Whether the IRS treats you as an active or passive partner changes how your share of partnership income gets taxed. The answer comes down to material participation, and the IRS uses seven tests to decide it. Meet one or more and you're an active partner. Meet none and you're passive.
The tests mostly weigh how much time you put in and what kind of work you do. The best known is the 500-hour test, and there are others, including one that looks at five of the last ten tax years and a facts-and-circumstances catch-all. The Fusion CPA blog gives a simple example: two partners buy a rental portfolio with equal capital. One handles leasing, maintenance and tenant screening. The other reviews the financials each quarter. The first is active and the second is passive.
Active income is generally subject to self-employment tax, but it can qualify for a wider range of deductions, including the QBI deduction. Passive income avoids self-employment tax, though it can pick up the 3.8% Net Investment Income Tax above certain income levels. Passive losses can only offset passive income, and any excess carries forward to the next year.
Because the classification affects every partner's return, it should be spelled out in the partnership agreement.
The full article walks through all seven tests, a side-by-side comparison of active and passive treatment, and a worked example of what the 3.8% tax actually costs. Read the full article on the Fusion CPA blog