Bookkeeping 101: Active and Passive Income

As you grow your business, you will find many available sources of income. You can generate direct sales from customers, or you can earn income from investments and appreciating assets. 

At the macro-level, you need to know about 2 types of income: active and passive. You need to be good at generating one of these income types to run a successful business, but many companies use both.

Understanding Active Income

Active income refers to money earned from performing a service or selling a good. The IRS includes other factors that contribute to the definition (like the number of hours worked), but the main definition refers to profits generated from goods or services. 

Active income is considered a low-risk form of profit earning. The income is predictable, so business owners can set monthly budgets and goals. However, active income is limited. Your business can only sell a certain number of items each month or spend a set number of hours working. 

A hair salon owner provides a strong example of active income. This professional earns active income from each client she meets with in exchange for cutting and dying hair but is limited by the number of clients he or she can see in a day (there are only so many working hours every day). He or she might also sell shampoo and other conditioning products in the store as additional active income, but that’s also limited by the number of products available.

These limits don’t mean the salon owner doesn’t earn a good living. Many people earn money with just active income and live comfortably. However, passive income provides alternative options to grow your profits alongside your active services. 

Understanding Passive Income

Passive income refers to earnings that come from an enterprise where a person is not actively involved. The IRS defines involvement by the number of hours a taxpayer puts into the business during the year and whether or not they do the majority of the work in the business.

Examples of passive income include real estate investments and limited partnerships where you serve more as a figurehead or investor instead of a day-to-day employee. In these cases, the work you do within the investment or company is greatly reduced, but you still get part of the profits.  

Portfolio income is also considered a form of passive income. Investments in the stock market and dividends or interest from other ventures are listed as passive income. However, some aspects of your portfolio might not be considered passive and would be taxed differently, which is why a tax professional can help sort out the difference. 

One of the main benefits of passive income is that there are fewer restrictions. You can get involved in multiple companies as an investor if you have the capital. You can also invest more in stocks and real estate if you so choose. However, passive income is considered riskier. If the market turns or the company you invest in flounders, you won’t get the payout you expect. 

The Colloquial Use of Passive Income

Over the past few years, the concept of passive income has become popular across the web as a way to promote online businesses that help you make money without actively selling to individuals or putting in a 40-hour workweek. 

For example, a blogger could earn “passive income” in the form of advertising revenue, commission from affiliate links, and paid downloads of webinars and tutorials. The colloquialism is used because the blogger earns money as people visit their website and click around, rather than producing and selling goods to customers. 

The blogger earns money even when they are not working. The IRS might not consider these channels passive income, especially if they are your main source of revenue, so talk to a tax professional about these income sources when you file.  

In many ways, these ventures have expanded our idea of passive income, and some of these options may work for you. However, other passive income businesses aren’t as lucrative as they seem. As you look to expand your income offerings, be wary of companies that promise large sums of money for very little work. Along with any investment, do your research on the risks involved and the realities of those who try to become rich from them. 

Manage Your Income Sources Effectively

As you grow your business, you might develop multiple sources of active and passive income. The salon owner mentioned earlier will actively cut hair but may also rent out other chairs in the salon to additional stylists. This diversification means he or she earns both active and passive income each month. 

Whatever your source of income, make sure you keep accurate books and organize your finances. Use a tool like Lendio’s software, which can track your invoices, export lists of expenses, and generally provide a clear picture of your business. We are here to support you and provide insight into your operations.