"Material Participation" determinations
There are some "fixed" rules:
Rental activities are always passive activities.
Working interest in an oil or gas deposit is always active.
If those do not apply, then:
"A taxpayer who has a significant nontax economic profit motive for participating in the activity is a 'material participant' ". -- per the Joint Committee on Taxation's Staff. Of course, that does not say much. IRS regulations provide seven tests for determining if a taxpayer's participation is material:
Does the individual participate in the activity for more than 500 hours during the year?
Does the individual's participation in the activity for the taxable year constitute substantially all of the participation in the activity of all individuals (including nonowner employees) for the year?
Does the individual participate in the activity for more than 100 hours during the year, and is the individual's participation in the activity for the year not less than the participation of any other individual (including nonowner employees) for the year?
Is the activity a significant participation activity for the taxable year, and does the individual's aggregate participation in all significant participation activities during the year exceed 500 hours?
Did the individual materially participate in the activity for any 5 taxable years (whether consecutive or not) during the 10 taxable years that immediately precede the taxable year?
Is the activity a personal service activity, and did the individual materially participate in the activity for any three preceding taxable years (whether consecutive or not)?
Based on all the facts and circumstances, did the individual participate in the activity on a regular, continuous, and substantial basis during the year?
"Work" in all of these tests must be the type of work normally done by an owner, not just some mundane, routine task generally done by an employee. That is to prevent the accumulation of hours solely for the purpose of satisfying the rules. Of course, if it is a one-person (or small) operation, the owner would normally do those mundane tasks.
Also, the taxpayer's spouse's work counts as the taxpayer's work, subject to the preceding paragraph.