The line between whether we are working to live, or living to work gets blurred. Clarity comes in the form of passive income. By diverting earnings to profitable channels that don’t require much effort, you can sleep easy knowing your money is working for you.
In this article:
- What is passive income?
- Passive vs active business income
- What is a silent investor?
- How does a passive investor get paid
What Is Passive Income?
Earned income or active income is how people amass savings to plug into passive investments. So, passive income is earnings generated without active participation. It is generally seen as an asset investment, with regular returns, that pays out over time. A common misconception with passive income is that it always requires no involvement.
If you don’t find a way to make money while you sleep you will work until you die—Warren Buffet.
Beginner passive income has an initial time investment. Over time you ease your responsibilities, and as long as you don’t meet the definition of an active earner, it remains passive literally and economically. The official classification of income for tax purposes can be confusing so let’s go through the differences between passive vs active business income.
Passive vs Active Business Income
Let’s begin with tax rates…
Passive income is not subject to SE tax and has more favorable rates than active income. Where active income traditionally follows standard income tax rates, that is not always the case for passive income. The type of passive investment determines the tax rate.
For Example: working capital investment and capital gains on stock will be taxed differently however both qualify as passive income.
The drawback is, you are generally limited in how much you can deduct against passive income especially if there is a net loss.
Active business income is subject to 15.3% FICA taxes aka SE Tax. This tax contributes to Social Security and Medicare funds and is paid each year. For hourly wages this is a tax that is levied on workers and business owners, so each party pays 7.65%. Self-employed individuals are responsible for paying FICA taxes in their entirety.
Passive Income Examples
Portfolio income: interest, dividends, royalties, etc
Rent from real estate
Income from a working capital investment
Partners in a law practice earning wages for minimal services
Active Income Examples
Salary at a job
Earning commission and bonuses
A rental property manager/owner who shares a percentage of properties with a co-owner
Material Participation Test To Determine Passive vs Active Business Income
To determine whether you are earning passive vs active business income you use the material participation test. Income is considered active if you say yes to any of these conditions:
- Work more than 500 hours/year
- Work 100 hours/year and you participate as much as other owners
- Perform the majority of the work
- Materially participated for any 5 years of the last 10 years, it does not need to be consecutive
- Participated by performing personal service for any of the last 3 years, it does not need to be consecutive
- Involved in the operation on a regular and continual basis
- It is considered significant participation passive activity
Other than #7 any other level of participation in an organization does not qualify as active. Therefore on taxes, it will be classified as passive income.
What Is Significant Participation Passive Activity?
Certain passive activities can fall under the significant participation category. When this happens part of the income is recharacterized as non-passive. This happens when you participate for more than 100 hours during the tax year but it isn’t considered materially participation under normal test rules. Certain corporate owners are subject to this clause in passive vs active business income.
What Is Scalable Passive Income?
First, understand the difference between growth vs scaling. Growth means the linear increase of the total size of a business, where assets and liabilities grow in parallel. To scale a business there is an increase in returns without exhausting resources.
By that definition, scalable passive income is an investment tagged with the potential to make significant returns, without much input. Seed and angel investors tap into this frame of mind when entering new business ventures as silent partners or passive investors.
Scalable passive income toes a pricey tax line. If a person earns a considerable amount of income from investment activities, it is subject to an extra tax called net investment income tax (NIIT). This additional rate of 3.8% is applied to large investments, no matter if it is passive vs active business income.
What Is A Silent Investor?
Silent investors put their money into a business but are detached from day-to-day management. Depending on the business structure they are identified as:
- Silent Partner or Sleeping Partner – for partnerships or LLC partnerships
- Passive Member/Investor/Owner – for incorporated LLCs
Per an agreement, they have a limited role in companies but earn a share of the profits. They hold limited voting rights in corporations but are privy to internal finances. Any “work” performed concerning financial investment reviewal is not considered in material participation tests.
Pros And Cons Of Being A Silent Investor
Less time and energy expenditure while earning money
Low risk with limited liability structure
Risks with insolvency or dilution in certain business structures
Minimal control of the actions of the company
How Does A Silent Partner Get Paid
Payment structures for a sleeping partner depend on the terms of a business agreement. Generally, they are paid a percentage of profits according to their tax basis in the company. These are common arrangements for earnings and ROI for silent investors:
In LLC business structures, with partnership designations, profit distributions are the preferred compensation. A sleeping partner will percentage profits equal monthly, quarterly, or annually depending on the initial agreement.
Profit Interest Units (PIUs)
When companies are in the early stages of development, profit interest units (PIUs) could be on the table. These represent a vested interest in the company, where a return will come after a certain amount of time when the company becomes profitable.
Silent partners can negotiate guaranteed payments into a business agreement. This is re-compensation for capital interest in the business, made regardless of profitability, and can come in addition to profit distributions. They are net tax-free at distribution as long as they are not payments for work or services.
Doing Taxes As A Passive Investor
Passive investors are not treated the same as active owners. As long as there is minimal material participation, a silent investor redeems favorable tax treatment for their capital contribution in an organization. Since they are not considered an employee they are spared self-employment taxes and income received is taxed at ordinary income rates.
Passive investors must abide by certain tax rules when deducting passive losses. There will be times in business when you experience a loss in your investment. While you can deduct loss to offset your passive income, you are restricted in that you can’t make passive loss deductions to active income. Anything over your total passive earnings is considered a net passive loss that is disallowed and carried over to the following year.
In real estate, there is a special allowance rule for net passive losses. If a passive investor suffers a net loss from rental properties, the loss doesn’t have to be carried over. The special allowance permits a deduction of up to $25,000 against total income for the year.
Sleeping Partner In An LLC
A sleeping partner is usually considered a limited partner. If you are investing in an LLC that is designated as a partnership, you need to consult with a tax advisor about your membership. Penalties will be imposed if you misclassify yourself as a passive member when you are actually an active member.
Passive Investor In An S Corp
In business structures with an S Corporation election, a silent investor could pay corporate tax rates on distributions. If the S Corp is considered to have excess net passive income then earnings will not be considered passive income, even if the investor did not materially participate. See the rule below:
Excess Net Passive Income Rule
An S Corp is liable for tax on excess net passive income if its passive investment income is more than 25% of its gross receipts…the tax imposed is at the highest corporate rate —IRS
This event tends to play out for silent investors in C Corporations that recently made an S Corp election. Excess net passive income can be an issue if the C Corp had profitable holdings or passive investments. When filing taxes it is important to accurately account for income, otherwise, you and the organization could be fined
A Silent Investors Liability
Depending on the business structure a silent investor will have a small degree of liability in the company. If a company were to go bankrupt, the only money that a silent investor would be liable for is the percentage of their investment, their personal assets would not be seized, and any wrongdoing would fall to the active members of the organization.
For liability coverage, it is safe to shelter under a limited partnership (LP) or limited liability company (LLC). Corporations offer more protection from liability if a business fails, however, they have less favorable taxation laws for passive income.
Passive Income: Sleep On This
Making money work for you is the smartest way to increase your wealth. Passive income requires minimum effort with a nice return paving the way for a comfortable lifestyle. There are caveats to being a sleeping partner or passive investor, so discuss any new investments with a tax consultant.