When you drive down the main road in your town and see a building site with a sign that has a company name ending in LP, that’s typically a signal that the construction or development project is managed by a limited partnership. Such an investment vehicle is one example of a passive income generator.
This article explains the difference between passive vs. active income, the types of businesses typically associated with each, and the level of involvement for investors or owners.
What is passive income?
Passive income is earned from business initiatives where you invest capital and you aren’t directly involved in daily operations. Any proceeds you get from an investment where you have an interest in an asset are considered passive income. The work continues to generate income for you without continued effort on your part.
Limited partnerships
Passive income arises from business arrangements known as limited partnerships. From the perspective of the Internal Revenue Service, these entities are often used to fund real estate projects, as well as oil and gas exploration–typically initiatives that require large amounts of capital. Not only do wealthy people invest in such partnerships, but also foundations, pension funds, and mutual funds.
The LP comprises a single partnership or several partnerships, depending on the size of the project and the amount of capital required to implement it. Investing partners are motivated by the passive income they will receive with relatively limited involvement in the project, and then sometimes, more importantly, the considerable tax breaks they will see as a result.
Limited partners also have more limited liability with regard to the project, which means that they are not responsible for any business debts in excess of the amount they originally invested. These partners earn passive income that arises from their initial investment, but they are not considered managers. If they later decide to become more involved and shift their role to general partner, then their personal liability will increase and their tax benefits will change.
Tax breaks
Using the oil and gas example of passive income generation, the federal government provides tax breaks to encourage exploration and new sources of national energy. From the standpoint of the project itself, limited partnerships are a particularly effective format to raise capital from a number of investors.
Limited partnership investors can take major tax deductions due to their involvement. Each situation is different, so potential limited partners should consult with their tax professional to determine their unique tax profile.
Real estate and other limited partnerships may receive local and state tax breaks, which is also very attractive for passive investors. Investment in real estate property that will ultimately produce rental units is a common example of passive income with state or local tax benefits.
Limited partnerships are pass-through entities, and partners don’t have to pay self-employment taxes. The Internal Revenue Service considers earnings passive income when a taxpayer “does not materially participate on a regular, continuous, and substantial basis.” Capital gains, dividends, and interest earned are not considered passive income.
Active income
Active income is earned from employment, such as a full-time W2 job, or W9 contract work, such as fixing someone’s house or working as a consultant. It’s also earned from running your own business, where you actively work on the operational side and play a direct role in business strategy, product ordering, hiring employees, marketing, and more.
In short, active income is earned in exchange for a good or service. It includes wages, salaries, commissions, and tips. Whether you’re working an hourly job or a position with a yearly salary or working a freelance gig, you’re earning active income from your efforts.
Active income work provides an opportunity for consistent earnings that can start quickly, whereas passive income may take some time to ramp up, such as when a real estate investor contributes capital and doesn’t see returns until a year or two when the project is complete and operational.
For tax purposes, income is considered active or “nonpassive” when the taxpayer does one of the following: works 500 or more hours in the business during the year, is an active participant in the majority of the business or works more than 100 hours in the business during the year and not less than any other employee.
Active and passive income-generating projects are quite different from a tax and participation standpoint. Active income derives from employment and passive income from investment and capital-raising activities. As a business owner, it’s important for you to understand the difference between the two.
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