Activities related to trade or business in which a foreigner do not materially participate throughout the year constitute passive activity.
Whether an activity is a material participation or nonparticipation, the Internal Revenue Service (IRS) uses a seven-material participation test. If the foreign individual meets these seven criteria, they are considered a material participant in an active business. Conversely, if they do not meet the seven tests, the activity is classified as “passive.” The seven tests are as follows:
The following are some examples of non-material participation activities that produce passive income. These are:
A limited partnership (LP) is a business structure in which at least two partners own the company. In this structure, at least one partner, known as the general partner, manages the business and is fully liable for its finances.
On the other hand, other partner(s) are known as limited partners. These limited partners have only limited liability up to the amount they invested.
As a foreigner, you can materially participate as a limited partner in an activity if you satisfy one of the following tests during the tax year:
So, if a foreign limited partner satisfies any of the above three tests, they materially participate in the Limited partnership’s activities. This rule applies even to limited foreign partners.
Facts:
Samir is a software engineer from India. In 2024, he invested $50,000 as a foreign limited partner in a US partnership with Mike, an American developer creating a college food delivery app.
Samir has no control over app development and related management as a foreign limited partner. Samir spends 15 hours per year on partnership activities.
Samir receives quarterly updates via email and hopes to eventually receive profit distributions or a return on investment if the app succeeds.
He began investing in partnerships in 2024. In other words, he never materially participated in any activity related to trade or business for any five of the previous ten tax years of 2024.
Furthermore, Samir has made only a capital investment, rather than providing personal services to the business.
Analysis: So, Samir fails all three material participation tests as a limited partner, which are as follows:
Conclusion: Samir failed to meet the material participation tests required as a limited partner. This means he had no active role in the U.S. limited partnership. Hence, his profits are taxed as passive income in the US.
In a limited liability company (LLC), the foreign limited member will be considered as materially participating in the trade or business if they meet one of the following tests:
If a foreign member satisfies any of the three tests, they are considered to participate in the limited liability company’s activities materially.
Facts: Sarah is a UK-based management consultant. She partners with David, a U.S. citizen, to form Global Strategy Partners, LLC, a consulting firm that helps tech companies expand internationally.
Sarah actively works in the business, spending 520 hours per year on partnership activities. She is also involved in personal service activities via consulting. Sarah leads client engagements for U.S. market entry strategies, conducts workshops and training sessions, and frequently travels to the US for in-person client meetings.
Analysis: Sarah meets one of the material participation tests as a limited member. Under one such test, Sarah participated in the partnership activity for more than 500 hours during the tax year.
Conclusion: As Sarah materially participated in LLC’s activities, these do not qualify as passive activities. Hence, her profits are taxed as effectively connected income instead of passive income.
A C-corporation is an independent legal entity separate from its owners. This separation protects the owners (aka shareholders) from personal liability.
Non-material participation tests apply to all Personal Service Corporations (PSCs) and closely held C Corporations.
It should be determined if all Personal Service Corporations (PSCs) or closely held corporations materially participate in its activities. Generally, the level of shareholder participation determines the material participation of the corporation.
A C-Corp that qualifies as either a Personal Service Corporation or a Closely held C corporation is materially involved in an activity only:
When a C-Corporation materially participates in a business activity, that activity generates active business income rather than passive income. This distinction has significant tax implications for foreign shareholders of the C-Corporation.
Foreign shareholders will likely receive active income from their proportionate share of those activities if the C-Corporation produces active income through material participation.
This active income is treated as Effectively Connected Income (ECI) for tax. This ECI income is generally subject to graduated tax rates for foreign individuals. Foreign corporations are subject to corporate tax rates on their ECI. Please note that a reduced rate may be applicable to individuals and entities under the relevant tax treaty.
If the C-Corporation produces passive income through non-material participation, foreign shareholders will likely receive passive income from their proportionate share of those activities.
Foreign shareholders would face different tax consequences if the income were classified as passive rather than active. Passive income from U.S. sources is typically subject to withholding tax (usually 30% or reduced rates under tax treaties).
Facts
John is a French citizen. He owns 60% of the outstanding stock in ABC Corp, a U.S. C-corporation that develops software applications. John is the company’s Chief Technology Officer (CTO). He works over 500 hours annually managing the development team, overseeing product strategy, and making key technical decisions.
Rule:
A C-Corp that qualifies as either a Personal Service Corporation or a closely held C corporation is materially involved in an activity only:
Analysis: In the present case, John participated in the activity for more than 500 hours during the tax year and owns more than 50% of the corporation’s stock value.
Conclusion:
C-Corp engages in active rather than passive business activity, which means John also received active income rather than passive income from those activities.