The new tax law (OK, it’s not so new) has changed the landscape when it comes to choosing corporate structures. Sure, pass-throughs get a 20% income eraser (as long as one’s income doesn’t exceed about $165K), but the corporate tax rate is also cut to shreds. (Remember: It’s only the small companies that pay the maximum rate of 21%- the behemoths hire great consultants to avoid taxes – many completely- between special deductions and overseas shenanigans.  That’s why 350 or so of the Fortune 500 paid 11%, the rest paid close to zero last year.)

But, that choice also depends whether one’s income is “active” or “passive”. The IRS considers passive income entities- typically derived from property and/or equipment rental, as well as from royalties (like mineral rights or patent rights for a product you are not producing)- to have no taxpayers “materially” participating on “a regular, continuous, or substantial basis”. (This means limited partners, who rarely if ever participate in day-to-day operations, are also considered to be involved in passive income.)

Just so you know, capital gains, stock and bond sales, interest, and dividends are specifically NOT consider passive income by the IRS. Neither are sales of undeveloped land or other investment property. Of course, salaries and wages (for which you receive a W-2) are non-passive. But, so it’s 1099 commission income, guaranteed payments (typically from partnerships), and sole proprietorships or farmers that all are defined as non-passive income activities. If the taxpayer materially participates in a partnership, an S Corporation, or limited liability company, the income so derived is also non-passive. And, as a great provision for me, when I am actively involved in managing a trust, that income is non-passive.

Active income is not really defined- since the IRS considers it “nonpassive income”. But, these involve activities where we taxpayers actively participate; we are selling a product or we a producing a service.

But, here’s where it gets interesting. (If you are our clients, you know many of these provisos- since we force you to log certain items.) If you work 500 or more hours in the business over the course of the year, you are well on your way to having that business be considered active. (OK, non-passive.) If the taxpayer does the majority of the work for the business or s/he works more than 100 hours in the venture during the year and no other soul works as long as s/he does, then the business is also considered to be non-passive.

Why do you care? Obviously passive income is passed through to the stockholder, shareholder, or proprietor. But, one must keep passive income and passive losses separate from active income and active losses. And, a passive loss can ONLY reduce taxability from passive income- and not active income sources.

(You do know that passive income is also not subject to employment taxes- Social Security and Medicare- right?)

Or, if the business was formed as a C (regular) corporation and then elected to convert to S (pass-through) status, there is a limit to how much passive income it can earn. (C corps retain their earnings and profits, which are not passed through to the stockholders. So, when that entity becomes an S, only there is a limitation that no more than 25% of its gross receipts can result from passive activities. Every dollar that exceeds the 25% level is taxed at the highest corporate rate. Exceed the threshold for three consecutive years and the entity loses its S status, reverting to a C Corporate structure.)

Oh, wait, there’s another wrinkle. A company can be deemed a personal holding company (PHC). There are two tests- an ownership test and an income test.

The ownership test? Five or fewer stockholders own more than half the stock.

The income test? 60% of the company’s income is derived from passive income sources.

These are two tests you WANT to flunk. Because if you pass them, there is a special PHC tax, 20% of all undistributed passive income. (If you render dividends of the passive income to shareholders, this penalty is moot.)

There are some statutory exemptions that won’t let you be termed a PHC. They are: if one is a tax-exempt venture, bank, domestic building and loan association, life insurer, surety company, business investment firm operating according to the rules of the Small Business Investment Act of 1958, corporation in Title 11 bankruptcy, plus some specific lending/finance companies and a few foreign company entities.