Passive Activity (Taxation) - Explained
What is a Passive Activity?
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Table of ContentsWhat is a Passive Activity?How does a Passive Activity Work? Passive activity and high net worth individualsAcademic Research on Passive Activity
What is a Passive Activity?
Passive activity refers to the activity where a taxpayer doesn't take part materially in the tax year. According to the Internal Revenue Service, passive activity is of two types. The first one includes commercial or business activity to which there were no contributions made by the taxpayer, and the second one includes rental activities that offer different forms of passive income until the taxpayer works in the real estate industry. As per the IRS, material participation refers to the participation in the business activity in a continuous and consistent manner. Rules for passive activity are applicable on individuals, trusts, estates, private service organizations, and closely held institutions.
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How does a Passive Activity Work?
It is important to differentiate between passive and active income for a lot of reasons. It is possible for a taxpayer to claim passive losses against sources of income obtained from passive activities. Though it is not possible to claim passive loss against active income. This correlates with the rules of passive activity loss established by the IRS. While activity income is earned when a specific service is performed. Active income can include commission, tips, wages, salaries, and income received from business operations in which the taxpayer takes part in an active and substantial manner. For instance, a taxpayer who owns a company, sells products and services, offers employment, and finances its operations tends to be a substantial player in active activity. If passive activity loss goes beyond a specific limit, then the taxpayer can carry forward it to prospective years. However, he or she can carry back this loss.
Passive activity and high net worth individuals
There are several high net worth individuals who use passive activity as a tax strategy for getting tax exemptions. A person is said to be a high net worth individual refers to a person or family having a net worth of more than $1 million as liquid asset. Though this amount can vary as per the location and financial institution. Individuals who have assets of $30 million fall in ultra high net worth individuals. Besides getting benefit from tax strategies, high net worth individuals are eligible for added preferential treatment in terms of investment. Usually, the average individual lacks adequate wealth for justifying time, expense of employing a tax professional, and formulating strategies for meeting passive and active income levels. They involve provision of different investment and probable involvement in initial public offering (IPO) through an intermediary. Personal wealth managers offer premium services to high net worth individuals, and help them in making decisions in areas of estate planning, tax planning, investment management, and a lot more. As per the Capegemini World Wealth Report published in the year 2017, the number of high net worth individuals increased by 7.5% on an international basis, making it to 16.5 million with the most number of such individuals in Asia. See also, passive activity loss rule.
Academic Research on Passive Activity