Earnings received from performing a service.
Active Income Details
Some examples of active income include monthly salaries, hourly wages, and commissions. Active income can also be in the form of profits from doing business as long as there is material participation. Martial participation means that the firm’s owner participates in the business, trade, rental, or other similar activity. If the owner doesn’t actively involve themselves in the business activity, the IRS categorizes the profit as passive income.
For those who own a business or are self-employed, the IRS considers their income active if they meet at least ONE of the following requirements set by the Internal Revenue Service (IRS):
- The individual is the one who does the majority of the work in the business.
- The individual has a total working time of at least five hundred hours in a single year.
- The individual has a total working time of at least a hundred hours per year, and no other individuals have as many working hours (similar working hours are fine).
- The individual materially participates in the activity for any five of the ten tax years, whether consecutively or not.
- The individual materially participates in a personal service activity for three tax years, whether consecutively or not. A personal service activity includes services in various personal fields such as health, accounting, law, engineering, consulting, and performing arts.
In real-world scenarios, employees’ salaries and wages from an employer are the most common instances of active income.
Example of Active Income
Ahmed works as a self-employed freelance writer. Since he does all of the freelancing works by himself, IRS categorizes his income as active. On the other hand, Lily is a self-employed business owner who rents out apartment buildings for a living. Since her property manager does most of the work for her, IRS considers her rent income from her paying tenant to be passive.
In a more tricky context, two people who jointly and equally own a business may have a different type of income. For instance, Andy and Bernard are business partners, each retaining 50% ownership of a food establishment. Andy is the one who does most of the work, and the IRS treats his income as active. On the other hand, the IRS treats Bernard’s income as passive as he only has less than five hundred hours per year of working time, comparatively smaller than Andy’s.
Significance of Active Income
IRS splits the categorization of income primarily for tax purposes. Usually, active income incurs higher effective tax rates compared to passive income. Using the apartment building rental example above, let’s say that Lily manages to gain $500,000 of revenue from her business as earnings before interest, taxes, depreciation, and amortization (EBITDA). If we consider depreciation and amortization, which the IRS often includes as expenses for taxing strategy, her income before taxes is $150,000.
Assuming her tax bracket is 35%, she needs to pay $52,500 (35% x $1,500) as a tax payment (not an accurate calculation as the real-world implementation of tax rates is more complicated). It might seem a lot, but if we compare this to her EBITDA, the effective tax rate is only 10.5% ($52,500 / $500,000). This would be wholly different if she earned that money as active income. Using the same tax bracket, she may need to potentially pay $35,000 (35% X $100,000) of her income as a tax payment.
IRS divides active and passive income to prevent business owners from abusing the tax losses privilege. A taxpayer who makes passive income can claim a tax loss against generated income if they fail to produce a net gain. If, however, that taxpayer also produces active income on the side, they shouldn’t have the ability to add this income for the tax benefit, so precise distinction is necessary.
Active Income vs. Passive Income
To make things more transparent, let’s try to define active income in another way. Active income is money earned as a direct result of a specific effort. Your work or input is directly related to the result or output. By nature, this characteristic doesn’t reflect passive income.
Passive income is income earned continuously even if you no longer put an effort to gain it, or at least only are working minimally on it. Some examples of passive income sources include property rental and limited partnership—where you jointly own a business but don’t partake in managing the company.
Another type of income outside these two is known as portfolio income. Portfolio income is earnings received from dividends, interest, capital gains, and other types of investments. Similar to passive income, portfolio income generally gets favorable tax treatment. The IRS usually tax capital gains and dividends at a lower rate than active income.