What defines a passive activity for tax purposes?

A passive activity is defined for tax purposes as an activity in which the taxpayer does not materially participate. This concept is crucial in determining how certain income or losses are treated under the tax code. When a taxpayer does not materially participate in an activity, any income derived from that activity is considered passive income, which is subject to different rules compared to active income.

Material participation can be assessed through various tests, such as the number of hours worked in an activity or significant involvement in decision-making, among other criteria. As a result, taxpayers may face limitations on how they can use losses from passive activities to offset other income types, particularly active income, which may influence their overall taxable income.

The other options do not accurately capture the definition of a passive activity. For instance, a business that generates active income typically involves the taxpayer's significant involvement, leading to different tax implications. Similarly, merely being a general partner or having numerous shareholders does not, in itself, determine whether an activity is passive; rather, it is the level of participation in the activity that is the deciding factor. Understanding what qualifies as passive income versus active income is essential for effective tax planning and compliance.