What Is Active Income?
Active income refers to income received for performing a service. Wages, tips, salaries, commissions, and income from businesses in which there is material participation are examples of active income.
- The most common types of income are active, passive, and portfolio.
- Active income includes salaries, wages, commissions, and tips.
- For income from a business to be considered active rather than passive, the owner must satisfy the requirements for material participation, based on hours worked or other factors.
Understanding Active Income
Income received in the form of a paycheck from an employer is the most common example of active income.
For the self-employed or anyone else with an ownership interest in a business, income from business activities is considered active if it meets the Internal Revenue Service (IRS) definition of material participation. That means at least one of the following is true:
- 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.
If someone receives income from a business in which they don’t actively participate, then that is considered passive income.
Portfolio income, meanwhile, is income from investments, such as dividends and capital gains.
These different types of income can be taxed differently, depending on the law at the time. For example, portfolio income is currently taxed at lower rates than active income.
Example of Active Income From a Business
Patrick and Emily, who are not married to each other, 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 fewer than 100 hours a year in the business. Therefore, the IRS considers her income from the business to be passive.
The material participation rule was established to stop individuals who don’t actively participate in a business from using it to generate tax losses that they could write off against their active income.