Passive income is not necessarily money that is not worked for as the financial colloquialism would have it. The reason being the U.S. Internal Revenue Service's definition of passive income(1) is also used by accountants nation wide. For income to be passive by IRS standards it a) has involved significant material participation and b) is received from a business in which the recipient of said income was not directly involved via material participation.
• Formal definition of passive income
Definitive attributes of passive income are that it comes from 1) rental income and 2) business income as defined by the IRS. This definition of passive income is also shared by State Departments of Revenue and many accountants. Moreover, for tax purposes, what many believe to be passive income is not. For example, royalties on literature, capital gains and dividends all seem like passive income but fail the 'material participation test' (2) because of what they are not, rather than what they are. In other words, passive income must not be excluded from the eligible types of income to qualify.
• Passive income as financial colloquialism
The term passive income can also be defined as a financial colloquialism. In other words, just because the IRS defines passive income in one way doesn't mean this is the only meaning of the term. The IRS definition of passive income is designed to prevent tax fraud from phony deductible 'passive losses', and not because it seeks a monopoly on what passive income is.
To illustrate what the financially colloquial meaning of what passive income is, consider an affiliate marketing campaign where income is received from traffic volume. In such cases, that income may be referred to as 'passive' even though it is not passive income by more formal use of the term. So, just as many everyday English words have dual meaning, and so too can financial terms. Thus, understanding what passive income is can be thought of in multiple contexts.
• Passive income and residual income
Passive income may also be confused or interchanged with residual income. Residual income, like passive income, has multiple meanings. For example, in the mortgage industry, residual income is money left over after having paid off debt.(2) However, in accounting, Residual Income (RI) is something entirely different; specifically income after the subtraction of Return on Assets (ROA) as a percentage of total operating assets.(4) Furthermore, in business marketing, residual income may be thought of as meaning the same thing as the colloquial financial version of passive income
Summary
Passive income has a strict definition from a business and tax-planning standpoint, and this is the definition of passive income that should be understood. However, in understanding what passive income is, it is also useful to realize it is used to describe income that is not worked for in a current time period such as "income earned while sleeping". Even though work may have been done during the day, the income may not be earned until night time hence the affiliation with the word 'passive' and 'residual'.
• Formal definition of passive income
Definitive attributes of passive income are that it comes from 1) rental income and 2) business income as defined by the IRS. This definition of passive income is also shared by State Departments of Revenue and many accountants. Moreover, for tax purposes, what many believe to be passive income is not. For example, royalties on literature, capital gains and dividends all seem like passive income but fail the 'material participation test' (2) because of what they are not, rather than what they are. In other words, passive income must not be excluded from the eligible types of income to qualify.
• Passive income as financial colloquialism
The term passive income can also be defined as a financial colloquialism. In other words, just because the IRS defines passive income in one way doesn't mean this is the only meaning of the term. The IRS definition of passive income is designed to prevent tax fraud from phony deductible 'passive losses', and not because it seeks a monopoly on what passive income is.
To illustrate what the financially colloquial meaning of what passive income is, consider an affiliate marketing campaign where income is received from traffic volume. In such cases, that income may be referred to as 'passive' even though it is not passive income by more formal use of the term. So, just as many everyday English words have dual meaning, and so too can financial terms. Thus, understanding what passive income is can be thought of in multiple contexts.
• Passive income and residual income
Passive income may also be confused or interchanged with residual income. Residual income, like passive income, has multiple meanings. For example, in the mortgage industry, residual income is money left over after having paid off debt.(2) However, in accounting, Residual Income (RI) is something entirely different; specifically income after the subtraction of Return on Assets (ROA) as a percentage of total operating assets.(4) Furthermore, in business marketing, residual income may be thought of as meaning the same thing as the colloquial financial version of passive income
Summary
Passive income has a strict definition from a business and tax-planning standpoint, and this is the definition of passive income that should be understood. However, in understanding what passive income is, it is also useful to realize it is used to describe income that is not worked for in a current time period such as "income earned while sleeping". Even though work may have been done during the day, the income may not be earned until night time hence the affiliation with the word 'passive' and 'residual'.
1. http://bit.ly/9pA7ZY (Internal Revenue Service)
2. http://bit.ly/aqvVSM(Investopedia)
3. http://bit.ly/9y14wb (Money Central Glossary)
4. http://bit.ly/9L9zo2 (All Business Glossary)
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