1. Three Types of Income
2. Passive vs. Non-Passive Income
3. Defining Material Participation
4. Affordable Care Act

Is S corp income passive or nonpassive? This is a question that many people want to know, but the answer really depends on material participation. Material participation makes your income non-passive. Otherwise, it would be classified as passive.

Three Types of Income

There are three types of income to consider:

  • Earned Income — This is income that is derived from your work. It is typically referenced as W-2 wages or Schedule C small business income filed with your personal tax returns. Both of these are subject to self-employment taxes (Medicare and Social Security).
  • Portfolio Income — This is money listed as income from selling an asset for more than what you paid for it. This means you have turned a profit, and it may be taxed at ordinary income tax rates or as a capital gain depending on the holding period of the asset. Examples of portfolio income are interest and dividends.
  • Passive Income — Income or losses can be classified as passive or non-passive. You can only offset passive income with passive losses.

Passive vs. Non-Passive Income

Passive income is defined as income that continues to accrue even if you do nothing. Passive income can be income derived from royalties, rental income, investment partnerships, and multi-member LLCs, provided you do not materially participate. You are not subject to self-employment tax, but you may have to pay Net Investment Income Tax in some instances.

If you have Schedule K-1 income that is generated from an S corporation, and you were actively participating in the business, then it would be non-passive. It is not automatically earned income or passive income. This means it falls somewhere in between, but without the Medicare and Social Security tax features. All shareholders in an S corporation will receive a Schedule K-1. Schedule K-1 is similar to a W-2 or Form 1099-INT, and shows a variety of investment income information related to S corporations:

  • Dividends.
  • Interest.
  • Passive income like rents and royalties.
  • Non-passive income.
  • Capital gains and/or losses.

People working abroad can exclude a percentage of their earned income while working overseas. Some people opt to establish an S corporation in the United States for their contract, which means the W-2 and Schedule K-1 income are excluded from income tax, up to a certain amount.

One example of passive versus non-passive income is the money an author earns from the sale of his book. If you wrote one book and only receive royalty payments, it would be considered passive income. However, if you continue to write more books, then you are materially participating, and the income would be classified as earned income. This income would be subject to self-employment taxes.

Defining Material Participation

Since it's determined whether income is passive or non-passive based on material participation, it's important to understand what the term means. Material participation is defined as when a taxpayer's involvement in the business or trade is substantial, and it's regular and continuous. Any work someone performs in an activity related to an interest they own is typically classified as participation, but it is not automatically material.

There are several tests used to determine whether an owner's involvement constitutes material participation or not:

  • Participate in related activity more than 500 hours per year.
  • Participation constitutes nearly all the participation by everyone (including non-owners).
  • Activity is significant participation activity and taxpayer is active more than 100 hours, and their annual significant participation is more than 500 hours.
  • Must have participated in the activity for any five years — does not have to be consecutive — during the prior 10 tax years.
  • If there is a personal service activity, material participation has to be for any three tax years, consecutive or not, preceding the current tax year.
  • Taxpayer participates on a regular and substantial basis throughout the year.

Affordable Care Act

For several years now, the Affordable Care Act has added a 3.8 percent surtax on investment income. In order to avoid this tax, your investment income has to be considered non-passive or it must be offset with investment losses. This determination is made on an annual basis because your tax status may change from year to year.

If you need help with determining whether S corporation income is passive or non-passive, you can post your legal need on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.