Active Income: Overview, Examples, vs. Passive Income

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Active income is money you receive in exchange for performing work or a service. Wages, salaries, hourly pay, tips, commissions, bonuses and net earnings from self-employment all count, as does income from a business in which you materially participate. The defining feature is that the income depends on your ongoing effort: when the work stops, the payments generally stop too.

How Active Income Works

For most people, active income arrives as a paycheck. An employer pays for time or output, withholds income tax and payroll taxes (Social Security and Medicare), and the employee receives the rest. Commissions, tips and bonuses work the same way: each is tied to a service the worker performed.

Self-employed people earn active income too, but it is measured differently. A freelancer or sole proprietor reports net earnings, meaning revenue minus business expenses, and that net amount is subject to both income tax and self-employment tax. Self-employment tax covers both the employee and employer shares of Social Security and Medicare.

Material Participation for Business Owners

Under IRS Publication 925, income from a business you own is active only if you materially participate during the tax year. The publication lists seven tests, and meeting any one is enough. Three of the most frequently used are:

• You worked 500 or more hours in the activity during the year.
• Your participation made up substantially all of the participation in the activity by anyone, including non-owners.
• You worked more than 100 hours, and no other individual worked more hours than you did.

If an owner meets none of the tests, their share of the business income is treated as passive. Before the Tax Reform Act of 1986, investors could buy into businesses they had no role in and use paper losses to shelter wages and other active income. The passive activity rules closed that door by generally limiting passive losses to offsetting passive income.

Active, Passive and Portfolio Income

The three categories differ in how the income is produced:

• Active income: earned by performing work. Examples include wages, salaries, tips, commissions and income from a business you materially participate in.
• Passive income: earned from a trade or business you do not materially participate in, and from most rental activities. A silent partner’s share of profits is a typical case.
• Portfolio income: earned from investments, such as interest, dividends and capital gains on stocks or bonds.

In everyday personal finance, “passive income” is often used loosely to mean any money that arrives without much day-to-day effort, including dividends. For tax purposes, the IRS keeps portfolio income separate from passive income, and dividends and interest are not passive activity income.

Example of Active Income

Hypothetical example. Ana and Ben each own 50% of an online furniture store. Ana handles sourcing, customer service and daily operations, logging about 1,800 hours a year, more than anyone else involved. Ben helps with marketing campaigns for roughly 80 hours a year and otherwise stays out of the business.

Ana meets the 500-hour test, so her share of the profit is active income. Ben worked fewer than 100 hours and meets none of the other tests, so his share is passive. They own the business equally, but what each person does decides the category.

Now suppose the store has a loss one year. Ana can generally deduct her share against her other income, such as a salary from a part-time job. Ben can generally use his share only against other passive income, carrying any unused loss forward to future years or until he disposes of his interest.

Why the Classification Matters

The main consequence is tax treatment. Wages are taxed at ordinary income tax rates and are subject to payroll taxes. Certain portfolio income, such as long-term capital gains and qualified dividends, is taxed at lower preferential rates and is not subject to payroll tax. Passive income avoids self-employment tax but faces the loss limitations described above, and high earners may also owe the 3.8% net investment income tax on passive and portfolio income.

Rental Property: The Common Point of Confusion

Managing rental property can feel like a job: screening tenants, arranging repairs and handling vacancies take real time, even with a property manager. For federal tax purposes, though, rental activity is generally treated as passive regardless of how many hours you put in. Two exceptions matter:

• Real estate professionals who spend more than 750 hours a year and more than half their working time in real property businesses, and who materially participate in the rentals, can treat rental income and losses as nonpassive.
• Active participation allowance: owners who actively participate (for example, by approving tenants and setting rents) can deduct up to $25,000 of rental losses against other income. The allowance phases out as modified adjusted gross income rises from $100,000 to $150,000.

Limitations of Active Income

Active income is reliable while you can work, but it has clear limits:

• It is capped by your time. Hours in a year are finite, so earnings grow mainly through raises, promotions or higher rates.
• It stops when you stop. Illness, layoffs or retirement can cut it off, which is why emergency savings and disability coverage matter.

FAQs

The Bottom Line

Employees, freelancers and business owners all earn active income, and the label affects how much tax they pay and how they can use losses. Owners should track their hours, because what each person does in a business sets the category. Since active income depends on your ability to keep working, emergency savings and disability coverage help protect it.