Passive income is a form of earning money without materially participating in the activity from which the income is derived. There are two definitions for passive income. Understanding the difference is essential for the small business entrepreneur.
There is the common business definition and the tax code definition. The common business definition is much broader in scope and is much more inclusive than the tax definition. A good example of passive income is earning interest on an investment. The capital loaned is earning the money and not the physical involvement from the investor. However, in the tax code, this is referred to as portfolio income and therefore not classified as passive.
When you hear the term ‘Passive Income’ you should immediately ask if the person is referring to the general meaning or the tax meaning. Most people believe they are referring to the tax meaning and they are usually mistaken. The following is a perfect example:
Thus, the key is to understand the two definitions and how they differ from one another. In addition, you should understand the tax code’s meaning and interpretation of passive income to properly record your tax based passive income as a subset of all passive income.
This article starts with a general summary of the two groups (tax based is a subset of all passive income) and describes how to pass the tests under the Internal Revenue Code and Regulations to classify the earnings as tax based passive income. Then the article will go into deeper details of broad based passive income definition. Once generated, the article will describe how to get that income classified as tax based passive and why you would want that form of income in your overall earnings. In effect, it will describe the advantages of having tax based passive income over other forms of taxable income. Finally, the detailed section will describe the at-risk rules and how these rules affect you.
A common vision most people desire is earning money while doing nothing. Think of sleeping at night and earning money. While on vacation, you are earning money. The most basic definition of passive income is ‘earning money with little or no participation in the process.’ Some simple examples include:
- Dividend income
- Annuity payments
- Limited Partnership income
- Rental Real Estate
- Oil and mining income from leasing the rights to your land
Notice the last item is similar to renting out your property. In the US, the largest source of passive income is renting real estate. The definition begins to get a little blurred because in some situations, the owner of the real estate has to put in more effort to rent out the real estate than he would to receive interest income. This is where the tax code comes into play in molding the definition of passive income.
Trade or Business Income
In general, the Internal Revenue Service identifies two types of passive income. The first is ‘trade or business income in which you do not materially participate’. In effect, you are an investor in a business and you receive a K-1 as the investor. This K-1 reports your passive income or loss. The IRS will allow you to treat this income as passive provided you did not materially participate in earning this money. This is defined by the following:
1. Less than 500 Hours/Year of time invested into the business activity;
2. Your invested time must be substantially less than any other person’s time (you are the 100% owner of the business activity, therefore your time is the substantial portion of the total time and the 500 hours test is irrelevant);
3. You participated less than 100 hours and this time must be less than any other person’s time (note how both 2 & 3 are similar in nature; except that 3 is setting the standard for a really small business);
4. You must not have been materially participating for at least five of the last ten years of business;
5. In general, personal service businesses do not meet the tests for passive income; examples include health care services, financial services, labor based services etc.;
6. Your participation cannot be regular or continuous, the business must be able to operate without your input.
Most small businesses cannot pass the required tests to count the income as passive in nature under the tax code. The passive tests work well with larger capital intensive operations like oil and mining operations whereby funding is acquired via the stock market and the investors receive a K-1 from the business each year.
The second type of passive income recognized by the IRS is rental income from property. Most folks immediately think of real estate, but property rental includes equipment and other personal property (artwork, tools, autos, planes, etc.).
Renting of non-real estate property is considered passive but there are exceptions and those exceptions are explained in more detail later in this article. Real estate rental is a different ball game. In general, the IRS allows the income earned from real estate rental property to be classified as passive provided you did not act on a similar level as a real estate broker/agent. In general, the IRS has two tests to determine if you are a real estate professional. The first is that if more than ½ of your total income is derived from real estate, then the IRS considers you to be a real estate professional and therefore the income derived from renting property cannot be classified as passive. The second test is the 750 hours rule. If you spend more than 750 hours of your time in renting out the real estate and providing typical real estate professional services, than the income derived from the rental property is considered active and is excluded from classification as passive. In effect, you must spend less than 750 hours of your time in real estate activities per year.
Test one is income based, test two is time based. Both tests are exclusive from each other.
Please see the following for a detailed explanation of passive activity and the rules related to this form of income: IRS Passive Activity Guide.
Detailed Understanding of Passive Income
Passive Income in General
In business, there is a broad based definition of passive income. Simply stated, it means ‘earning money with little to no participation in the investment’. If you think about this, it really means it’s a capital intensive function whereby you receive some form of financial return on this capital investment. The capital investment can come from various resources:
- Financial in nature
- Labor investment – man hours of work to build a business that generates income into the future, examples include blogging, writing, creating art, and other literary based work
- Innovation – patents, research, technology (apps, software programs), music, business ideas (franchises, systems)
- Perseverance (time related) – waiting on the business to grow or markets to change; examples include tree growing operations, mineral rights, land developments, etc.
Financial in Nature
One of the most common forms of passive based income is interest, dividends, or capital gains from investments. There are over 1,000 different types of market investments that you can make. Some require business sophistication and savvy, others are simple in nature. The common savings account generates interest and interest is considered passive from the business perspective. Note how it qualifies under the general definition – ‘earning money with little or no participation in the investment’. However, the IRS does not consider interest, dividends, or capital gains/losses as passive in nature. These items are considered either portfolio income or capital income by law. The Internal Revenue Service has a stricter definition of passive income than the much broader based business definition.
The most common form of labor based capital investment is working for your retirement. You work years and years and finally a retirement check comes to you during your later years of life. This retirement check requires ‘little to no participation’ to receive the check. Retirement checks are commonly found with annuities, government retirement, and insurance instruments that bring income to you in the future.
The second most common form of labor based investment is writing or literary work. During the last decade we have witnessed a boom in blogging. This article is a part of an authority website on the subject of business. Bloggers spend many hours creating and writing the work, developing the website, and generating markets. As time goes on, they are rewarded for their work. As the site grows with more visitors, sources of income are generated from advertising, product sales and e-books. This income is earned in the future. However, the labor investment decreases over time where the writer spends only a little to no time maintaining the site and earns money. Notice how this meets the definition of passive income – ‘earning money with little or no participation in the investment’. However, it does not meet the definition of passive income as defined by the IRS. Literary work is excluded from the passive income classification. In addition, any royalties earned from writing is excluded in accordance with the code.
Other examples of labor intensive work that earns money in the future with little to no further investment include the following careers:
- Writers – books, training courses, articles etc.
- Art workers that sell or lease out their creations – advertising works, logo creators, general art work, video creations including movies, commercials or even U-Tube videos
- Small business entrepreneurs – this is the category whereby most of the readers of this article fall. You build a successful business over time and if you implement good management systems you can spend little to no time in the future maintaining the operations of the business. You hire good people to manage and run the business and you can sit back and earn the money.
Only with the small business entrepreneur scenario is it possible to have the income classified as passive under the Internal Revenue Code. The most common example is a limited partnership investment.
In this situation, the partner or investor is considered silent in nature and only has risk associated with his financial investment. However, many limited partners started out as active partners and over time reduced their personal commitment to the business and retired from regular day to day operations. Once that partner passes the five year test (not active for five years) he can begin to classify his income from the business as passive under the Internal Revenue Code and Regulations. There are other tests for the even smaller business operations that must be passed in order to classify the income as passive in accordance with the code. The following elaborates on these rules:
In general, the code is looking at your participation and the term that is used is material participation in the business operations. The key is to meet the most basic test of limited input into the operations of the business. The primary test is less than 500 hours of work per year in the business. If you own the business and go into the office once a week for about 3 hours to meet with staff and review progress, then you can pass this test.
A second test is that you cannot participate more than any other person in the company. This means any employee too. If your time investment is greater than anybody else, you will fail the test and therefore the income is considered active and not passive.
The third test is a further elaboration of the second test above. If you participated for more than 100 hours per year and your participation was greater than any other individual in the company (including employees) then you will have failed the test. This test is designed to establish the boundaries for the really small business operations. As an example, suppose you own an insurance agency and you no longer pursue new clients and your so called ‘Book of Business’ requires some annual paperwork to maintain the accounts. The question is ‘how much time do you invest into this?’ If you spend more than 100 hours and you have some part time person who spends less time than you, then you will fail the test. Your 100 hours should be more management based and you should have staff that takes care of the paperwork to keep the book of business maintained. That staff should spend substantially more time doing the work than you.
Same situation as above, there is another test you must pass. Notice that the insurance work qualifies as personal service and therefore the earnings is not allowed to be classified as passive. However, another test the IRS uses is that you shall not have participated in providing that service for at least the last three years. If your hire a new agent, train him and get him to manage the books then three years later you may qualify your income as passive in nature provided you meet the other tests above.
The final critical test is basic in nature and provides a lot of latitude by the IRS to qualify your income as active and not passive. This final test states: ‘Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year’. This is their test to negate you calling your income passive. The most common point of contention is the ‘Key Man’ test. Can the business continue to operate without you? In many small businesses, this is a difficult test to pass.
We have all heard the stories of some kid or individual that creates some new application for the smart phone and then sells the application for a million dollars. Well, this is an example of innovation based capital investment that can generate earnings in the future with little to no participation.
The most common types of innovation based investments include software creations, writing music, creating a patent or starting some new franchise. The investment is brain power up front, lots of patience to test the creation and some good fortune to get the product to market. Once there, it begins to sell and before you know it; you have a hit and money comes into the mailbox in the form of fees, royalties, or commissions.
Again, there is little to no participation in maintaining these earnings. Think of the continuous royalties from the Beatles Music or fees paid to the creator of Facebook.
I once had the privilege of preparing a tax return for a new client involved in trash. We got to talking and he told me a story of real perseverance. He owned 200 acres of land in the country. The land was clear cut for the sale of pine trees to a regional lumber company. After clear cutting, he paid $21,000 for rare Japanese fir tree saplings and proceeded to plant the saplings. I looked at him in a curious manner. Why?
Well, trees have a non-linear growth rate; they grow on the outside on not on the inside. Remember your earth science about counting the rings on the tree. The rings form on the outside. Well, as a circle expands, the outside circle has more material than the circle inside of it and so on. Hmm… think about this for a minute. Lumber is measured in board feet; therefore, as each year passes, the amount of total board feet grown in your miniature forest is more than the previous year and so on.
He explained to me that the trees generally have a 24 year growth time frame and once achieving maturity, they grow at a very slow if any at all. It is like a law of diminishing returns, waiting one more year generates less revenue than having the tree cut down and growing a new sapling. In general, the best return on the investment for these particular trees is around the 21st year. In effect, you have to wait 21 years to earn your money. One fascinating retirement plan if you ask me. He estimates that based on the current market price and the volume of lumber he currently has, that his unrealized value is more than $1.2 million. At maturity, he expected to earn in excess of $2.8 million for his $21,000 investment. That is a remarkable 23% annual rate of return. He further elaborated that based on historical rain cycles, if he can catch 2 or 3 more wet years before maturity, he could be looking at more than $3.5 million in earnings.
He does very little to maintain the land other than cutting down the dead trees and monitoring for wood boring pests. Twenty-one years is true perseverance with making money.
Another example of perseverance includes waiting on markets to change for your investment(s). Then once the market swings back to your investment area, you sell your investments and move on to new ones. Other examples include the fluctuating price of mineral and precious materials such as gold or silver.
By waiting out the markets, you can earn money and this meets the definition of passive in nature. However, the IRS does not qualify this as passive so a small businessman needs to understand why you would desire tax classified passive income and how to ensure your income is passive in nature for tax purposes.
Internal Revenue Code Passive Income
Passive income is governed by Chapter 26, Section 469 of the US Code and Section 1.469 of the regulations to the Internal Revenue Code.
The section above described passive income in the business sense. In general, it is income earned with little to no additional participation. But most people are more interested in the tax definition which is much more narrowly defined. The reason Congress coded passive income is to limit its advantages to a taxpayer. What are these advantages?
There is really only one advantage: passive income can be offset by passive losses. Other forms of income active and portfolio can only have their positive gains offset by the losses. However, it is rare to have active income losses. Most people don’t participate in ongoing losses from their businesses because of the financial impact it makes on the household. In addition, most people don’t sell their bonds or stocks for losses. They most often wait for the market to come back or keep on earning the dividends or interest these investments generate. But in the passive classification, there is opportunity to build long term wealth and the current losses generated can offset passive earnings.
For the last 60 years or so, this wealth accumulation has stood out with real estate investments. An investor purchases rental property for a low sum, invests money to renovate and maintain the property. These costs are offset by the rent earned and in general, most small rental property owners lose money. However, the market over the last 60 years has generated massive wealth due to the increase in value for this property. All of us have heard the stories of folks walking away from the sale of their rental property with thousands of dollars in gains.
Passive earnings during the year can offset the losses generated (usually) by real estate. This is a big tax advantage when you talk about the tax on $40,000 of passive income being offset by similar losses. You are talking about $8,000 savings in taxes. This is the primary reason a businessman wants his income to be classified as passive under the code.
To be fair, if you do not desire to get involved in real estate rentals; then there really isn’t much of an advantage to get your income classified as passive under the code. It can be passive in general as a business form of earnings, but there really is no reason to get it classified as passive within the definition of the code.
To meet the definition of passive within the IRS Code, the income must be earned without material participation by the beneficiary of the earnings.
In general, the IRS classifies passive income if it is sourced from two types of earnings:
1. A rental activity – the most common is renting of real estate.
2. Business income provided the taxpayer did not materially participate in its earnings.
Because the later if very difficult to prove, the most common type of business income reported is earnings from a limited partnership or S-Corporation income for an investor.
Many businesses are set up in the limited partnership format. This means that some or most of the financial investment comes from investors that will have no say in the operations of the company. The investor may or may not receive dividend earnings or partnership distributions for their investment. However, each year this partner receives a K-1 statement usually a Form 1065 K-1 that identifies the amount of his share of earnings or losses associated with this company.
Because the investor meets the test of limited or no material participation, this income or loss can offset other passive losses or income.
This is very similar to the limited partnership described above. Except here, the company is an S-Corporation and is generally smaller in nature than Limited Partnerships. The code restricts the number of investors for an S-Corporation. The most common investors for S-Corporations are family members that put up the capital to start a company and a single or a few family members are actively involved in its day to day operations.
Just like the Limited Partnership, a K-1 report (Form 1120-S K-1) is filed with the IRS and provided to the investor to report their respective passive income or losses.
To get your income classified as passive, you must pass the material participation tests. These tests are designed to set the thresholds of activity by you in the business so that income can be classified as passive.
1. The first test that you must pass which is the most difficult is the 5 year test. This means that you cannot be actively involved in the business for five years. This is the most difficult to overcome.
2. The second hardest test to overcome is the 500 hours test. In effect, if you spend more than 500 hours per year in your business operation, then the income is classified as active and not passive.
3. The next most difficult standard to overcome is the 100 hours test. This test is aimed at the really small business operation. This is oriented towards the small family operation where there are less than five employees and is managed by one person. Here, the test states that you must not exceed 100 hours per year of work and that you must work less than any other employee or investor. This one is very difficult to overcome for most small business owners. The reason is that the operation generally relies on the key owner to maintain or direct operations on a regular basis. It is rare for a business to have stable ongoing operations without input from the original creator or person that ran the business operation in the past.
To pass the above tests, an owner of a small business needs to achieve an economy of scale whereby a professional or another family member truly understands and runs the business operation. You pretty much have to be hands off and receive a distribution or partnership draw as your source of earnings from this operation. Depending on your situation; it may be worth the five year wait and the amount of work it will take to set your business up to be self-sufficient. Seek guidance from this site or from your CPA to assist you in getting to that level of business operations.
However, there are very individuals that need their income classified as passive in accordance with the code. The key question is ‘Why do you need your income classed as passive for tax purposes’? Once you can substantiate this need to achieve this high standard, then you have to develop a plan to get there. But again, in my opinion, there is very little to no tax advantage to have your income classed as passive. You may e-mail me at firstname.lastname@example.org and explain your situation and I’ll provide you some guidance or point you in the right direction.
Summary – Passive Income
This article explained the difference between the general business definition of passive income ‘earning money with little or no participation in the process’ and the Internal Revenue Code’s definition. Remember, the IRS code is limited to two types of income. The first is rental property income and the second is income from a business operation provided the taxpayer has little to no material participation in that operation’s activities.
The only advantage to have income classed as passive for tax purposes is that this income can offset passive losses. If you anticipate significant losses over an extended period of time, then there is a substantial reason to get your income classed as passive in nature for tax purposes. The standard for passive income classification is high and very difficult to achieve for the small business owner and should only be pursued with the help of a professional. Make sure you understand the reason to achieve this goal and the costs associated with this classification.
For most individuals, suffice it to say that your income is passive in nature under the general business definition. Hopefully, you can sit back and reap the rewards of hard work. And now you can earn money like it is growing on a tree. Act on Knowledge.
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