Running a marketing agency isn’t just about creative ideas and big strategies. It’s also about understanding the roles people play, and how those roles can impact your finances and taxes.
One important distinction is between active and passive partners.
Ever wondered how being an active partner versus a passive one affects your money? Let’s dive into what these roles mean and how they can influence your financial situation in easy-to-understand terms.
Starting with the active partner…
What is an Active Partner in an Agency?
An “active partner” is someone deeply involved in the agency’s daily operations. They help run the business, make decisions, and handle management tasks. Essentially, they are hands-on with the day-to-day activities.
To qualify as an active partner for tax purposes, you need to meet criteria in three areas: material participation, management activity, and compensation.
Material Participation: To be considered an active partner, you need to answer “yes” to at least one of these questions:
- Are you spending more than 500 hours a year working on the business?
- Are you the primary person involved in the business activities?
- Are you participating more than 100 hours a year, and no one else participates more than you?
Management Activities: Active partners take part in crucial management decisions, hiring staff, and strategic planning.
Compensation: They often receive guaranteed payments for their services, which are subject to self-employment tax.
What is a Passive Partner in an Agency?
On the other hand, a passive partner has limited involvement in the agency’s operations. They might invest money in the business but don’t engage in its day-to-day activities.
Limited Involvement: A passive partner does not meet the material participation criteria. They might provide financial support but are not actively managing the business.
Investment Only: These partners typically invest capital into the agency without participating in its operations. This role is more about investing rather than managing.
Limited Partners: In many cases, limited partners in a partnership are considered passive unless they are involved in management activities.
What are the Tax Implications of Active vs. Passive Partners?
It’s important to know if you’re an active or passive partner because this distinction has significant tax consequences.
For Active Partners:
- Self-Employment Tax: Income from active participation is subject to self-employment tax, which includes Social Security and Medicare taxes. This means you’ll be paying a higher percentage of your income towards these taxes compared to passive partners. However, this also qualifies you for certain benefits, such as Social Security credits.
- Offsetting Losses: Active partners have the advantage of being able to offset their business losses against other income. This provides more flexibility in managing your taxes. For instance, if your agency incurs a loss, you can use that loss to reduce your taxable income from other sources, such as another business or a salary.
- Deductions: Active partners can benefit from various deductions that reduce their taxable income. These include:
- Contributions to Retirement Plans: You can deduct contributions made to retirement plans like SEP IRAs or solo 401(k)s.
- Health Insurance Premiums: If you pay for your own health insurance, you can deduct the premiums from your taxable income.
- Business Expenses: Ordinary and necessary business expenses, such as office supplies, marketing costs, and travel expenses, can also be deducted.
For Passive Partners:
- No Self-Employment Tax: Passive income is generally not subject to self-employment tax. This can result in a lower tax burden compared to active partners. However, this also means you don’t accrue benefits such as Social Security credits from this income.
- Limited Loss Offset: Passive losses can usually only offset passive income. If there’s no other passive income, these losses can be carried forward to future years. For example, if you have a loss from your passive investment in the agency but no other passive income, you cannot use that loss to offset your salary or other active income. Instead, the loss is carried forward to offset future passive income.
- Higher Tax Payments: Without the benefits of self-employment tax deductions and other active partner benefits, passive partners might face higher tax payments. This means they could end up paying more in taxes relative to their share of income from the agency.
What About Implications When Selling The Business?
When it comes time to sell your business, the way you’re classified—whether as an active or passive partner—can also significantly impact the amount of tax you pay on the sale.
Active Partners: If you’re an active partner, your deep involvement in the business’s day-to-day operations can work in your favor when it’s time to sell.
- Avoiding the 3.8% Net Investment Income Tax (NIIT): Active partners may avoid this extra tax. How? By proving they’ve been materially participating in the business, which generally means putting in more than 500 hours a year. So, if you’ve been hands-on, you could save big.
- Lower Tax Burden: Skipping the NIIT means more money stays in your pocket after the sale. This lower tax burden can significantly boost your net proceeds.
Passive Partners: On the flip side, passive partners, who have limited involvement in the daily operations, face different tax rules.
- 3.8% Net Investment Income Tax (NIIT): Passive partners are usually hit with this tax when they sell their shares. Since their income from the sale is considered investment income, not active income, the NIIT applies.
- Higher Tax Burden: This means a chunk of your sale proceeds goes to paying this additional tax, leaving you with less net profit compared to an active partner.
Example Scenario:
Imagine you and a partner own a marketing agency. You’re the one actively running the business, involved in every decision and operation, making you an active partner. Your partner, however, only invested money and doesn’t participate in the daily grind, making them a passive partner.
When it’s time to sell:
- You, the active partner, can avoid the 3.8% NIIT, reducing your tax bill and increasing your net proceeds.
- Your passive partner will have to pay the NIIT, resulting in a higher tax bill and a smaller net profit from the sale.
Need extra help determining the tax implications of active vs. passive partners in agencies?
Knowing whether you’re an active or passive partner isn’t just about day-to-day responsibilities; it’s also about maximizing your financial benefits when it comes time to sell your business.
Active partners can enjoy a lighter tax load, while passive partners might face higher taxes.
Understanding these roles and their tax implications helps you plan smarter for the future and make the most of your hard-earned business success.
If you need help with understanding the tax implications of being an active or passive partner, Agency CPAs are always here to help. We make sure our clients are structured for success and ensure you’re paying as little tax as legally possible to Uncle Sam.
If you’re looking for an experienced agency accounting team to help, you can reach out to us anytime. Simply head over to our Let’s Chat page to schedule your first introductory call.
Until next time!
