What it means
The defining test is material participation, meaning regular, continuous and substantial involvement in the activity. A partner working 40 hours a week in a restaurant earns active income from it, while a silent backer who only supplied money does not.
The practical consequence is the size of the tax bill. Active earnings usually attract payroll or self employment charges on top of income tax, whereas dividends, long term capital gains and some rental profits are taxed at lower rates and escape those extra charges.
Classification also decides how losses can be used. Passive losses can generally only be set against passive income, so a loss making rental property cannot normally reduce the tax on a salary, while a genuine trading loss often can.
For business owners the line is worth planning around rather than ignoring. Converting some earnings from salary into distributions or rent can lower the total charge, but tax authorities push back hard when the remaining salary is unreasonably low for the work being done.
In corporate tax the same words carry a different meaning. Rules on controlled foreign companies separate active business income, earned from real operations abroad, from passive income such as royalties and interest, which is usually taxed sooner and more heavily.
In practice
Real-world examples
Example 1
A software developer earns $140,000 in salary and $9,000 in dividends from a share portfolio. Only the $140,000 is active income, which is why his payroll deductions are calculated on the salary alone.
Example 2
A landlord with six flats spends more than 750 hours a year managing them and qualifies as a real estate professional. That reclassifies the rental profits as active, allowing losses from one property to reduce the tax on his other earnings.
Example 3
A hairdresser opens a second salon run entirely by a manager. She works full time in the first salon and never visits the second, so her share of the second salon's profit is treated as passive while the first is active.
Think of it
Active income is like riding a bicycle. As long as you keep pedalling, you move forward, but the moment you stop pedalling, the bike eventually comes to a halt.
Formula
Calculation
Active income = wages and salary + bonuses and commission + net profit from any trade in which you materially participate
A marketing manager earns a salary of $95,000 and runs a consultancy in the evenings with net profit of $30,000, working in it regularly throughout the year. She also receives $8,000 of dividends and $12,000 of net rent from a flat run by a letting agent.
Active income = $95,000 + $30,000 = $125,000
Passive income = $8,000 + $12,000 = $20,000
Total income = $145,000, of which $125,000 / $145,000 = 86.2% is active
The consultancy profit carries an extra cost the investment income does not. Applying a combined self employment charge of 15.3% to the standard base of 92.35% of net earnings, the base is $30,000 x 92.35% = $27,705 and the charge is $27,705 x 15.3% = $4,238.87, on top of ordinary income tax.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. Rowanmere Fitness, an invented studio owned and run by a single founder, generated $180,000 of profit before any owner remuneration. In its first two years the founder took the whole amount as salary, so all $180,000 was active income and every dollar attracted payroll charges.
Her accountant proposed a split for the third year: $110,000 as salary for the work actually performed, and $70,000 as a dividend on the shares she owned. At a combined 15.3% payroll rate, moving $70,000 out of active earnings saved roughly $70,000 x 15.3% = $10,710 a year.
The accountant was careful about the limit of the idea. Because the founder taught most classes herself, a salary far below $110,000 would have been indefensible if questioned, and in this fictional example the recommendation came with a written note supporting the figure by reference to what an employed studio manager and lead instructor would have been paid.
Watch out
Common mistakes
- Assuming any money earned from a business you own is active, when income from a venture you do not materially participate in is usually passive.
- Expecting rental losses to reduce the tax on a salary, which passive loss rules generally prevent.
- Cutting an owner's salary to an artificially low level to reduce payroll charges, which is one of the most frequently challenged positions in small business tax.
Questions
People also ask
Is interest on savings active income?
No, interest is passive because it is generated by capital rather than by work, even though it is often taxed at ordinary rates.
Does a side business count as active income?
Yes, provided you materially participate in it, and most regimes measure that by hours worked and by whether your involvement is regular, continuous and substantial rather than occasional supervision.
Why do people chase passive income if active income is usually larger?
Because passive income does not stop when you do, and it is often taxed at lower rates, though it normally requires capital or years of work to build.