What Is Active Income?
Active income refers to income received from performing a service such as 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.
- The most common types of income are active, passive, and portfolio.
- Active income includes income earned such as 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 of income are important because losses in passive income generally cannot be offset against active or 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 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.
Advantages of Active Income
Pros of Active Income
Carries lower risk than other types of income
More predictable than other types of income
Makes it easy to plan monthly budget
Cons of Active Income
May make individuals complacent and/or risk-averse
Can limit earning potential
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 like saving for a vacation or going to restaurants.
Limitations of Active Income
Individuals who earn active income might become complacent, which could prevent them from discovering new opportunities. For example, an investment banker may earn a lucrative salary and decide it is not worth taking the risk to open his or her private hedge fund.
Earning an active income can limit earning potential. There are only so many hours in the day that an individual can work, which limits the amount of income he or she can earn. For instance, a freelance writer who bills a client per article can only produce a limited amount of content per day.
Example of Active Income
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.