Passive income is
unearned income
Unearned income is a term coined by Henry George to refer to income gained through ownership of land and other monopoly. Today the term often refers to income received by virtue of owning property (known as property income), inheritance, pensions ...
that is acquired automatically with minimal labor to earn or maintain. It is often combined with another source of income, such as a
side job
A side job, also informally called a side hustle or side gig, is an additional job that a person takes in addition to their primary job in order to supplement their income. Side jobs may be done out of necessity, when one's income from their mai ...
. In the United States, the
IRS
The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory tax ...
divides income into three categories: active income, passive income, and portfolio income. Passive income, as an acquired income, is the result of
capital growth or is related to the
tax deduction
Tax deduction is a reduction of income that is able to be taxed and is commonly a result of expenses, particularly those incurred to produce additional income. Tax deductions are a form of tax incentives, along with exemptions and tax credits. T ...
mechanism, and is taxable.
It is called progressive passive income when the earner expends little effort to grow the income. Examples of passive income include
rental income and business activities in which the earner does not materially participate. Some jurisdictions' taxing authorities, such as the
Internal Revenue Service
The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory ta ...
in the
United States of America
The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territo ...
, distinguish passive income from other forms of income, such as earnings from regular or contractual employment, and may tax it differently.
It can take a long period of work and accumulation before passive income can be earned. Passive income can be a way of creating
financial independence
Financial independence is the status of having enough income or wealth sufficient to pay one's living expenses for the rest of one's life without having to be employed or dependent on others.Cummuta, John. The Myths & Realities of Achieving Fina ...
and early retirement, because the beneficiary will receive an income regardless of whether they are materially active in the activity creating the revenue.
Passive income is not always a
lump sum payment, like an inheritance or proceeds from the sale of an asset such as a home or stock.
It can also come from a source that has a likely continuity over time but is not guaranteed. Some passive incomes may last for several years, or even centuries across generations. Examples of these longer term sources of passive income can include: property; dividends; debt; and other appreciating asset classes.
Just because one person considers a source of income to be passive, does not mean it was the case in creation of the wealth/revenue/asset value increase.
[ Whilst to the end beneficiary the income may be passive, there can often be effort expended by others to generate value, such as renovations to modernize and enhance a building that increases rental income and/or creates an increase in the property's value. The degree of passivity of an income depends on the perspective of the person concerned. What one person sees as passive income may be the active income to another person.
Generally speaking, high-income groups have more diversified sources of revenue leading to a higher probability to have access to hidden income, and therefore passive income can also be a good excuse for ]tax avoidance
Tax avoidance is the legal usage of the tax regime in a single territory to one's own advantage to reduce the amount of tax that is payable by means that are within the law. A tax shelter is one type of tax avoidance, and tax havens are jurisdict ...
by transferring active income into the passive one. The loophole
A loophole is an ambiguity or inadequacy in a system, such as a law or security, which can be used to circumvent or otherwise avoid the purpose, implied or explicitly stated, of the system.
Originally, the word meant an arrowslit, a narrow verti ...
has resulted in a large amount of "passive income" such as income from property transfer and property leasing, and even "earned income" such as income from non-regularly occurring labor remuneration, which to a large extent has not been taxed to the fullest extent. As a result, there is voice from the public that personal tax has been degraded to a "wage tax" aimed at exploited middle income working class.
Types of income
As mentioned above, passive income is, in general, income that requires little to no work to produce and maintain. Active income is earned income
The United States federal earned income tax credit or earned income credit (EITC or EIC) is a refundable tax credit for low- to moderate-income working individuals and couples, particularly those with children. The amount of EITC benefit depends ...
including all taxable income and wages the earner receives for working. Active income includes wages, self-employment income, and material participation in an S corporation
An S corporation, for United States federal income tax, is a closely held corporation (or, in some cases, a limited liability company (LLC) or a partnership) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal ...
or partnership. In other words, active income refers to income earned by performing a service or some kind of work. Income from business is considered active in case that the owner satisfies the requirements for material participation (which is based on many factors, mainly on hours worked). Portfolio income is derived from investments such as dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-in ...
s, interest
In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...
, capital gain
Capital gain is an economic concept defined as the profit earned on the sale of an asset which has increased in value over the holding period. An asset may include tangible property, a car, a business, or intangible property such as shares.
...
s, and some royalties
A royalty payment is a payment made by one party to another that owns a particular asset, for the right to ongoing use of that asset. Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset o ...
.
Types of income are defined differently among the states and countries and can be taxed differently, depending on the law at the time. For example, portfolio income is often taxed at lower rates than active income in the USA.
Classification based on income source
According to the US tax code, it does not specifically define income, but lists the various income items. The basic concept of the US federal personal income tax is the gross income, which is defined by the IRS as all income from any source, except for those excluded by law. There are four types of income depending on the income source:
# income derived from labor, also known as active income, which is income derived from labor provided by an individual in return for remuneration, or income derived from the conduct of a business.[Zhao J. (2011). The two categories of income in the United States and their implications for China. Journal of Shanxi University: Philosophy and Social Sciences, 34(1), 127-130.] Common types of income from active working include: wages, salaries, tips, bonuses and commissions; income from an active activity in a trade or business; income from the provision of labor; and income from illegal activities.
# income from capital, also known as passive income, includes investments and the sale, trade or other disposal of invested assets.[ Common types of non-working income include: interest income; dividend income; income from leasing or royalty-related activities; annuity income; income from partnerships, S corporations etc.; and income from the sale of assets that can generate the five categories of income listed above.
# income constituted by a transfer from another person.][ Common types of income derived from transfers from others include: prizes and awards; unemployment compensation; social security benefits; and alimony received.
# presumptive income. Common presumptive income includes: loans at below-market interest rates; expenses borne by others; and low-cost purchases.][
The four categories of income are not designed to differentiate tax rate, but rather to introduce a credit for active work.
]
Classification based on the deficit of passive activities
In the US tax system, various types of income can be classified under the negative activity loss rules as follows:
* First, portfolio income. Portfolio income includes: unearned income from dividends, interest, royalties, annuities and other assets held as investments; income from the sale of assets that generate portfolio income.[
* Second, active income. Active income includes: wages and salaries; other income from transactions or operations in which the taxpayer is substantially involved.][
* Third, passive income. Passive income includes income from transactions or operations in which the taxpayer is not actively and fully involved, for example, ordinary rental income. However, the following rental activities are not considered negative activities: hotel rooms, hospital housing, car rentals, video rentals, clothing rentals, golf course fees, tool rentals, car dealerships renting cars, and cable TV rentals.][ In addition, income from limited partnerships is also considered negative income.
Investment portfolios and passive income are also covered by the personal income tax rules regarding the earned income tax credit.
]
United States
The United States Internal Revenue Service
The Internal Revenue Service (IRS) is the revenue service for the United States federal government, which is responsible for collecting U.S. federal taxes and administering the Internal Revenue Code, the main body of the federal statutory ta ...
categorizes income as active income, passive income, or portfolio income. It defines passive income as only coming from two sources, or "passive activities": rental activity or "trade or business activities in which you do not materially participate."["Publication 925 — Passive Activity and At-Risk Rules"](_blank)
Retrieved 2019-10-19. Other financial and government institutions also recognize it as an income obtained as a result of capital growth or in relation to negative gearing
Negative gearing is a form of financial leverage whereby an investor borrows money to acquire an income-producing investment and the gross income generated by the investment (at least in the short term) is less than the cost of owning and manag ...
. Passive income is usually taxable.
Passive activities
According to IRS, there are two kinds of passive activities.
* Rental activities, one may even materially participate in them unless he is a real estate professional.
* Trade or business activities in which one does not materially participate during the year.
Portfolio income (interest, dividends, royalties, gains on stocks and bonds) is considered passive income by some analysts. However, the IRS does not generally consider portfolio income as passive. Thus it would be wise to turn to a tax professional on that subject.
Also self-charged interest can be included in passive income "if the loan proceeds are used in a passive activity". Self-charged interest income usually refers to loans between you and a partnership or S corporation
An S corporation, for United States federal income tax, is a closely held corporation (or, in some cases, a limited liability company (LLC) or a partnership) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal ...
in which you had a direct or indirect ownership interest at any time during their tax year (this applies for both loans you made to the partnership or S corporation and loans that were made to you).
In some cases, royalties
A royalty payment is a payment made by one party to another that owns a particular asset, for the right to ongoing use of that asset. Royalties are typically agreed upon as a percentage of gross or net revenues derived from the use of an asset o ...
could be put in the category of passive income. Royalties are payments made by one company (the licensee) to another company or person (the licensor) for the right to use the latter's intellectual property
Intellectual property (IP) is a category of property that includes intangible creations of the human intellect. There are many types of intellectual property, and some countries recognize more than others. The best-known types are patents, cop ...
(book, music, video) or patent
A patent is a type of intellectual property that gives its owner the legal right to exclude others from making, using, or selling an invention for a limited period of time in exchange for publishing an enabling disclosure of the invention."A p ...
. However, the Internal Revenue Service only considers royalties passive income when they are "not derived in the ordinary course of a trade or business."
Silent partner
Passive income also includes earnings from other business in which a person is not actively involved. An example could be silent partner
A silent partner is one who shares in the profits and losses of a business, but is not involved in its management.
Silent partner or Silent Partners may also refer to:
Arts and entertainment
* ''Silent Partner'', a 2005 film starring Tara Reid ...
. A silent partner is an individual who does not have any role in company and whose participation in a partnership is limited to providing capital to the business (that is why they are sometimes called limited partners). A silent partner earns a passive income since he gets an agreed percentage of the gross profits on a regular basis.
Rental activities
In order to be considered a rental activity, tangible property is used by customers and the gross income from the activity represents amounts paid mainly for the use of the property. Activity isn’t a rental activity if any of the following apply:
* The average period of customer use is:
** 7 days or less
** 30 days or less and significant personal services were provided (cleaning of common areas or repairing property do not count as personal services)
* Extraordinary personal services are provided, i.e. they are performed by individuals and the customers' use of the property is incidental in terms of receiving the services
* The rental is incidental to a non-rental activity. In other words, if the main purpose of holding the property is to attain a gain from its appreciation (and also applies the condition that the gross rental income from the property is less than 2% of fair market value).
Trade or business activities
A trade or business activity is an activity that involves running a trade or business, is conducted in expectation of starting a trade or business or involves research or experimental expenditures.
Lottery
Winning a lottery can be viewed as a shock to household wealth or, equivalently, a permanent shock to unearned income. In the U.S., lottery winnings are considered ordinary taxable income in the year the payment is made. The vast majority of winnings are paid lump sum but there is a small fraction of winnings that are paid in installments over time. Currently, 45 U.S. states conduct some type of lottery tax rate from 10%~ 37% responsively. Any winning of at least $600 and at least 300 times the purchase price of a ticket triggers generation of Form W-2G. This form is provided to both the winner and to tax authorities, and is used for income tax filing.
Europe
It would be complicated to state one conclusion about the passive income and the taxation of this type of income in Europe. In fact, there is no word defined as "passive income" by the European Commission. In addition, the European Union
The European Union (EU) is a supranational political and economic union of member states that are located primarily in Europe. The union has a total area of and an estimated total population of about 447million. The EU has often been des ...
itself has no taxation powers. Every country levies different taxes on activities that are defined above as "passive".
The Organisation for Economic Co-operation and Development (OECD)
The Common Reporting Standard (CRS) does not define passive income as well. Each jurisdiction can define the items included in the list of passive income in its own way in accordance with domestic rules. However, the CRS provides a list of items that should generally be considered as passive income and should guide the countries.
Income should be characterized as passive if it contains the portion of gross income that consists of:
* dividends
* interest (or income equivalent to interest)
* rents and royalties (that are not made in the active conduct of a business )
* annuities; the excess of gains over losses from the sale or exchange of Financial Assets
* the excess of gains over losses from transactions in any Financial Assets
* the excess of foreign currency gains over foreign currency losses
* net income from swaps; a swap is a contract between two parties to exchange
Exchange may refer to:
Physics
*Gas exchange is the movement of oxygen and carbon dioxide molecules from a region of higher concentration to a region of lower concentration. Places United States
* Exchange, Indiana, an unincorporated community
* ...
cashflows or other financial instrument
Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...
s for a certain period.
China
China currently adopts a proportional tax rate of 20% for passive income and unearned income, which does not play the role of regulating the income distribution gap between active income and passive income as some expects argued.[Chen, Ling. (2009). The choice of taxation models for hard-working and non-hard-working income. Modern Business, (18), 84-84.] Specifically, the relative tax rates on these two incomes, with the former one being subject to a progressive marginal tax rate of up to 45% on larger amounts of income, while the later income, particularly capital gains, is only subject to a proportional tax rate of 20%, which is unfair on a horizontal basis and does not have the effect of regulating excessive income.
Sources
There are more types of passive income than is shown in this article. In any case, it is preferable to consult with financial advisor
A financial adviser or financial advisor is a professional who provides financial services to clients based on their financial situation. In many countries, financial advisors must complete specific training and be registered with a regulatory ...
first.
* Bank deposit
A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below.
...
It is one of the most popular and simplest ways to gain passive income. A person gives a certain amount of money to a bank and takes interest every month.
* Securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
The profit, created by security, is in general inversely proportional to the risk it holds.
* Bonds
Bonds are debt securities issued by the state or company for gaining investments. By purchasing a bond, a person is lending savings to the issuer for a specified period. In return, he receives income at the very end of the bond validity period, or he can also earn so-called coupon income.
* Dividend stocks
It is a reliable way to generate income passively. However, it is important to mention the research to find stocks with desirable risk/income ratio.
See also
* Cash flow
A cash flow is a real or virtual movement of money:
*a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...
* Capital gains
Capital gain is an economic concept defined as the profit earned on the sale of an asset which has increased in value over the holding period. An asset may include tangible property, a car, a business, or intangible property such as shares.
...
* Economic rent
In economics, economic rent is any payment (in the context of a market transaction) to the owner of a factor of production in excess of the cost needed to bring that factor into production. In classical economics, economic rent is any payment m ...
* Profit
Profit may refer to:
Business and law
* Profit (accounting), the difference between the purchase price and the costs of bringing to market
* Profit (economics), normal profit and economic profit
* Profit (real property), a nonpossessory intere ...
* Property income
Property income refers to profit or income received by virtue of owning property. The three forms of property income are rent, received from the ownership of natural resources; interest, received by virtue of owning financial assets; and profit, ...
* Rent seeking
Rent-seeking is the act of growing one's existing wealth without creating new wealth by manipulating the social or political environment.
Rent-seeking activities have negative effects on the rest of society. They result in reduced economic effic ...
* Surplus value
In Marxian economics, surplus value is the difference between the amount raised through a sale of a product and the amount it cost to the owner of that product to manufacture it: i.e. the amount raised through sale of the product minus the cost ...
* Unearned income
Unearned income is a term coined by Henry George to refer to income gained through ownership of land and other monopoly. Today the term often refers to income received by virtue of owning property (known as property income), inheritance, pensions ...
Notes
References
External links
{{wiktionary
Passive income
Investopedia
ASIC's MoneySmart website
Profit
Income