section 469(h)(1) provides that a taxpayer shall be treated as materially participating in
an activity only if the taxpayer is involved in the operations of the activity on a basis
which is regular, continuous, and substantial.

Section 469(l)(1) provides that the Secretary shall provide such regulations as may be
necessary or appropriate to carry out provisions of § 469, including regulations which
specify what constitutes an activity, material participation, or active participation for
purposes of § 469.



2 Example 4 only illustrates the application of the SPA test for material participation in § 1.469-5T(a)(4).

The facts state, without further analysis, that the two activities are significant participation activities under
1.469-5T(c).
TAM-114797-21                                  5

Treas. Reg. §§ 1.469-5T(a)(1)-(7) provide quantitative tests for when individuals shall
be treated, for purposes of § 469, as materially participating in an activity.

Treas. Reg. § 1.469-5T(a)(4) provides that an individual shall be treated as materially
participating in an activity for the taxable year if the activity is a significant participation
activity (within the meaning of paragraph (c) of § 1.469-5T) for the taxable year, and the
individual’s aggregate participation in all significant participation activities during such
year exceeds 500 hours.

Treas. Reg. § 1.469-5T(a)(5) provides that an individual shall be treated as materially
participating in an activity for the taxable year if the individual materially participated in
the activity (determined without regard to this paragraph (a)(5)) for any five taxable
years (whether or not consecutive) during the ten taxable years that immediately
precede the taxable year.

Treas. Reg. § 1.469-5T(c)(1) provides that for purposes of § 1.469-5T(a)(4) an activity is
a significant participation activity of an individual if and only if such activity (i) is a trade
or business activity (within the meaning of § 1.469-1T(e)(2)) in which the individual
significantly participates for the taxable year; and (ii) would be an activity in which the
individual does not materially participate for the taxable year if material participation for
such year were determined without regard to paragraph (a)(4) of this § 1.469-5T.

Treas. Reg. § 1.469-5T(c)(2) provides that an individual is treated as significantly
participating in an activity for a taxable year if and only if the individual participates in
the activity for more than 100 hours during such year.

There are no court opinions addressing whether an activity meets the 5/10 test solely by
having been a SPA for the requisite number of prior years. Although not directly on
point, the Tax Court has discussed the SPA test in relation to the other six tests. In
Scheiner v. Commissioner, T.C. Memo 1996-554 at *8, the Court provides a general
explanation of the SPA rules, stating, “[a] significant participation activity is one in which
the taxpayer participates for more than 100 hours, but which fails to constitute material
participation under one of the other six tests [emphasis added].” In Gregg v. United
States, 186 F.Supp.2d 1123, 1130 (D. Or. 2000), the District Court held that one of
plaintiff’s activities was not a SPA as the plaintiff exceeded the 500-hour minimum
standard of § 1.469-5T(a)(1), and thus the activity could not be a SPA under § 1.469-
5T(a)(1).

Section 1.469-5T(c) provides the requirements to ascertain whether an activity is a
significant participation activity for purposes of determining material participation under
§ 1.469-5T(a)(4). Section 1.469-5T(c)(1) clearly states that an activity is a significant
participation activity “if and only if” such activity meets the two requirements in (c)(i) and
(ii). The parties agree that Taxpayer’s activities are trade or business activities and
meet the requirement of subparagraph (c)(1)(i). As to the second requirement, we
agree with Exam’s conclusion. For those activities in which Taxpayer materially
TAM-114797-21                                6

participated under § 1.469-5T(a)(4) in any five years during the preceding ten years, ----
----- cannot satisfy the requirement under § 1.469-5T(c)(1)(ii) because Taxpayer is
otherwise treated as materially participating in each of those activities under § 1.469-
5T(a).

Taxpayer’s position that the language in § 1.469-5T(c)(1)(ii) provides that material
participation for a taxable year is determined by disregarding whether Taxpayer
satisfied § 1.469-5T(a)(4) in the tested taxable year and any other relevant year, is
unsupported by the language. The language of § 1.469-5T(c)(1)(ii) specifies that the
relevant inquiry is whether the taxpayer materially participated for “the taxable year” and
that determination is being made “for such year” without taking § 1.469-5T(a)(4) into
account. Section 1.469-5T(c)(1)(ii) does not say to disregard § 1.469-5T(a)(4) for every
previous year where a taxpayer was treated as having materially participated under that
test.

Thus, an activity that met the requirements of § 1.469-5T(a)(4) in any five of the last ten
taxable years satisfies the 5/10 test under § 1.469-5T(a)(5) for material participation in
the taxable year and no longer satisfies the requirement in § 1.469-5T(c)(1)(ii). Once
the activity no longer meets the 5/10 test, the activity may, provided it otherwise meets
the requirements of § 1.469-5T(c)(1), again be classified as a SPA.

The Service acknowledges that § 1.469-5T(c)(1)(ii) imposes an additional requirement
on SPA activities, one that potentially removes an activity from being treated as a SPA
in the current tax year based on participation in prior years, as is the case here. The
additional requirement in §1.469-5T(c)(1)(ii) results in a significant participation activity
shifting out of the SPA test and into the 5/10 test because under §1.469-5T(c)(1)(ii) an
activity cannot be both a SPA and satisfy another material participation test. In contrast,
for example, an activity that satisfies the 500 hour test also satisfies the 5/10 test in the
same year because there is no similar restriction. The difference in treatment is a direct
result of the SPA test having a separate qualifying section in § 1.469-5T(c)(1), where
there is no such additional qualifying section for (a)(1).

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.