S Corp & IRS Rules: Passive vs Nonpassive Income

Key Takeaways

• S corp income can be passive or non-passive, depending on material participation.
• Passive income includes rental activities, limited partnerships, and royalties where the taxpayer is not materially involved.
• Non-passive income includes wages and active business income from S corps where the shareholder materially participates.
• The IRS uses seven tests to determine material participation.
• Non-passive income is not subject to the Net Investment Income Tax, while passive income may be.
• Recharacterization rules can shift income between passive and non-passive under IRS scrutiny.

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.

Common Sources of Passive and Non-Passive Income

Understanding where income originates helps determine whether it's passive or non-passive:

Examples of Passive Income:

• Rental real estate (unless the taxpayer is a real estate professional)
• Limited partnerships
• Income from a business in which the taxpayer does not materially participate
• Royalties from intellectual property
• Certain investment partnerships

Examples of Non-Passive Income:

• Wages and salaries
• Business income from an S corp or LLC where the taxpayer materially participates
• Active participation in rental real estate (e.g., short-term Airbnb rentals with substantial services)
• Consulting or freelance income
• Self-employment income subject to FICA taxes

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.

How the IRS Evaluates Passive vs Nonpassive Income

The IRS uses seven tests to determine material participation, and these are critical in the classification of income. Even within S corps, passive vs nonpassive income depends on the shareholder's involvement.

An activity is non-passive if you meet any one of the following:

1. Participate in the activity more than 500 hours during the year.
2. Your participation constitutes substantially all of the participation.
3. Participate more than 100 hours and no one else participates more.
4. Combine multiple "significant participation activities" exceeding 500 hours total.
5. You materially participated in the activity for any five years in the past 10.
6. For personal service activities, material participation in any three years.
7. Based on facts and circumstances, you participate on a regular, continuous, and substantial basis.

The IRS scrutinizes these activities especially when claiming losses, credits, or trying to avoid the 3.8% Net Investment Income Tax.

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.

Passive Loss Limitations and Grouping Elections

Passive losses can only offset passive income. This limitation can restrict your ability to deduct losses from passive activities unless:

• You dispose of the passive activity (e.g., sell the business or rental property).
• You group related activities under IRS Reg. §1.469-4 to combine passive and non-passive work (a strategic tax planning move).

Example:If you own two businesses—one where you participate materially and one where you do not—you may be able to group them into a single activity if they form an "appropriate economic unit." This grouping helps you qualify for material participation tests and deduct losses across entities.

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.

Net Investment Income Tax and Passive Income

The Net Investment Income Tax (NIIT) adds a 3.8% surtax on passive income for individuals with modified adjusted gross income (MAGI) exceeding:

• $200,000 (single)
• $250,000 (married filing jointly)
• $125,000 (married filing separately)

Passive income subject to NIIT includes:

• Dividends
• Interest
• Rental income (if not materially participating)
• Capital gains
• Royalties

Non-passive income is not subject to NIIT, making it critical for high-income individuals to evaluate their material participation status each year to reduce tax exposure.

Frequently Asked Questions

1. Can S corp income be considered passive income?
   Yes, if the shareholder does not materially participate in the business, the income may be classified as passive.
2. What is the significance of material participation for taxes?
   Material participation determines whether income is subject to self-employment tax or the Net Investment Income Tax.
3. Is S corp income subject to the 3.8% Net Investment Income Tax?
   Only if it is classified as passive. Non-passive income from S corps is generally exempt from this surtax.
4. Can you group multiple businesses for passive activity rules?
   Yes, under IRS rules, you may elect to group activities to meet material participation standards and better manage losses.
5. Are rental properties always considered passive income?
   Generally, yes—unless the taxpayer qualifies as a real estate professional or provides substantial services with short-term rentals.

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