When you look at the various income sources, you can broadly classify them into two categories. These are passive income and nonpassive income. The moment you think of a passive source, you could consider any form of business or earning where you do not have to be involved on a day to day basis actively. Nonpassive source of earning, by definition, points to any kind of activity where the level of initiative or activity is more pronounced.
Often the difference and debate about passive and nonpassive income is seen in the taxation perspective in a most pronounced manner. The rate of tax that you pay is often dependent on whether you have passive vs nonpassive income. The US revenue department, in fact, has incorporated several tests to identify whether a source of income is passive or nonpassive. Passive vs nonpassive income have a direct correlation to the amount of tax that you pay. Additionally, in many ways, it impacts the exact amount of income that you can hope to generate from a profession. It also often decides on the career path that you eventually zero in on.
Definition of Passive income
- Passive income
- Active income
- Portfolio income
So, what exactly is meant by passive income?
As the name suggests, it is any income where you are not actively involved. So, it could be the earnings that you could generate from a rental property or for that matter, a business where you have a limited partnership. You are not actively involved in the day to day running of the business and have no material involvement in the overall running of the business. Even for that, portfolio income is considered as passive income by some analysts.
The argument is rather simple.
The dividends and interest that you earn are often without your direct involvement in the entire procedure. Of course, you might have worked hard in getting the portfolio created but beyond that, the market forces come to play, and an individual’s role is almost non-existent. If you notice the recent trends, passive income has often been used rather loosely in the modern perspective. The most basic derivation is any regular source of income where you have little or no role beyond the conceptualization part.
Most times, when people seek to adopt a better-quality life, devote more quality time to family, this is seen as the most convenient arrangement. You work from home on your own terms, and that is often the biggest pull for opting passive income. While it might not be something as effortless as a lottery win every time, but surely the capital gains that you incur can be termed as passive. But if you are trying to classify these from the taxation perspective, then passive income has a relatively more precise positioning.
For example, it does not include a lot of online work from home in that category. Therefore, a very technical definition of passive income would be any kind of earning where there is no material involvement of the taxpayer. So, material involvement becomes the key point of consideration when you are trying to differentiate between passive and nonpassive income. Perhaps this is the reason that often instances of self-charged interest and situation where you earn profits from shares issued to you as an incentive is termed as passive income.
Here are some basic income options that get termed as passive:
1. Property Income
When you go on to define passive income, this is perhaps the most popular format of income that is considered. Whether you own a commercial property or a residential one, any income that gets generated through these channels will be termed as passive income. However, it won’t be considered passive if you are a real estate professional actively involved in buying, selling and leasing of property. Though this income is not strictly passive in the IRS book, you can surely claim the advantage of the passive income loss rules if the property happens to see a depreciation in value. In the taxation terminology, all holdings in land and otherwise is termed as active or nonpassive income.
2. Self-Charged Interest
Essentially this is the income generated from the interest that is accrued from a partnership or a corporation. This is a business arrangement that is often undertaken to nullify the impact of double taxation. So, the interest accrued is seen as a pass through impact that gets taxed as passive income. Also, care has to be taken to make sure that the loan proceeds too are used for the passive activity. In simple terms, this is a unique situation that refers to the kind of income that you might gain through a chain of passive involvement or rather lack of involvement in a business venture.
3. Why You Would Choose Passive Income Options
Often when you are trying to figure out the difference between passive vs nonpassive income options, the benefits of each individually comes to play do proper justice to the overall concept.
As we discuss passive income options, let us first understand their benefits:
1. This arrangement makes an investor take maximum advantage of the available tax deduction. This is because when an individual claims loss on a passive income avenue, they often have the deductions offset against the taxpayer’s overall tax claims. The earnings of consecutive years are also sometimes taken into consideration for arriving at a reasonable tax computation.
2. Moreover, a tax paper who is involved in multiple passive income avenues has the option to group all of these into one large unit. Then the IRS would not count your material involvement in each of these activities individually. On the contrary, they will be able to project their involvement in one economic unit that groups all these passive activities together. This is particularly important in terms of how the tax liabilities are computed in the overall service profile.
Tax Deduction Advantages
The reason being the grouping activity helps you to claim the various tax deduction advantages in the most beneficial manner. In case it suits your purpose, you can also look at keeping them ungrouped as standalone entities. It is a kind of business arrangement that is aimed at bringing about the most sustainable value addition to the overall service profile. Most times, passive income opportunities are more an extension of the individual’s need to generate multiple earning avenues. As against popular notion, passive income is not just a chosen channel of earnings for retired persons or aged people.
Often, those at the pinnacle of their professional career could look at exploring these opportunities to value add to their existing income opportunities. However, the concept of passive income strictly in the IRS terms is not exactly how you would consider the options in the practical terms. It is needless to mention that if you intend to take the maximum possible advantage of this opportunity, you must understand the tax implications very clearly.
Definition of Nonpassive Income
Now that you understand what is passive income, it is time to understand the comprehensive details about what constitutes nonpassive income. You must understand that just by referring to it as nonpassive income, you cannot term it as active. In fact, nonpassive opportunities can be,
- Active Income: This will include the likes of salary, daily wages and the like;
- Business Income: This is essentially the earnings generated from a business or an investment where you are actively involved;
In general, nonpassive income comprises a significantly large number of active income opportunities. Here there is no via route to get your earnings. Your income is directly related to the overall work you are doing. In other words, you are doing something and getting paid in return. That is also what you would think is active income.
So, while nonpassive income is not equal to active income, this later one forms a very important part of the former larger group. Without it, the core concept of nonpassive income cannot be judged or considered adequately. Therefore, it needs to be seen in appropriate perspective. It is worthwhile to understand in this context that nonpassive income is taxed differently from that of passive income. You cannot use the losses incurred in one to offset the losses incurred by other type of income. So nonpassive losses and income cannot be used to offset passive income and losses and the vice-versa as well.
This is particularly important when you are trying to offset losses in a business operation. However, you must remember that while passive losses can be carried forward, in the case of nonpassive losses, it needs to be settled against income in a specific year. The concept of carrying forward does not function here in any way. So, it would not be wrong to define that nonpassive income is essentially a full-time job. You are putting in a lot of effort and then seeing the returns from this in the form of the income generated through it. Whether you are in a business or a service, as professional is almost always in control of the nonpassive income that they generate. It is common sense that if you put in 8 hours of work, you will surely earn more than what you would from 4 hours of effort. Also, not all nonpassive income opportunities are office based either.
You can also be home and be part of a non passive or active engagement. One of the best examples of this might be the job of IT professional. Given the advancement in technology and the easy access to internet, a lot of IT professionals are working from home. They are doing so to spend more quality time at home, but their earning is directly proportional to the hours they are putting in to get their job done. In contrast, if you see the role of an app developer, they surely put in effort in developing an application.
But once that is built, and they have sold it for a profit, it ceases to be a nonpassive income destination. It instantly becomes a passive income opportunity. They are at that point of time not actively involved in the amount of money they are earning. Neither are they in control of increasing it as per their requirement.
Till they are negotiating for the right price of the app, this is an active income destination. But the moment they have got the money in the bank and start enjoying the interest, it is a passive income. However, if they used the money they earned to develop a new application or used this income to start some new venture, this will again be counted as nonpassive income.
The point here is that whenever we discuss passive vs nonpassive income opportunities, the quality of your participation becomes the crucial and the biggest deciding factor in the entire game plan. In fact, in the entire differentiation process of the two distinctly different income opportunities, it is the engagement level that makes all the difference in the core profit that is earned or loss that is booked. Therefore, the involvement in any venture is a primary factor to consider.
Material Involvement in Passive vs Nonpassive Income
Often when you set out to differentiate between passive vs nonpassive income, material involvement is a key term that you often come across. I think this is one of those unique terminologies that needs to pe explained with an example for better and deeper understanding of the various income formats. Let’s say I am an investor. I decide to invest $30,000 in a business initiative, perhaps a mom & pop store at the corner of the locality I stay in. But I have no time or understanding of the business. So, I find out someone else who runs a similar store but is in need of fund. I get an agreement from that person that they would pay me a certain percentage of the profit in return for the money that I am investing in.
This earning would then be classified as passive income.
So essentially this means that as long as the investor is not actively involved in the overall business operation and has no role in its profitability apart from providing the money for it, it gets counted as passive income. As an investor, I do help the owner manage the same store, my earnings would then be termed as nonpassive income. According to the US tax department, any situation where the overall involvement is beyond mere capital payment would be termed as nonpassive or rather active income opportunity. One of the simplest examples to understand the difference between passive vs nonpassive income is perhaps the difference between a venture capitalist and a limited business partnership.
The VC firm involved with a company is very actively involved in the running of the business, they oversee the various business decisions and often have a very important voice in board meetings, etc. But in comparison to this, when you analyze the role of the limited partners in a business and the income they get, it would be considered as passive income in entirety. Apart from the money they have invested in the company, they have no material involvement in the entire operation of the business. Therefore, material involvement is often the catch phrase that seeks to differentiate between passive vs nonpassive income, especially for taxation purposes.
So how exactly the tax department seeks to make this differentiation. The IRS terms an involvement decidedly material if it exceeds involvement of 500 hours in a business where you are invested. The minimum hours of the range are seen at 100 hours at least. In other words, the IRS terms any business activity where you have participated for at least 100 hours as material involvement in the entire business. Therefore, there are some clearly defined rules that will help you grasp material involvement in a business with relative clarity. More than the actual implications, this is material from grasping the resultant tax implications of this arrangement.
1. The overall individual participation of a tax paper needs to be above 500 hours on an annualized basis. Often, this will be counted as material involvement that can actually bring about a meaningful difference to business profitability.
2. This essentially comprises the business activity by the group of investors who are not direct owners in the business.
3. However, a taxpayer’s 100 hours of participation in a business can also be termed as non-passive, in case no one else participates for longer hours than this specific individual, who has put in 100 hours.
Therefore, it is very important to identify the entire business activity in relative levels.
4. In terms of total tax computation and difference between passive vs nonpassive income, it is also important to see the period of this material involvement or active participation.
So, on an annualized basis, it can be 500 hours a year but it is also important to calculate the number of years that this has continued. It is needless to mention that both the individual levels of participation, the group activities and the groups in which the entire list of passive activity is considered all make a huge difference to this core concept of material involvement. Ultimately, it is the material involvement aspect that seeks to differentiate between passive vs nonpassive income, at least in terms of tax computation and overall tax liabilities of an individual. Basically, the material involvement is the IRS’ way of understanding about how substantial is the quality of your overall involvement in the entire business activity.
1. What Is Passive Activity & Loss Rules
That brings us to the other important aspect in understanding the difference between passive vs nonpassive income. What exactly is passive activity? Let us understand this concept with the help of an example. Let’s assume you have a rental property, the income generated from this source comes to be termed as decidedly nonpassive income. In the case of a loss, the taxpayer can then claim losses against income from these passive activities. You cannot look at offsetting this loss against your active income channels. Though it is possible to pursue both these opportunities simultaneously, a taxpayer needs to be extremely careful about how they put up the claims and tax liabilities. In case if you cannot offset your entire passive loss in one year, you can also carry it forward in future to get a comprehensive and complete deduction.
This is a direct fallout of the passive activity loss rules. It is only pertinent in the case of those income opportunities where they are not materially involved or active engaged. The moment you are not able to substantiate claims of the passive engagement, or if your material involvement is higher than the predefined standards, it comes to be termed as active involvement, and your tax liabilities get computed accordingly. So, if you are not able to stay within the predefined boundaries of passive income, you cannot claim deductions on the basis of the passive loss rules. So, while the colloquial definition of both the income opportunities often merges into each other, in the tax department’s rulebook, there is a clear demarcation. A proper understanding of this demarcation helps you take proper advantage of the tax deduction.
2. Is Portfolio Income a Passive or Nonpassive Income?
However, there is one more avenue to explore before you understand if you can pursue passive income and nonpassive income simultaneously. That is the grey zone called portfolio income. The debate on whether it is a passive or nonpassive out is not completely settled. Often the income generated from portfolios can involve significant engagement in the initial stage and almost next to nothing involvement in the later phase. Therefore, this is an opportunity where you do some bit of both of these.
Essentially portfolio income refers to Portfolio income refers to the kind of income that you earn from the various investment that you might have made. It could also comprise of dividends, royalties and capital gains that you might have earned. While you may not be working too hard for this income at the moment. It is important to understand it is not possible to create a portfolio with passive investment. At some point of time, you would have had to put in significant work to create a reasonable investment portfolio or create a music album from which you can earn the royalty.
Identifying and having a clear sense of what is passive and nonpassive income is very important. This is because most taxpayers tend to lose money by not being able to categorize their business in the appropriate channel. After all, nonpassive losses cannot be offset against passive income and the vice-versa. Therefore, inaccurate categorization of these different income opportunities can severely impact the kind of income and losses that you have to report every year. This is particularly important to understand because while passive losses can be settled over a few years, active losses need to be settled within a particular financial year that they have been filed.
3. Pursuing Passive and Nonpassive Income Simultaneously
Therefore, we come to the basic point we started this entire article about- can you pursue them together? Yes, it is possible to pursue passive and nonpassive income opportunities together. But you need to be careful about how you compute the taxes for it. After all, we all want to take advantage of the best tax saving opportunities, and often an inaccurate analysis of these two different income options could severely impact your tax liabilities. So our advice is to get in touch with a good CA with an in-depth understanding to help you tide through this.
They will be able to help you understand how to work out your income and liabilities to and take advantage of the maximum deduction. This is also an important consideration when you think about the future prospects and your need to create a comfortable retirement kitty. After all, you do not want your retirement money to get eroded paying passive income taxes because you were not careful or clear about the various distinction between the two.
Passive vs Nonpassive Income
Essentially the debate between passive vs nonpassive income reaches a definitive point with the term ‘material involvement’. This will define how actively you are engaged in generating the income. Apart from determining how much income you generate through the level of your engagement, the ‘material involvement’ angle also has very serious implication on your overall tax liability for a year. The passive and nonpassive income have different tax computation rules, and that is exactly why you need to be rather careful about how you group your income avenue.
This is particularly useful if you have multiple channels to earn money and you would want to consolidate them and conserve maximum gains for yourself.
After all, who pays the tax department willfully?
But yes, it is possible to pursue both these forms of income simultaneously. For example, when you write a book and put in an effort to write a book, your material involvement is in the active segment. But when the book becomes a success, and you begin to earn the royalty, it is passive. But in case you are constantly updating the contents to make it relevant, or write another one with the money you earn you are simultaneously involved in passive and nonpassive income options.