Three Types of Income
By Jason Watson (Google+)
Posted August 18, 2015
Let’s back up a bit. Our book loves to spill the beans so-to-speak with the net-net fun facts, and
then dig a hole under the house for the foundation. Wow. All kinds of metaphors. There are three
types of income- earned, portfolio and passive. There is also a small subset of passive income
called non-passive income.
Earned Income
Earned income is income that is a direct result of your labor. This income is usually in the form
of W-2 wages or as small business income reported on Schedule C of your personal tax return,
both subjected to Social Security and Medicare taxes (self-employment taxes).
Portfolio Income
Portfolio income is income generated from selling an asset, and if you sell that asset for a higher
price than what you paid for it originally, you will have a gain. Depending on the holding period
of the asset, and other factors, that gain might be taxed at ordinary income tax rates or capital
gains tax rates. Interest and dividends are other examples of portfolio income.
Capital gains is not a form of income per se. Capital gains simply defines how your portfolio
income will be taxed. Subtle difference.
Portfolio income is not subjected to self-employment taxes, but as illustrated earlier it might be
subjected to net investment income (NII) Medicare surtax.
Passive Income
Passive income bluntly is income that would continue to generate if you died. Morbid. How
about this? Passive income is income that would continue to generate if you decided to do
nothing and sunbathe on some beach. That sounds better. Passive income includes rental
income, royalties and income from businesses or investment partnerships where you do not
materially participate.
Passive income is also not subjected to self-employment taxes. But similar to portfolio income, it
might be subject to an additional Medicare surtax.
So, if you own a rental house, the income generated from the rental house is considered passive
income. And if you wrote a book and receive royalty checks, that income is also passive and not
subjected to self-employment taxes. But, if you write several books and consider yourself a
writer, then you are materially participating in your activity and your income is earned income.
And Yes, you would pay self-employment taxes on that income.
Non-Passive Income
But there is another funny thing. K-1 income generated from an S Corp where you materially
participate is considered non-passive income. It is not necessarily earned income and it is not
passive income. It is something in between, but definitely without the Social Security and
Medicare tax element.
As an aside, expatriates, or expats for short, can exclude up to $100,800 for 2015 of earned
income while working overseas. Many establish S corporations stateside for their contract gigboth the W-2 and K-1 income up to $100,800 are excluded from income tax.
So, while a K-1 in your name is generated from an S corporation since you are an investor, the
income type can vary depending on your material participation in the operation of the business.
Material participation makes your K-1 income non-passive income, otherwise it is passive
income. As mentioned earlier, this changes the color of money.
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Where is this all leading to? Good question.
More Net Investment Tax, Self-Rentals and S Corps
The net investment income tax was a topic that was briefly broached earlier. Generally speaking,
passive income such as rental income will be considered net investment income and subject to
the Medicare surtax. Why do you care?
It is common for a business owner who relies on machinery or equipment to have two business
entities. One entity is an LLC that owns the assets. The other entity is an S corporation which
leases the assets from the LLC to use in the business. This directly reduces the S Corp’s income,
and reduces the amount of salary required to be paid by the business to the shareholders. Good
news.
Here is an example.
Gross Income
Rental Expense
Net Income
Reasonable Salary
Payroll Taxes
S Corp Owns Building
LLC Owns Building
100,000
0
100,000
40,000
5,640
S Corp Rents from LLC
100,000
30,000
70,000
28,000
3,948
Savings
1,692
This is an overly simplified example and leaves out depreciation, etc., but you get the idea. And
as the owner of both the LLC and the S corporation, you take home the same cash plus the
savings. As mentioned in Chapter 1, the arrangement also allows you to have different partners
in each entity.
More good news. The LLC’s activities are considered self-rental activities meaning that you are
creating a transaction with yourself. Provided that this arrangement is at market rates, the IRS
accepts this relationship. Moreover, the rental income is not considered passive and therefore
not subjected to the net investment income tax calculations.
We know what you are thinking.. wait for it.. Yes, this changes the color of money.
Here is the code. Regulations Section 1.469-2 boringly read(f)(6) Property rented to a non-passive activity. An amount of the taxpayer's gross rental activity
income for the taxable year from an item of property equal to the net rental activity income for
the year from that item of property is treated as not from a passive activity if the property(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this
section) in which the taxpayer materially participates (within the meaning of Section 1.469-5T)
for the taxable year; and
(ii) Is not described in Section 1.469-2T(f)(5).
Read that first paragraph again. Only attorneys (including our friend Tony) and legislators (we
have no legislative friends) could have taken a simple concept and made it unnecessarily
complicated. Let’s summarize. If you have a self-rental situation with a business where you
materially participate, that income is not considered passive income.
Self-rental situations are not just limited to buildings. You could lease your car to your S
corporation. No, this isn’t the same as leasing a car from a dealership. This is where you own a
piece of equipment, let’s say an automobile, and you lease it back to your company for your
company’s use. Sounds exotic, but it is quite simple. More about this in Chapter 7 – Fringe
Benefits.
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This is about the equipment used in your trade or craft. Field engineers and landscapers are just
a few that come to mind who benefit from a self-rental situation.
Wait! There’s more. There’s always more.
Interest income generated from loans to the S corporation are also excluded from the net
investment income tax calculations to the extent of your allocable share of non-passive
deduction. Huh? Example time.
Jim Smith and Sharon Jones own JS Toys as 60-40 partners. Jim received $1,000 in interest
income from the business because he lent the company money. Jim owns 60% of the business.
Therefore, Jim can exclude $600 from his net investment income since that is his allocable share
of non-passive income. The remaining $400 would be subjected to the net investment income tax
calculation. Yes, we accountants love a stupidly convoluted tax code- keeps you confused or
bored, and keeps us employed.
Make sure this stuff is handled correctly. You might be paying a Medicare surtax gratuitously.
Income Types Recap
We talked about a lot of things regarding the type of income and how it is treated. Here is a brief
recapEarned income is subjected to self-employment taxes for self-employed, or payroll taxes
in the form of Social Security and Medicare taxes for the W-2 employee. Easy.
Portfolio income is generated by selling assets and is taxed at the capital gains rate or
ordinary income tax rate depending on how long you owned the asset. Interest and
dividends are also considered portfolio income. Also easy.
Rental income is considered passive income which is taxed at the ordinary income tax
rate only (as opposed to being taxed twice, once with self-employment taxes and again
with ordinary income taxes). Rental losses are considered passive losses.
Passive losses can only be deducted from passive income, generally. But there are
exceptions of course.
Passive losses may be deducted against other forms of income such as earned income,
portfolio income and non-passive income up to a $25,000 limit. This requires your
participation to be considered active, which is a much easier threshold than material
participation. Usually a 100 hours will do it.
The deduction of passive losses with active participation becomes limited when modified
adjusted gross incomes exceed $100,000 and are reduced to zero at $150,000. Those
disallowed losses are carried forward into the future to be used when incomes or
dispositions of assets allow.
Non-passive income cannot be offset or reduced by passive losses except the magical
$25,000 figure. So, if you have $100,000 in passive losses from your rental properties
and $100,000 in income generated from your self-rental to your business, your nonpassive income can only be reduced to $75,000.
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Tilt. This can be confusing. Please contact the Watson CPA Group for more assistance and
hopefully clarification.
Taxpayer's Comprehensive Guide to LLCs and S Corps
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Article ID: 263
Last updated: 18 Aug, 2015
Revision: 6
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