JohnAlanCohan@aol.com 310.278.0203 Probate/Conservatorships IRS Audits IRS Collection IRS Appeals U.S. Tax Court IRS Criminal Investigation Tax Litigation Tax Opinion Letters Business Plans Aviation Law Tax Exempt/Nonprofit Organizations All aspects of equine and livestock law, particularly tax matters, syndications, business plans, tax opinion letters, and drafting of business documents.		The Material Participation Test and The Forestry Industry by John Alan Cohan, Attorney at Law Woodland owners who undergo IRS audits often come up against a hurdle known as the Material Participation Test. Contained in section 469 of the Tax Code, this provision disallows tax deductions on forestry losses against outside income if your participation in the venture is “passive” in nature. For many owners, losses are incurred, perhaps over a period of years, and it is desirable to deduct these forestry expenses against one’s other income. Without this tax incentive many people would not get involved in the timber industry in the first place. The Material Participation Test is in a sense a trap for the unwary. Many people are actively involved in their woodland, yet may fail to meet the test or fail to prove their participation to the satisfaction of the IRS. This can mean losing tax deductions. In order to withstand IRS scrutiny, it is important to recognize the key points of the Material Participation Test. This means being prepared to prove that you are involved in the operations on a “regular, continuous, and substantial” basis. Also, it is necessary to show that your participation in decision-making is bona fide rather than merely pro forma. “Bona fide” means that the taxpayer actually does participate in the activity as a principal or a manager, and he actually does exercise the powers of a manager. The sort of activities that a taxpayer needs to show under the Material Participation Test include the following: consulting with advisers in the industry, attending industry events, keeping business records, discussing matters with one’s spouse and other partners, implementing or formulating business plans and revising them, reviewing finances, making budgets and cost projections, making disbursements, visiting to monitor operations, organizing records, speaking with vendors on the telephone or in person, attending to pruning and maintenance of trees, communicating with loggers, lumber mills and other customers, harvesting of trees, planning and making improvements, hiring and firing personnel, supervising others hired to work for you, and performing other tasks and decision- making functions. The Material Participation Test will take into account a taxpayer’s “investor-type” activities only if the taxpayer is directly involved in day-to-day management or operations. If you have a manager working on the woodland, the IRS will argue that you have relinquished too much control and therefore you are not directly involved in day-to-day management or operations. Thus, the IRS will seek to disregard any hours you have spent in “investor-type” activities. What constitutes “investor-type” activities is a matter of contention--but the IRS claims that such activities include time spent reading or studying journals, reviewing price reports, evaluating budgets, analyzing costs, and so on. It is therefore helpful to have a written contract with key employees setting forth their duties and specifying that you retain day-to-day management control. Assuming you are involved in the woodland venture on a “regular, continuous, and substantial” basis, and that your participation is bona fide--how do you prove this? The law provides seven tests to prove you have materially participated in the venture, two of which are discussed below: the “500-hour” test and the “facts and circumstances” test. Under the 500-hour test you must show participation for at least 500 hours during the tax year in question. You can establish the time spent by any reasonable means including “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” It is important to keep records showing the number of hours involved. It is best to keep a detailed time log, identifying what you did and when you did it. Phone records of calls made concerning management of the woodland should be maintained. Records of research you have conducted should be kept. Time records of seminars and or other events you attended, as well time spent studying journals and other research you conducted, should also be kept. Many taxpayers cannot meet the 500-hour test, so an alternative is the “facts and circumstances” test. Under this test the IRS will evaluate whether you have participated in the activity on a regular, continuous and substantial basis based on all of the facts and circumstances. This test seeks to accommodate activities that may not take a great deal of time to operate properly. The test has two hurdles: one, you must have participated at least 100 hours during the year; and two, any time you spent in management duties will be disregarded if you have hired a manager who spent more time than you did managing the venture. This test is a significant hurdle if anyone is paid for management services. Again, it is important to have a written contract specifying the duties of key personnel so as to rebut an inference that you are relinquishing management control. The contract should indicate that the employee is beholden to you, the taxpayer, for guidance, advice, management and supervision. In determining whether a taxpayer materially participates, the participation of the taxpayer’s spouse may be taken into account. Generally speaking, commute time to the forest site is not included, but travel time to other venue--such as to seminars and industry events, to meet with buyers, meet with consultants, and so on, are included. The overall key “philosophy” underlying the Material Participation Test is that in order to take tax deductions against your outside income it is necessary to show that you are directly involved in day-to-day management or operations, and that you are really in control of the operations. The Material Participation Test is supplemental to the IRS “hobby loss” rule. Under the hobby loss rule the IRS will argue, in some cases, that the venture is a hobby, not a business, and therefore disallow tax deductions. Under the hobby loss rule the IRS will argue that the taxpayer does not have the overall intention to be engaged in a business for profit based on such elements as recreation, lack of reliance on experts, a prolonged history of losses, or other factors set forth in IRS Regulations on the subject. Back to Top