What constitutes a passive activity for tax reporting?

A passive activity for tax reporting refers primarily to a business in which the taxpayer does not materially participate in its operations. This classification is crucial for understanding how income and losses from various activities are treated under tax law.

Material participation generally means being involved in the activity on a regular, continuous, and substantial basis. If a taxpayer does not meet the criteria for material participation, any income generated from the activity is considered passive. Consequently, passive losses can only offset passive income, which has significant implications for tax reporting and liability.

In contrast, businesses where the taxpayer actively participates or invests significant hours generally fall under active participation, which allows for more favorable treatment of losses and income on the tax return. Being an owner alone does not necessarily determine whether an activity is passive or active; it is the level of participation that is key for tax purposes.