What Is Non-Passive Income and How Is It Taxed?

For United States tax purposes, the Internal Revenue Service (IRS) does not treat all income equally. The government requires taxpayers to separate their earnings into distinct categories, a process that determines an individual’s tax liability. The character of income, whether from direct labor, investments, or other business activities, influences the application of specific tax rules. This framework reflects the taxpayer’s level of involvement in generating that income, and as a result, the same dollar amount of income can have a different tax outcome depending on its source.

The Three Categories of Income

The IRS framework divides income into three primary types: active (or non-passive), passive, and portfolio. Each category has a specific definition and corresponding tax treatment, making proper classification a foundational element of tax compliance. This system prevents certain types of losses from offsetting certain types of income.

Active (Non-Passive) Income

Active, or non-passive, income is what most people think of as earnings. It includes wages, salaries, tips, commissions, and other payments for services performed, reported on a Form W-2. This category also encompasses the profits from a trade or business in which the taxpayer works on a regular, continuous, and substantial basis, with this income reported on Schedule C for self-employed individuals.

The defining characteristic of active income is the taxpayer’s direct effort. For example, the income a freelance graphic designer generates is active, as are the profits a restaurant owner earns from personally managing the establishment. This income is subject to ordinary income tax rates as well as employment taxes like Social Security and Medicare.

Passive Income

Passive income comes from trade or business activities in which a taxpayer does not materially participate. The most common examples are rental real estate activities and income received from a limited partnership. In these scenarios, the taxpayer’s involvement is minimal.

For instance, owning a rental property that is managed entirely by a third-party company generates passive income. Another example is being a silent partner in a business, where you have invested capital but have no role in the daily operations.

Portfolio Income

Portfolio income is derived from investments rather than from business operations. This category includes interest earned from savings accounts or bonds, dividends paid on stocks, and royalties received from intellectual property. It also covers capital gains from the sale of an asset like a stock or mutual fund.

For example, if you buy shares of a publicly traded company and later sell them for a profit, that profit is portfolio income. This income is not subject to self-employment taxes but may be subject to the Net Investment Income Tax for higher-income individuals.

Determining Active Participation in a Business

The distinction between passive and non-passive income from a business or rental activity hinges on “material participation.” To classify income as non-passive, a taxpayer must demonstrate their involvement in the activity was regular, continuous, and substantial. The IRS provides seven specific tests to measure this involvement, and a taxpayer only needs to satisfy one for the tax year.

The first test is the 500-hour rule. If an individual participates in the business activity for more than 500 hours during the tax year, their involvement qualifies as material participation. These hours include any work an owner would customarily do, such as managing operations or performing services.

A second test considers whether the taxpayer’s participation constituted substantially all of the participation in the activity for the year. This test is often met by sole proprietors or individuals running a one-person business where no one else contributes to the work. A freelance consultant who is the only person performing services for their business would meet this standard.

The third test requires participation for more than 100 hours, provided that this level of involvement is not less than the participation of any other individual. This includes the time spent by employees or other owners. If a taxpayer works 120 hours in a small retail business and no other single person worked more than 120 hours, this test is satisfied.

A fourth standard applies to “significant participation activities.” An activity is a significant participation activity if the individual participates for more than 100 hours during the year. If a taxpayer’s combined participation in all of their significant participation activities exceeds 500 hours, they are considered a material participant in each of those activities.

The IRS also provides two look-back tests. Under the fifth test, an individual materially participated if they did so in the activity for any five of the ten immediately preceding tax years. The sixth test is for personal service activities, like law or accounting, and is met if the taxpayer materially participated in any three prior tax years.

The final test is a facts-and-circumstances determination. It requires the taxpayer to show they participated on a regular, continuous, and substantial basis during the year. This test cannot be used unless the individual participated for more than 100 hours, and it does not count time spent in a management capacity if anyone else was compensated for managing the activity or spent more hours managing it.

Tax Treatment and Reporting

The classification of income as non-passive or passive is governed by the Passive Activity Loss (PAL) rules. These rules, detailed in Internal Revenue Code Section 469, prevent taxpayers from using losses from passive business ventures to offset their active or portfolio income. This means that if a passive activity generates a loss, that loss can generally only be used to offset income from other passive activities.

For example, if an individual has $50,000 in W-2 wages and a $10,000 loss from a limited partnership investment, they cannot use that loss to reduce their taxable wages. This prevents a high-wage earner from investing in a business that generates paper losses simply to lower their overall tax bill.

When passive losses exceed passive income in a given year, the excess loss is carried forward to future tax years. If the taxpayer disposes of their entire interest in the passive activity, any suspended losses from that activity are freed up and can be used to offset any type of income.

Taxpayers use IRS Form 8582, Passive Activity Loss Limitations, to calculate and track these rules. This form guides individuals through netting their income and losses from all passive activities to determine the allowable loss for the current year and the total suspended loss to carry forward.