Is Nonpassive Income From Schedule K-1 Taxable?
Understand how nonpassive income from Schedule K-1 is taxed, including key components like self-employment tax and Medicare surtax, and potential recharacterizations.
Income reported on a Schedule K-1 can be classified as passive or nonpassive, a distinction with significant tax implications. Nonpassive income typically comes from active business participation and is subject to different tax treatments than passive income. Proper classification ensures compliance with tax laws and helps avoid unexpected liabilities.
Criteria for Nonpassive Classification
The IRS determines nonpassive income based on material participation, assessed through specific tests in Treasury Regulation 1.469-5T. A taxpayer qualifies by spending at least 500 hours per year on the activity or meeting other criteria, such as contributing more time than anyone else involved.
Business structure also plays a role. General partners are usually considered active participants unless their involvement is minimal. Limited partners must meet stricter criteria. S corporation shareholders who work in the business can have nonpassive income, while passive shareholders generally receive passive income.
Key Items Commonly Reported
Schedule K-1 reports various types of income, deductions, and credits from partnerships, S corporations, or trusts. Nonpassive income often includes business earnings, guaranteed payments, and gains from selling business assets.
Guaranteed payments compensate partners for services or capital contributions, regardless of profitability. These payments are treated as earned income and subject to self-employment tax.
Section 1231 gains from selling business property used for more than a year may qualify for long-term capital gain treatment. However, in some cases, they can be recharacterized as ordinary income, particularly if depreciation recapture applies.
Tax Components for Nonpassive Amounts
Nonpassive income from a Schedule K-1 is subject to multiple taxes beyond ordinary income tax, including self-employment tax and Medicare surtaxes.
Income Tax
Nonpassive income is taxed at ordinary income tax rates, ranging from 10% to 37% in 2024. Unlike long-term capital gains, which benefit from lower rates, nonpassive business income is taxed like wages.
The Qualified Business Income (QBI) deduction under Section 199A may reduce taxable income by up to 20%. However, this deduction is subject to limitations based on income level, business type, and wage and capital restrictions. In 2024, phaseouts begin at $191,950 for single filers and $383,900 for joint filers.
Additional Medicare Tax
High-income earners may owe a 0.9% Additional Medicare Tax on wages and self-employment income exceeding $200,000 (single filers) or $250,000 (married filing jointly). Unlike the standard Medicare tax, this surtax is solely the taxpayer’s responsibility.
For those receiving nonpassive income via a partnership or S corporation, the surtax applies only to self-employment income or wages. S corporation distributions are not subject to this tax, making entity structure an important tax planning factor. Since this tax is not automatically withheld from K-1 income, estimated payments may be necessary to avoid penalties.
Self-Employment Tax
Nonpassive income earned by general partners and sole proprietors is subject to self-employment tax, covering Social Security and Medicare contributions. The rate is 15.3%, with 12.4% for Social Security (on income up to $168,600 in 2024) and 2.9% for Medicare (with no income cap). Unlike employees, self-employed individuals pay the full amount.
Taxpayers can deduct half of the self-employment tax paid as an adjustment to income. S corporation shareholders who work in the business can reduce their self-employment tax liability by taking a portion of earnings as distributions rather than wages. However, the IRS requires “reasonable compensation” for shareholder-employees, and misclassification can result in penalties.
Recharacterizations That Shift Income Status
Income classification can change due to recharacterization rules, affecting how it is taxed. One common scenario occurs when business income is later determined to be investment-related. For instance, if a partnership generates portfolio income—such as dividends or interest—that was initially misclassified, it may need to be recharacterized as passive or investment income. Investment income is generally not subject to self-employment tax.
A business activity may also be reclassified due to operational or ownership changes. If a taxpayer materially participated but later reduces involvement, future earnings may be treated as passive. This often happens when a general partner becomes a limited partner or when an S corporation owner steps away from management. Such shifts can impact deductions, particularly the ability to offset income with business losses.