Posted by Abundant Wealth Planning LLC

Understanding The Differences in Passive & Non-Passive Activities and Examples

Understanding The Differences in Passive & Non-Passive Activities and Examples

Uncle Sam defines passive activities as a business venture you are not actively involved in. For the purpose of tax, income can be grouped into two categories according to the IRS – active and passive. Taxpayers need to meet some criteria to make the IRS believe they were engaged in the business with income in the active category. 

The passive activity, on the other hand, does not require you to be an active participant. Although it also does not mean that you were completely inactive in the business. It is only the IRS that classifies the venture as a passive activity. Passive activities are of two types – rental units and running a nonmaterial business. 

It is essential to differentiate between active and passive activities as Uncle Sam categorizes losses in different ways. One can employ loss from operational activities to bring down one's taxable income, like business profit and salary. 

Using loss from passive activities to reduce taxable income, however, applies to passive activities only. People without passive income can carry the loss forward to the future till they have a passive income. 


Examples of Passive Activities 

Business investment or buying a rental unit is a passive activity. For instance, you might decide to start a haulage business with four business partners. According to Uncle Sam's standard, if you are not actively involved in the  running of the business, the business is a passive activity for you. 

Any loss from the haulage business cannot help you bring down your taxable income from your monthly salary job. The loss, however, becomes helpful whenever you decide to sell your share of the business. All the previous losses can help take care of the profit you realize from the sale.


Non-Passive Activities

On the other hand, non-passive activities are the ones in which the parties work effectively, substantially, and continuously. Guaranteed payment, salaries, investment income, portfolio income, etc., are non-passive. Examples of portfolio income are pensions, royalties, dividends, interest income, proceeds from lottery, gains and losses from royalties, etc. 

Further examples of non-passive activities are all income from the following:

  • Bonds and stocks

  • Dividends and interests

  • Guaranteed payment 

  • Sales of investment properties

  • Sales of an expanse of land

  • Wages, salaries, and commission income from Form 1099

  • Business types like limited liability, partnership, and S corporations where shareholders participate materially

  • Farming activities where the shareholders participate materially

  • Royalties realized in the line of business. 


Special Considerations 

Many individuals with high net worth do employ various tax strategies, including the use of passive income as a significant way of bringing down their taxable income. Uncle Sam classifies a high net-worth individual as a single person or family with over $1 million as net worth or liquid asset. The exact figure, however, varies based on the region and financial institution involved. Similarly, people with a net asset of over 30 million USD are considered ultra high net worth individuals. 

A high net worth individual does have extra preferential treatment when it comes to their investment alongside the ability to utilize tax strategies. An ordinary person will likely not have enough means in terms of cost and time of hiring a tax expert and coming up with strategies that can help them match their streams of active and passive income.


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