What Is Active Income?
Active income refers to income received from performing a service and includes wages, tips, salaries, commissions, and income from businesses in which there is material participation. An accountant who works for a monthly paycheck, for example, receives active income.
- The most common types of income are active, passive, and portfolio.
- Active income includes income earned as a salary, wages, commissions, and tips.
- Key qualifications for business income to be considered active are the number of hours worked, who does the majority of the work, and how many hours the taxpayer works in the business.
Understanding Active Income
There are three main categories of income: active income, passive income, and portfolio income. These categories are important because losses in passive income generally cannot be offset against active or portfolio income.
For taxation purposes, income received from business activities is considered “active” if it meets the Internal Revenue Service’s (IRS’s) definition of material participation. The key tests are as follows:
- The taxpayer works 500 or more hours in the business during the year.
- The taxpayer does the majority of the work in the business.
- The taxpayer works more than 100 hours in the business during the year and no other staff works more hours than the taxpayer.
Losses in passive income generally cannot be offset against active or portfolio income.
Example of Active Income
Patrick and Emily each have a 50% interest in an online business. Patrick does the majority of the day-to-day work in the business. Therefore, the IRS considers his income “active.” Emily assists with the marketing activities but works less than 100 hours a year in the business. Therefore, the IRS considers her income from the business “passive.” The material participation rule was established by the IRS to stop individuals who don’t actively participate in a business from profiting from tax losses.
Pros and Cons of Active Income
Earning active income has several advantages. For one, it typically carries lower risk. An individual who participates in an activity to earn income, for instance, isn't risking capital to try to earn passive income.
Active income is also more predictable. Individuals who receive the same monthly wage and know when it is going to be received are able to plan accordingly. Employees who get paid on the 15th of every month, for example, might allocate 30% of their wages to mortgage repayments; 50% to utilities, food, clothing, and other expenses; and 20% to discretionary expenses, such as saving for a vacation or dining out in restaurants.
Carries lower risk than other types of income
More predictable than other types of income
Makes it easy to plan monthly budget
May make individuals complacent and/or averse to risk
Can limit earning potential
But there are potential downsides too. Individuals who earn active income might become complacent, which could prevent them from discovering new opportunities. An investment banker, for example, may earn a lucrative salary and decide it is not worth taking the risk to open a private hedge fund.
Earning an active income can also limit earning potential. There are only so many hours in the day that an individual can work, which limits the amount of income a person can earn. A freelance writer who bills a client per article, for example, can produce only a limited amount of content per day.