For the Purposes of the Material Participation Tests, Does an “Individual” Mean One Person, or a Company?

Are you trying to use losses from your short-term rental (STR) property to reduce taxes on your W-2 of active business income?… If so, this article may just save you tens of thousands of dollars…

As you may know, in order for losses from a STR to offset your active income, the STR needs to have an average stay of seven days or less, and you must meet one of the seven material participation tests. 

For many STR investors, the most viable test is the third test, which states that the “individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual”

The problem is, there is a debate around what the term “individual” means. Does it mean “one human being” or is it referring to an entire company?

Why the Debate and Why Does it Matter?

The debate partially stems from the tax code’s definition of a “person”, which includes a trust, estate, partnership, or corporation. 

Because the tax code is so complex and contains so much legalese, it’s easy for tax pros and investors alike to misinterpret the meaning of simple, everyday words. 

This led many tax pros and investors to question the definition of an “individual”. Does an “individual” mean one “human being” or one “person”, which can include a partnership, corporation, and so on. 

This is an important distinction because if you’re trying to spend more than 100 hours on your STR(s) and make sure its not less than any other “individual” (in other words no other “individual” spends more time than you), then it’s important to know if an “individual” means “one human” or “one person” as in a partnership, corporation, and so on.

For example, if you hire ABC Cleaners, Inc (a corp) to clean your STR in between guest stays and have 3 different individual cleaners in rotation, do you count Cleaner A’s and Cleaner B’s hours separately, or combine them together (because they are part of one company) for the purposes of determining if an “individual” spent for time than you?

If the definition means “one human”, this is certainly more advantageous to you, because you can hire one cleaning company to handle your cleanings and make sure they rotate different cleaners to ensure none of them spend more time than you. 

But if it means one company, then you may have to hire multiple companies, which can be a hassle and lead to inefficiencies.

So What Does “Individual” Actually Mean?

When confusion like this exists, many would rather be safe than sorry and take the more conservative option, which in this case is saying an “individual” means a company. (After all, the IRS generally doesn’t argue against things that are in their favor.)

But if you look hard enough, you’ll find that’s just not true…

For starters, under §1.469-5T (where the material participation tests are found), the definition of individual states an “individual is not a QBU”.

§1.989(a)-1, defines a “QBU” and states that corporations, partnerships, estates, and trusts are QBUs (qualified business units) and “individuals” are NOT.

This right here is saying that an “individual” is not a corporation, partnership, estate, and trust. This should be enough to end the debate, but I want to put a nail in the coffin so I’ll continue. 

Examples under §1.469-5T all appear to refer to an “individual” as one human being. Just to give one example, one states “a married individual filing a separate return”. Last I checked, corporations and partnerships don’t get married, but humans do.

Last but not least, Section 7701(a)(14) defines “taxpayer” as “any person” subject to any internal revenue tax, and section 7701(a)(1) defines “person” to include an individual, trust, estate, partnership, or corporation.

This brings clarity to the definition of “person” as it includes an individual as well as trust, estate, partnership, or corporation, and further indicates that an “individual” means one “human”.

The Bottom Line

The tax code is complex, and with so much legalese, it’s easy to confuse the definition of simple, everyday words. 

However, there is overwhelming evidence to conclude that the term “individual” means one human being and not an entire company (in my book, the case is closed).

This should come as welcome news to many STR owners as the third material participation test, the “100+ hour” test is often the most viable option for many.