What Are the Differences Between Ordinary, Passive, and Non-Passive Income?
As a business owner, you’re likely aware that not all income is taxed the same way. The IRS divides income into distinct categories-ordinary, passive, and non-passive. Understanding these differences can have a profound impact on how much you pay in taxes.
With a little strategy, you can navigate these rules to keep more of what you earn and reinvest it into growing your business.
Let’s dive into the details of each income type, their tax implications, and how entrepreneurs can use these distinctions to their advantage.
Ordinary Income: The Backbone of Earnings
Ordinary income is the most common type of income, earned through active participation in work or business operations. It’s the money you earn through salaries, wages, or business profits generated by your efforts. For example, if you own a marketing agency and spend your days creating campaigns, managing clients, and growing your team, the income generated by the agency is considered ordinary income.
This income is taxed at progressive rates based on your tax bracket. For individuals working in their own business, it may also be subject to self-employment tax, which covers Social Security and Medicare contributions.
Tax strategies for ordinary income often include maximizing retirement contributions. Suppose you set up a Solo 401(k) plan for your agency and contribute a portion of your earnings to the plan. This reduces your taxable income, allowing you to save for the future while lowering your tax liability today.
Additionally, claiming legitimate business expenses, such as software subscriptions or client travel, can also help reduce the taxable portion of your earnings.
Passive Income: Earnings Without Active Involvement
Passive income is derived from activities in which you are not actively involved. This type of income often comes from rental properties, royalties, or investments in businesses where you are not materially participating. For instance, if you own a duplex and rent it out, the income from tenants is considered passive income.
Unlike ordinary income, passive income is not subject to self-employment taxes, but it is taxed at your ordinary income tax rate. Imagine you earn $15,000 in rental income from your duplex after accounting for expenses like property taxes, maintenance, and insurance. This income is taxed as part of your total earnings for the year, but you avoid the additional self-employment tax burden.
The IRS has specific rules regarding how passive income and losses are treated. If your duplex generates a $5,000 loss due to repairs and other costs, you cannot use this loss to offset the income you earn from your marketing agency. Passive losses can only offset passive income (in most cases).
However, real estate investors often use strategies like depreciation to reduce taxable income. For instance, if you depreciate the property over time, you may show a loss on paper even while generating positive cash flow.
Non-Passive Income: Bridging the Gap
Non-passive income exists in a gray area between ordinary and passive income. This income comes from ventures where you are involved in some capacity but not to the extent of full-time engagement. Income from partnerships or S-Corporations often falls into this category. Imagine you are a minority partner in a consulting firm, owning 20% of the business but not working there day-to-day. The income you receive from your share of the profits is considered non-passive.
Non-passive income is taxed similarly to ordinary income, but the taxation can vary based on the structure of the entity and your level of involvement. For example, if the consulting firm generates $500,000 in profit and your 20% share is $100,000, that income is reported to you on a Schedule K-1. You’ll pay taxes on it at your ordinary income tax rate, and depending on the nature of the business, you may also owe self-employment taxes.
One way entrepreneurs optimize non-passive income is by carefully structuring their ownership interests and compensation arrangements. If you also receive a salary from the firm for occasional consulting work, the salary would be subject to payroll taxes, but your share of the profits might not be. This separation can provide tax efficiency while maintaining compliance with IRS rules.
Strategic Tax Planning Across Income Streams
The interplay between these income types presents opportunities for tax planning. For example, entrepreneurs often use business losses from ordinary income activities to reduce their taxable income. Imagine you incur a $10,000 loss in your marketing agency due to a major equipment purchase. This loss can offset your ordinary income from other ventures, lowering your overall tax bill.
Passive income streams, while appealing for their reduced tax burden, require careful management to maximize benefits. Suppose you own multiple rental properties. By grouping them as a single passive activity, you can use losses from one property to offset income from another. This strategy ensures you aren’t overpaying taxes on your passive earnings.
Non-passive income can also be optimized. If you’re a partner in an S-Corporation, timing your income distributions strategically – for instance, during a year when your overall taxable income is lower – can help you minimize the tax impact. Similarly, reinvesting profits into the business or leveraging advanced retirement contribution plans can defer taxes while promoting growth.
Portfolio Income: Earnings from Investments
Portfolio income is generated through investments, including dividends, interest, and capital gains from the sale of assets such as stocks, bonds, or mutual funds. For instance, if you invest $50,000 in a dividend-paying stock and earn $2,500 in dividends for the year, that income falls under this category.
Portfolio income is taxed differently depending on its source. Dividends, for example, may be taxed at a lower rate as qualified dividends, while interest income from bonds or savings accounts is taxed at your ordinary income rate.
Capital gains from the sale of investments are taxed based on how long you held the asset. Short-term gains, for assets held less than a year, are taxed at ordinary income rates, while long-term gains enjoy preferential lower rates.
A strategic approach to portfolio income involves timing asset sales. Suppose you own shares that have appreciated significantly. You may lower your capital gains tax rate by holding them for over a year before selling.
Additionally, tax-loss harvesting – selling underperforming investments to offset gains – can further reduce your tax liability.
Royalty Income: Profiting from Intellectual Property
If you own intellectual property such as patents, copyrights, trademarks, or even creative works like books or music, the income generated from licensing or usage rights is categorized as royalty income. For example, an entrepreneur who self-publishes an e-book on marketing strategies might earn royalties every time the book sells online.
Royalty income is generally taxed as ordinary income unless it comes from a passive activity, such as a patent held by an investor. Entrepreneurs can benefit from royalty income because it allows them to monetize assets repeatedly without direct involvement, creating an additional revenue stream.
Strategically managing royalty income involves maximizing deductions related to the creation or maintenance of the intellectual property. Suppose you incurred $5,000 in legal fees to register a trademark for your business. Those expenses may be deductible, reducing the taxable portion of your royalties.
Rental Income Beyond Residential Properties
Rental income isn’t limited to residential properties. Leasing commercial spaces, equipment, or even intellectual property like patents can all generate rental income. For example, if you own a piece of machinery that another business needs, leasing it out could bring in additional revenue.
The tax treatment is similar to that of residential rentals, but with unique opportunities. For instance, if you own a coworking space, you can claim deductions for utilities, furnishings, and even marketing costs associated with renting out desks.
Depreciation on commercial real estate is also more advantageous due to shorter recovery periods for specific improvements. Naturally, it also comes with its own set of risks and challenges, but may have a very specific place in your portfolio.
A Unified Tax Strategy
Each type of income – ordinary, passive, and non-passive – has unique tax implications, but they don’t exist in isolation. Entrepreneurs who understand the distinctions and apply strategic tax planning can significantly reduce their tax burden and redirect those savings toward building their businesses.
Whether it’s structuring your entities to maximize deductions, leveraging depreciation on passive assets, or strategically timing distributions from non-passive income, the opportunities are endless with the right strategy.
Welcome to the New Age of Accounting. Let’s begin.
