Active investment income refers to earnings that are effectively connected with a trade or business in the U.S.
As discussed earlier, many types of income, such as dividends and capital gains, are typically classified as passive investment income. However, the IRS provides exceptions that can cause certain passive investment income to be treated as active investment income.
To determine whether passive investment income should be reclassified as active investment income, the IRS applies specific tests. One of these tests is known as the business activities test. According to this test, income typically considered passive can be reclassified as active if it is generated through the active conduct of a trade or business in the United States.
The following are some examples of active investment income:
Note: Activities related solely to managing investment portfolios are not considered part of a U.S. trade or business unless portfolio management is the principal business activity of the taxpayer.
Active Investment Income is generally taxed as effectively connected income, subject to graduated tax rates. However, the rate may be reduced if a tax treaty between the U.S. and the individual’s home country applies.
Please note that there is a difference between active income and active investment income, which we will discuss in the following paragraph.
Active income is generally different from active investment income. Active income generally refers to income that is effectively connected with a U.S. trade or business. This may include earnings from operating a business or providing services in the United States.
On the other hand, Active investment income is a narrower subset of active income. It begins as passive investment income, like dividends, interest, or royalties, but is reclassified as active when it meets specific IRS tests. These tests classify an investment income as active if it was generated through the active conduct of a U.S. trade or business.
Importantly, active investment income does not include all types of active income. For example, service income earned from performing services in the United States is active income but not active investment income. Such income is generally not classified as investment income and therefore does not fall under the active investment income category.
Now, let’s explore the tax treatment of active income and active investment income in the United States in the following section.
The U.S. tax treatment of active income and active investment is quite similar. Since both types of income are generated through active conduct of a U.S. trade or business, they are taxed as effectively connected income. Therefore, they are generally subject to graduated tax rates.
However, the rate may be reduced if a tax treaty between the U.S. and the individual’s home country applies.
For more information about active income and its U.S. tax impact, please refer to the following article.