Beware the SPPA Trap!

By Marc Lovell posted Tue January 19,2016 10:59 AM


Had this issue recently come up in an audit for a client referred to me by a CPA for representation.  In this case, we established that the client properly characterized the income (once I got the examiner to agree on how these rules applied to the case at hand), but it can easily be a "trap" for a taxpayer who wants income characterized as passive. Like most things associated with other material participation rules, this income characterization rule can be a double-edged sword for the taxpayer.  Your tax software may also require some "manual finessing" in order to ensure income is characterized and reported properly where these rules apply or are being used. Essentially, this is all about income characterization (passive or nonpassive).


IRS guidance regarding material participation is provided in Treas. Reg. §1.469-5T(a). This regulation provides seven tests under which a taxpayer will be treated as meeting the material participation requirement for an activity to be classified as active (or “nonpassive”[1]) instead of passive.[2] The conduct of the taxpayer in connection with an activity must be “regular, continuous, and substantial” as a prerequisite to being deemed a material participant by meeting any one of the seven tests.[3]

If the regular, continuous and substantial prerequisite is met, and one of the seven tests is met, the taxpayer is deemed a material participant in the relevant activities, and the taxpayer’s income from those activities will be considered active whether or not the taxpayer wants this outcome.[4] This may be problematic for a taxpayer with substantial passive losses who may desire to categorize a profitable activity as passive in order to deduct their passive losses. If the taxpayer’s level of involvement in the profitable activity any of the seven tests, the activity will be treated as active and the passive losses cannot be used against the activity’s income.

One of the more arcane and least understood tests of the seven is mentioned in Treas. Reg. §1.469-5T(a)(4), which is referred to as the significant participation activities test (SPA test). Devoting over 500 hours to SPA will result in the taxpayer being deemed a material participant in those SPAs, and the resulting income or loss will be active, not passive. Taxpayers must group time spent on significant participation activities (SPA) in order to determine whether to the material participation requirement is met for the group. An SPA is characterized as follows.

  • The trade or business activity is not an activity in rental real estate[5]
  • The taxpayer participates for more than 100 hours (ie. “significant participation”) during the tax year[6]
  • The taxpayer would not be considered a material participant under any other of the seven tests[7]

It should be noted that the material participation determination is done independently for each taxation year, The taxpayer’s level of participation during one tax year may rise to the level of triggering deemed material participation while in a subsequent year, reduced participation in the activities may result in the determination that no material participation exists.

In addition, because the taxpayer doesn’t meet any other material participation rule with respect to an SPA, SPAs are passive in nature. However, under this test,[8] if the taxpayer’s participation in all of their SPAs exceeds a total of 500 hours for the year, the taxpayer will be considered to materially participate in each of the activities.  In order to be an SPA, the taxpayer’s level of activity must be more than 100 hours during the year.[9]

Example 1. Samantha is a part-time employee working as a broker at a local insurance brokerage firm. She has ownership interests in three other businesses in which she is somewhat active and these businesses are owned by her and a number of other individuals. These are the only businesses in which Samantha is involved.

These businesses consist of a convenience store, a tack shop, and a ship’s chandlery. Under the other six tests for material participation,[10] Samantha does not materially participate in any of these activities. The other co-owners who own the businesses with Samantha work in these businesses on a full-time basis, so Samantha also does not meet the Treas. Reg. §1.469-5T(a)(2) “substantially all of the participation” test for any of these activities.

Samantha’s participation in any one of these three activities may not even meet the “regular, continuous, and substantial” prerequisite. These activities are passive activities for Samantha. The hours that Samantha expends in these three activities are shown in the following table. These hours include only those that qualify for the material participation test in 2015.


Convenience Store

Tack Shop



Material participation hours for 2014





Under the SPA rule, Samantha must aggregate the hours from those SPAs in which she has more than 100 hours. The total number of hours exceeds 500 in 2015, and accordingly, under the SPA test, the income or losses from those activities is grouped together and Samantha will be deemed to have materially participated in these activities. Therefore, the activities as a group are treated as nonpassive.

The SPPA Trap for the Unwary.

Significant participation passive activities (SPPAs) are SPAs that do not meet the material participation tests, including the grouping exception under Treas. Reg. §1.469-5T(a)(4) discussed above. This may be due to insufficient hours to arrive at a total of 500 hours expended for the year in the aggregate for the activities. Special rules[11] indicate that in the event that the aggregate of the net profit and losses from all SPPAs results in a net profit, that net profit will be recharacterized as nonpassive. The recharacterized net profit amount is allocated among the activities proportionately.

Example 2. Assume the same facts in Example 1, except Samantha’s hours spent in the three activities are summarized as follows, along with her share of the income and deductions from each activity.


Convenience Store

Tack Shop



Material participation hours for 2014








Convenience Store

Tack Shop



Passive gross income


$ 5,000



Passive deductions


$ 6,000

$ 7,000


Net passive income

$ 9,000


$ 7,000




In addition to these activities, Samantha also has $60,000 of 2015 limited partnership losses from a number of limited partnership interests that she owns. She does not participate at all in these limited partnership activities.

Because Samantha did not spend more than 500 hours on the businesses as a group in 2015, she does not meet the SPA exception for material participation under Treas. Reg. 1.469-5T(a)(4). However, because she expended more than 100 hours on each of them, they are SPPAs.

Because Samantha realized a net profit from all of these SPPAs in the aggregate, the total net profit of $15,000 must be recharacterized as nonpassive income. This net profit is then allocated to the profitable activities as follows.

Profitable SPPAs

Convenience Store



Net passive income

$ 9,000

$ 7,000


Percentage of total




Net SPPA profit to allocate




Income recharacterized as nonpassive

$ 8,438

$ 6,563



The convenience store’s net passive income of $9,000 represents 56.25% of the total of $16,000 of total net passive income from those activities that have a net profit. (($9,000 ÷ $16,000) X 100 = 56.25%). The $7,000 of Chandlery net passive income represents 43.75% of the total of $16,000 of total net passive income. These percentages are used to allocate the net SPPA profit to each of the two profitable activities.

None of Samantha’s $60,000 in losses from her passive limited partnership activities can be used against the income from the SPPAs, because this SPPA income is now considered nonpassive.

This example shows how these rules can act as a trap for the unwary for taxpayers that have more than 100 hours expended in various activities who may want income from those activities characterized as passive (but find that this trap instead leaves them with active income against which passive losses may not be used).  I’ve seen this very issue come up on examination for three different taxpayers referred to me during the past few months. This also attests to the need for taxpayers to adequately document their participation in activities in order to substantiate either their material participation (or the lack thereof) in each of those activities.  It should be remembered that the seven tests that lead to deemed material participation in Treas. Reg. §1.469-5T(a) are not elective in nature.  If the taxpayer’s hours meet one of the tests, including the Treas. Reg. §1.469-5T(a)(4) SPA test discussed above, the taxpayer is deemed a material participant, (and will not be a material participant if hours are insufficient to meet any of the seven tests).

[1] The terms “active” and “nonpassive” are used interchangeably in this article.

[2] Treas. Reg. §1.469-5T(a).

[3] IRC §469(h).

[4] Ibid.

[5] Treas. Reg. §1.469-5T(c)(1)(i).

[6] Treas. Reg. §1.469-5T(c)(2).

[7] Treas. Reg. §1.469-5T(c)(1)(ii).

[8] Treas. Reg. §1.469-5T(a)(4).

[9] Treas. Reg. §1.469-5T(c)(2).

[10] Specifically, these are the tests listed in Treas. Reg. §1.469-5T(a) except for the SPA test mentioned in Treas. Reg. §1.469-5T(a)(4).

[11] Treas. Reg. §1.469-2T(f).