What is Passive Income?
The IRS categorizes three types of incomes, those of which are active income, passive income, and portfolio income. Passive income is earnings derived from a rental property, business or other enterprises in which an individual is not actively involved and where money is being earned regularly with little to no efforts by the receiving individual. Passive income is premised upon there being no material participation in the business activity. For example, if an individual or an entity decides to invest $100,000 in a restaurant with a contractual agreement that they will receive a percentage of the restaurants’ earnings, that income will be considered passive because the investor is not actively participating with the operations or management of the restaurant itself. They are merely just earning income based on that investment.
What is Self-Employment Tax?
For tax purposes, self-employed taxes are designed to help ensure that individuals who are considered self-employed pay the required Social Security and Medicaid taxes, that would otherwise be withheld by their employer if they were classified as employees. An individual is considered self-employed if they conduct a trade or business as a LLC, sole proprietor or a partnership.
Members of a LLC have the right to actively engage in their business or sit back and allow other members to manage and control day to day operations. Those members conducting no material participation are excluded for self-employment tax purposes. LLC members who are active in the management or substantial performance related to the LLC’s business are usually subject to self-employment tax. Limited partnerships, however, which are always limited in both their ability to manage the partnership and liability for the partnership’s debts, are not subject to self-employment taxes because their distributive shares of income are not acquired through active participation of the business.
Thus, the IRS considers a LLC member’s distributive share exempt from self-employment tax unless the individual is personally liable for the LLC’s debts, has authority to contract for the LLC, or participates in the LLC’s business for more than 500 hours per year. If the LLC member does not partake in any of those activities, their income is considered passive, and therefore, not subject to self-employment tax.