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.3 min read updated on February 01, 2023
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.
FAQs
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.
Is S corp income considered passive? ›
S corporation income, gains and other tax items flow through to the shareholders and are reported by the shareholders on their personal income tax returns. The passive income tax often comes as a surprise when S corporation assets are sold and the corporation remains in existence receiving income from passive sources.
What type of income is S corp income? ›
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Is my income passive or non passive? ›
In the world of personal finance, understanding the distinction between passive and non-passive income is incredibly important. Passive income is generated with minimal effort and offers financial freedom, while non-passive income often demands more active involvement.
Is an S corp a non taxable income? ›
S Corporation Income
In general, an S corporation does not pay tax on its income. Instead, the income, losses, deductions, and credits of the corporation are passed through to the shareholders based on each shareholder's pro rata share. You must report your share of these items on your return.
Can an S corp owner be passive? ›
If you are a passive investor in the S corporation, not serving as a corporation officer, and not otherwise providing the corporation with any services, then most likely you'll receive your share of the profits as some kind of distribution.
What does the IRS consider passive income? ›
Gross income from passive sources includes: Dividends, interest, and annuities. Royalties (including overriding royalties), whether measured by production or by gross or taxable income from the property.
Is S Corp income considered unearned income? ›
S corporation earnings are considered unearned income, which means that the so-called “kiddie tax” can limit tax savings on transfers to children. Therefore, this incomeshifting strategy might have its greatest payoff after children leave school or reach age 24, when the kiddie tax won't apply.
Can you leave money in an S Corp and not pay taxes? ›
You will need to file the tax return for S-corporation - form 1120S - and will calculate taxable income after all deductions. That income is passed to you on K1 - because S-corporation is pass-through entity. You will include that amount from K1 into your income REGARDLESS if you took distribution or not.
How is income reported for S Corp? ›
Use Form 1120-S to report the income, gains, losses, deductions, credits, etc., of a domestic corporation or other entity for any tax year covered by an election to be an S corporation.
Non-passive income can be derived from various sources. Wages, salaries, tips, bonuses, commissions and self-employment income are all examples. Each source represents a different form of active involvement, whether it's a traditional job, a freelance gig, or a personal business venture.
How do you know if income is passive or active? ›
Active income, generally speaking, is generated from tasks linked to your job or career that take up time. Passive income, on the other hand, is income that you can earn with relatively minimal effort, such as renting out a property or earning money from a business without much active participation.
Which is not an example of passive income? ›
Business activity: If you engage in business activity or stock trading related to the business activity during the tax year, the profits you generate are a type of non-passive income. Active stock trading: Any active stock trading in an attempt to earn profits is an example of non-passive income.
How does S Corp avoid taxes? ›
Employing an S Corporation structure can lower the self-employment tax. The taxable business income can be split into two components—salary and distribution. Here, only the salary component attracts the self-employment tax, thus reducing the overall tax liability.
How is net income from an S Corp taxed? ›
Generally, California law follows federal law in computing the S corporation's income. However, the major difference is that for California purposes, an S corporation's income is taxable at the corporate level and the pass-through of its income to the shareholders is also taxable on their returns.
Is S Corp income considered investment income? ›
Ordinary income reported to an individual shareholder on Schedule K-1 from an S-Corporation is not considered earned income. Such income is investment income, thus not subject to self-employment tax, and it isn't taken into account when calculating a tax credit that uses earned income in its calculation.
Is S corp income considered self-employment income? ›
So, what's the tax benefit of an S Corp? The S Corp advantage is that you only pay FICA payroll tax on your employment wages. The remaining profits from your S Corp are not subject to self-employment tax or FICA payroll taxes. Those profits are only subject to income tax.
Is S corp income considered investment income? ›
Ordinary income reported to an individual shareholder on Schedule K-1 from an S-Corporation is not considered earned income. Such income is investment income, thus not subject to self-employment tax, and it isn't taken into account when calculating a tax credit that uses earned income in its calculation.
What is passive income for a corporation? ›
Passive income includes interest, dividends, mutual fund income, capital gains and most rental real-estate income. Beginning in 2019, as your passive income increases, there is a corresponding decrease in the amount of your active business income that can be taxed at the small business tax rate.
Is S corp income considered net investment income? ›
S corporations are not subject to the net investment income (NII) tax, but S corporation shareholders may be subject to the tax on income items related to their investments in the corporation.
