What is Active Income
Active income refers to income received from performing a service. This includes wages, tips, salaries, commissions and income from businesses in which there is material participation. For example, an accountant who works for a monthly paycheck receives active income.
BREAKING DOWN Active Income
There are three main categories of income: active income, passive income and portfolio income. These categories of income are important because losses in passive income generally cannot be offset against active or portfolio income.
Active Income and Material Participation
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:
- 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.
For example, 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 the business from profiting from tax losses.
Advantages of Active Income
Earning active income typically carries lower risk. For instance, an individual is participating in an activity to earn income; they are not risking capital to try and earn passive income. Earning active income is also more predictable. Individuals receive the same monthly wage and know when it is going to be received, allowing them to plan accordingly. For example, an employee who gets paid on the 15th of every month might allocate 30% of her wage to mortgage repayments, 50% to other expenses and 20% for discretionary expenses, such as saving for a vacation or going to restaurants.
Limitations of Active Income
Individuals who earn active income might become complacent which could prevent them discovering new opportunities. For example, an investment banker may be earning a lucrative salary and decide that it is not worth taking the risk to open his or her private hedge fund. Earning active income limits earnings potential. There are only so many hours in the day that an individual can work which limits the amount of income that can be earned. For instance, a freelance writer who bills a client per article can only produce a limited amount of content per day.