Active Income: Definition, Types & Active vs Passive Income Explained

Definition

Active income refers to earnings derived from direct business, trade, or employment participation.

Description

Active income requires active involvement or effort to generate, including wages, salaries, bonuses, and income from self-employment or business activities in which an individual is directly engaged. 

Active income contrasts with passive income, where earnings, such as dividends, rental income, or interest from investments, are generated with minimal effort. Active income is typically subject to regular income taxes and often requires ongoing work or effort.

Importance to know Active Income
 

This is why the active income is important for startups or businesses:

Understanding the importance of active income is crucial for businesses to manage their financial well-being and make informed decisions. Here are some key pointers highlighting the significance of knowing about active income:

Financial Planning:

• Awareness of active income is fundamental for effective financial planning.
• Helps individuals budget, set financial goals, and make informed spending, saving, and investing decisions.

Income Source:

• Active income is the primary source of livelihood for many individuals.
• Knowledge of this income type allows people to assess their earning capacity and make career or business decisions accordingly.

Tax Implications:

• Active income is typically subject to income taxes.
• Understanding tax obligations related to active income helps comply and plan for tax liabilities.

Budgeting and Spending:

• Active income is the foundation for creating realistic budgets.
• Knowing the amount of income allows individuals to allocate funds for essential expenses, discretionary spending, and savings.

Debt Management:

• Active income is essential for managing and repaying debts.
• Knowledge of income levels helps individuals plan debt payments and avoid overextending financially.

Investment Strategies:

• Active income can be used to fund investments and savings.
• Understanding one's active income enables individuals to develop suitable investment strategies based on their financial capacity.

How to compute active income for businesses?

These are the steps involved to compute active income for business:

Step 1: Calculate Gross Revenue:

Add up all sources of revenue generated by the business. This includes sales of goods or services and any other income streams.

Step 2: Deduct Cost of Goods Sold (COGS):

Subtract the cost of goods sold from the gross revenue. COGS includes direct costs associated with producing goods or services.

Step 3: Compute Gross Profit:

The result after deducting COGS is the gross profit. This represents the income remaining after covering the direct costs of production.

Step 4: Deduct Operating Expenses:

Subtract operating expenses from the gross profit. Operating expenses include rent, utilities, salaries, and other costs necessary for day-to-day operations.

Step 5: Calculate Operating Income:

The result after deducting operating expenses is the operating income. This reflects the profit generated from core business operations.

Step 6: Deduct Interest and Taxes:

Subtract interest expenses and taxes from the operating income. This provides a clearer picture of the business's profitability after considering financial obligations.

Step 7: Compute Net Income:

The final step is to deduct any remaining non-operating expenses or gains to arrive at the net income. Net income is the overall profit or loss after all expenses have been accounted for.

Understanding Active Income and Passive Income for startups
 

Example of Active income

Consider a software development startup that specialises in creating custom applications for clients. The startup appointed someone to develop a mobile app for a local business. The client agrees to pay the startup $10,000 upon completing the project.

• Active Income Example for the Startup:
  • Source: Custom software development services.
  • Earning Method: The startup actively engages in the development process, utilising its expertise and manpower to create the mobile app.
  • Payment: The $10,000 payment from the client constitutes active income for the startup.

In this case, the startup's active income is derived from the direct provision of services, showcasing how their efforts lead to revenue generation.
 

FAQ

What is the main difference between active income and passive income?

Active income is earned through direct participation and effort, such as working or providing services. In contrast, passive income is generated with minimal active involvement, often through investments or recurring revenue streams.

Can a source of income be both active and passive?

Yes, some income sources may have active and passive income elements. For example, a business owner actively manages their company (active income) but may also earn passive income through investments or royalties from intellectual property.

How does tax treatment differ for active income vs. passive income?

Taxation varies between active and passive income. Generally, active income is taxed at regular income tax rates, whereas passive income might enjoy more favourable tax treatment, such as lower rates applicable to capital gains. It's essential to grasp these distinctions to engage in effective tax planning.