Don’t Mix Passive and Active Income

Mixing active and passive income in one entity could be costing you thousands. Let's break down why separating your income streams is essential. You’ll learn how to structure your business the right way using S Corps, LLCs, holding companies, and even C Corps to unlock advanced tax strategies. From hiring your kids to slashing self-employment tax, this is the blueprint smart business owners use to keep more of what they earn.

One Entity Doesn't Mean Smart Structure

Running everything through one LLC is simple, but it’s not tax-saving smart.

The IRS treats active income and passive income differently. When you mix them, you limit your deductions and muddy your audit trail.

Active income: When you materially participate (run a business, coach, operate a side hustle)
Passive income: When you don’t materially participate (rental properties, syndications, LPs)

Separate Passive and Active Income Into Different Entities

Step 1: Create an S Corp Holding Company

Set up an LLC taxed as an S Corporation. This becomes your holding company for all active income.

• You only pay one salary (instead of one for every business)

• It helps reduce self-employment tax

• You can consolidate multiple income streams under one umbrella

Step 2: Run Active Businesses Under LLCs or DBAs

Each income stream like consulting, software, or training should be in a separate LLC or DBA owned by your S Corp.

This keeps things clean, protects you legally, and simplifies your taxes.

Step 3: Keep Passive Income in Separate LLCs

Rentals, real estate syndications, and silent partnerships should be in their own LLCs.

Never put passive income under your S Corp or mix it with your active operations.

Special Use Cases to Consider

Some situations call for exceptions to the standard S Corp structure.

👨‍👧 Hiring Your Kids? Use a Sole Proprietorship

If you pay your kids through a sole proprietorship, you do not owe FICA taxes on their wages (as long as they’re under 18).
This gives you a full deduction without payroll tax liability.

That strategy doesn’t work the same way under an S Corp.
Many business owners operate a small side gig as a sole proprietorship just for this purpose.

🏥 Need Fringe Benefits or Want to Keep Profits in the Business? Use a C Corp

C Corps are taxed at a flat 21 percent and are ideal if:

• You don’t need all your profits right away

• You want to deduct healthcare or fringe benefits

• You’re planning to leave cash in the business long term

There is double taxation, but with the right planning, a C Corp can unlock benefits an S Corp cannot.

How to Decide What You Need

Before you set up or fix your structure, ask these four questions:

1. Is the income active or passive?
   This determines the structure you need.

2. Do I have partners or investors?
   If yes, use a separate LLC and have your S Corp hold your ownership share.

3. Does this income stream carry risk?
   If yes, set up a separate LLC for liability protection.

4. Does this need to be its own entity or just a DBA?
   If it’s low risk and 100 percent owned by you, a DBA might be enough.

Structure Creates Savings

Most business owners just set up one LLC and put everything into it. But the IRS doesn’t care how simple your setup is. They care how your income is classified.

When you structure correctly, you:

• Unlock more tax strategies

• Lower your self-employment tax

• Reduce audit risk

• Gain legal protection across business activities

Want to know how these new tax cuts apply to you personally? 

Book a free discovery call with our team and we’ll walk you through it.

👉 Book your call now 

🎙 ABOUT THE PODCAST
The Small Business Tax Savings Podcast is your go-to resource for cutting-edge tax strategies to help entrepreneurs legally slash their tax bills. Hosted by Mike Jesowshek, CPA, this show breaks down complex tax topics into clear, no-fluff insights so you can keep more of your hard-earned money.

**[00:00:00] Why Entity Structure Matters**

Transcript

Why Entity Structure Matters

[00:00:00] How you structure your business could be the reason you're overpaying taxes or worse missing out on massive tax saving opportunities. Today we're diving into a strategy that too many business owners overlook when and why you should separate your business activities into different entities. I'll show you why.

[00:00:16] Keeping your active and passive income under one. Could be limiting your deductions. I'll talk about how an S corp holding company can streamline your ownership across multiple businesses and even partnerships, and how tools like a family management company or even a standalone C corporation might be the key to hiring your kids or unlocking advanced tax strategies.

[00:00:36] This isn't just theory, it's the blueprint behind how savvy entrepreneurs build tax efficient empires. Alright, let's dive into it. Welcome to the Small Business Tax Savings Podcast, your ultimate guide to legally slashing your tax bill while building your wealth. Get ready to unlock the secrets of tax savings with your host Mike Che, [00:01:00] CPA.

[00:01:04] So the first thing I wanna talk about is why separation matters and kind of an introduction to this concept. And when we talk to small business owners and just general investors overall, we want, we always talk about this point of the importance of separating passive. Versus active income, we want to split your life into two pieces.

[00:01:23] So we want to have an active piece of your life there. These are activities that you're active in, and then we want to have a passive piece of your life, and these are activities that you are passive in. So let's look at kind the difference between these. First off, active. Active is basically what you do to earn your day-to-day income.

[00:01:40] So think of a business that you operate, or even W2 income that's considered active income. So active income. Is the stuff that you do on a day-to-day basis, that's kind of the main revenue generator that you're active. You're, you're doing a lot in the day-to-day operations of passive's kind. The other side, passive, you're not too active in, think of rental [00:02:00] real estate or maybe a limited partnership or some type of investment fund, or maybe even a business that you own, but you don't materially participate in.

[00:02:08] So the key here is that we want to always keep active activities. Separate from passive activities, we wouldn't want to mix rental real estate in with a business that we fully operate. We want to keep those separate. So lemme go through an example. I wanna use an example of a business coach. So imagine we're business Coach Bob or business Coach Mary here, and they have all these kind of different activities that they're invested in that's generating income for them.

[00:02:35] Let's break down and let's give some examples of what's active. And what's passive and making sure that we keep separation of those. So their day, day business in their business, that would be active income. You know, the, the coaching that they're doing to business owners that's active income, let's say they built a software to help generate, uh, to help.

[00:02:52] With their coaching activities, they're generating some income from that software. They manage it, they're continually updating it. That software is gonna be [00:03:00] active income to them. Maybe they also have a training program where they teach other coaches how to be coaches, and as part of that, they're active into that.

[00:03:07] That would be active income as well. But now they have four rental parties, rental properties. That's gonna be passive income. Maybe they invested in a real estate syndication. They wanted to get into real estate, but they don't wanna be active in it. They don't want to be doing it the day, day, day of it.

[00:03:22] That's gonna be passive type income. Maybe their friend, their brother, their sister opened up a car wash and needed some money to open that car wash and they said, we'll give you some money. We don't wanna be part of the operations, but we'll give you some money for this. So we're gonna be an owner in it.

[00:03:35] That's gonna be passive. Type income. So again, for that business coach, that day-to-day business, that software they built, that training program that they're operating, that's all gonna be active income. We wanna keep that separate on one side of their life. And then that rental property, that real estate syndication or maybe that car wash that they just put money into as an investor, not part of the day-to-day, that's all gonna be passive income.

[00:03:56] And we want to keep that separate as well. You know, different [00:04:00] types of income and even different tax strategies that we may look at may require different entity types. And that's what we want to go through today. What type of entity types make sense, and which ones are we combining and which ones are we separating?

[00:04:11] So. When we talk about different types of entities, the main one that we get to choose from is a sole proprietorship, an LLC or a C corporation. Those are the three main entity types. We initially look at a sole proprietorship has no entity structure. At the state level, you're just kind of going out and you're starting your business.

[00:04:27] You're operating a lot of like Uber drivers when they first start out, they'll be like. I just wanna generate some income. I'm not gonna open up a company or a state level company or anything like that. I'm just gonna go out and drive and earn some income. They're operating as a sole proprietor. They, there's no liability protection from an entity structure in that, in that type of setup.

Active vs Passive: What's the Difference?

[00:04:45] The next setup is a limited liability company or an LLC, and everyone's kind of heard of these. These are an entity structure that you set up at the state level, so you're setting up an actual entity structure, which as attorney can talk to you about, can help provide some liability protection for you.

[00:05:00] Now, a sole prop and an LLC on the surface are taxed exactly the same way. There is no tax savings from just simply opening up an LLC. The true benefits of an LLC. From the initial out opening of it is the liability and a legal, an attorney obviously can talk to you through that, but the LLC also, and we'll talk about this a little bit later, can also kind of provide a safety net for a tax strategy called an S Corporation, which we'll talk about next.

[00:05:24] Uh, finally, C Corporation is also, uh, a tax entity, uh, that is, uh, organized at the, at the entity level. Now, sole proprietorships and LLCs, they're considered what you call a pass through entity, which means that any profit from those businesses, uh, come through, pass through to you on your personal tax return, and then you pay taxes on the profit of those businesses.

[00:05:44] On your personal tax return. A C Corporation's different. A C Corporation is not a pass through entity. So with a C corporation, you pay taxes on the profit of the business at the corporate level, and then if you pay yourself over and above that, if you pay yourself outta that corporate entity, you're gonna be [00:06:00] taxed again on those, on those pieces that are sent to you as the owner of the business.

[00:06:04] That's what they often call double taxation. So those are kinda the three entities that we like to put, put ourselves into. And I'd like to give this example. Let's imagine that I am a, a, a person that wants to start this, create this revolutionizing new golf tool. And this golf tool is just gonna change the way golfers golf, if that's possible.

[00:06:24] But this golf tool is just gonna be change the world. But I don't know what the tool does. I don't know what the tool is. I'm just testing some things out to see what it might be. In that example, I'm probably just gonna start as a sole prop because I don't even have a prototype. I don't even have anything for that.

[00:06:38] So I'm probably just gonna start as a sole prop. But also, now, let's say I create a golf ball, A golf ball that has a GPS wrapped into it, it floats. It can't be lost, it can't be racked. It can't go in the water no matter what. You're getting that golf ball back no matter where you hit it. And I have a prototype for it.

[00:06:54] Now I might be looking at an LLC because now I'm starting to operate an actual business, and that might be [00:07:00] when it's time to start an LLC. I always say people should have an LLC set up. Once you start having a regular operating business for liability protection, and then for this tax kind of insurance policy for something we call an S corporation.

[00:07:14] Now an S corporation is not, uh, an entity structure at the state level. It's simply a tax. Election and you can elect for a sole proprietorship to be taxed as an S corporation. You can, uh, you can, I'm sorry. You can elect for an LLC to be taxed as an S corporation and you can elect for a C corp to be taxed as an S corporation, but you cannot elect an sole proprietorship.

[00:07:37] To be an S corporation. Now, why even think about S corporation and we have tons of, uh, content about S corporations, the benefits of them, why you might want to, and why you might wanna hold off on it. We have a whole, uh, episode, YouTube video on that, so go check that out. But the general premise is, is we start to look at an S corporation once we have profit of about $50,000 or more with the purpose of helping limit the amount that we're [00:08:00] paying in self-employment taxes.

[00:08:01] So again, if you have a sole proprietorship, we cannot elect S-Corp status on that. So you're gonna pay self-employment taxes no matter what. And that's why we often say, let's maybe open up an LLC. We, we might not elect S-corp status right away, but at least we now have that LLC structure so that we can elect S-corp status when it makes sense.

[00:08:18] So those are the anti types sole prop, LLC. C corporation. And then we have this S corporation, which is simply a tax election that we might choose for one of our entities, our LLC or our C Corp, to be taxed at when the time makes sense. Now, one of the big question is, is what activities do I put into these entities?

[00:08:35] How many of these entities do I need to have? And that really comes down to liability. First off, passive versus active. We never want to mix the two of them. So if you have a rental property and you have a business, those are gonna be two separate LLCs. We never wanna put them into one LLC. But then the question comes up, you know, we gave that example example before of that business coach.

[00:08:55] That had four rental properties. Do we put all four of those rental properties into one LLC? [00:09:00] Do we have one LLC for every single one of those rental properties? Now we have four LLCs for each rental property. That's something you're gonna wanna talk to an attorney about and see what makes sense. And typically they're gonna say, okay, what is the liability protection?

[00:09:11] Because anything that we put into one LLC. Is able to, if, if they were to get sued, they could attack everything within that LLC. So sometimes we wanna look at liability protection, and again, an attorney can kind of walk you through that. So I'm not gonna talk about how many different entities to put in or how many different activities to put in each entity.

[00:09:29] What I wanna talk about is to make sure we have separation. So in that example above. That day-to-day business coach business is gonna be an LLC. If they have a software that might be another LLC, that's all on the active side. If they have a training program, that might be another LC. Sometimes it might just be A DBA that operates under that main company, but those rental properties, they're gonna be an LC.

Common Mistakes and How to Fix Them

[00:09:48] That's separate. From that software, from that training program, from that day-to-day business, that real estate syndication's gonna be a separate entity. If they invested in a car wash, that's gonna be a separate entity that's separate from [00:10:00] the active side. So key thing here, keep active activities separate from passive activities.

[00:10:06] Alright, so let's kind of put this all together in what I call the case study for an S corporation.

[00:10:11] Holding company now, what is a holding company? Because there's a lot of miscommunication up there. All these business owners are just gonna start like, I want a holding company. First off, holding company means something very different for someone. You know, your everyday run of the mill business owners like me and you, a holding company, is gonna be very different for us than say somebody like Apple or Google.

[00:10:30] So take your mind out of that very large, big business concept of say an Apple or Google, and let's think as a small business owner, a holding company is just a structure. Entity structure that we have that will own ownership in other entities that we have that we're a part of in my favorite part. Let's, let's focus on the, the, the active side.

[00:10:48] This is your business. This is your active type income. My favorite setup to have, if it makes sense, and if you're in a situation where an S corp makes sense, is to have one LLCS Corp as your holding company, [00:11:00] that S corp, LLC, you will own a hundred percent of, and any ownership you have in other active businesses will be owned.

[00:11:08] By that holding company. So let's go back to that example. Let's say you set up a holding company. It's uh, A-B-C-L-L-C. You elect for it to be taxes and s corporation. And now maybe you inside that holding company, you operate your day-to-day business in there. And now you build a software that you're actively involved in and you want to have separation from that.

[00:11:27] Maybe you have other partners in that. So we're gonna start an LLC for that software. Maybe you have partners in it, your ownership percentage in that software is gonna be through your S corporation. And then let's say you have a training program for other coaches that you have, and maybe you're like, we don't need an LLC for this.

[00:11:42] But we wanna put it under a holding company. Maybe we just do that one as a DBA or a doing business as it's not a physical entity structure, but it is kind of its own operations that's separate from our main and day business. So we're just gonna do a DBA for that. That's 100% owned by our holding company.

[00:11:57] Again, this is simply and only for active [00:12:00] businesses, and what that does is it provides this funnel that anything that we actively participate in, whether it's separate entities or not, is eventually gonna flow through. To this S corporation holding company and that S corporation holding company is gonna flow through to us.

[00:12:15] So why would we do a structure like that? Well, first off. Let's say an S corporation did make sense. I would not want you to do have an S corp for your day-to-day operations, an S-corp for your software and an S-corp for your training program. Why? Because now as a requirement of the S corporation, as the owner, you have to pay a reasonable salary for yourself.

[00:12:34] So now you're paying a reasonable salary out. S corp. One S-corp, two scorp. That's three reasonable salaries. That's three costs to run payroll on all those three entities or maybe in and, and even on top of that, an S corp is the more complex tax return. So now you're filing not one S-corp return, but you're filing three S-corp tax returns.

[00:12:52] Those cost money, and so that's one reason why we like the structure. The other reason is that if you have partners, it provides a really good [00:13:00] opportunity for tax planning. Let's say you're in a partnership and let's say you had that partnership be an scorpion and you have five kids and your partner has two kids, and you wanna hire your kids in your business as a tax strategy.

[00:13:11] Well, the partner with five kids. It's gonna get a lot better benefit than the partner with two kids. And so there might be conflict there. Or let's say one partner wants to drive an F three 50 and the other partner wants to drive a Prius, there's gonna be a cost difference there. So how do you work that out in the partnership?

[00:13:26] That's why I like having a partnership with the ownership interest in that partnership being your S corporation that you want a hundred percent of. Because then you can do those planning, those vehicle planning, those hiring your kids, various different tax planning inside your S corporation, and it has no effect.

[00:13:42] On your other partners in that business. It's clean. It has a good, it has an easy flow, and so these are types of setups that we set up every day over at taxo. The next thing we're gonna talk about here though, is different structures for different use cases and what that might look like in your overall picture.

[00:13:57] Remember, we're always keeping active. Separate from [00:14:00] passive type activities. Now, real quick, if you're looking for a tax strategies that you can actually implement, I built a software called Tax Zone where we don't just show you how to save on taxes, we help you turn those strategies into real dollars, saved with clear step-by-step guidance, full implementation modules, and so much more.

[00:14:17] So if you're serious about paying the least amount of taxes legally possible this year, click the link in the description and book a free discovery call with our team. All right. Now back to business structures, and let's look at strategic entity use. Let's look at some actual real life use cases. So for any active businesses, again, as we kind of just mentioned, typically we're gonna have those organized as separate LLCs or DBAs, so separate LLCs or DBAs for any businesses that we're active in.

Use Cases: S Corps, C Corps, and Family Management Companies

[00:14:44] But then the ownership in those LLCs, our ownership is gonna be, or DBAs is gonna be with one. S-corp holding company so that all these active businesses are gonna go for one entity and then come to us. Now, key thing about S corporation, we want to make sure it makes sense. Typically, we say [00:15:00] once you have profit about $50,000 or more per year, that's when the S corporation opens up.

[00:15:04] So don't rush into this S-corp, check out our training on that, but that if an S-corp makes sense, that's the type of structure that we like to see. Now, what about passive rental properties? Passive rental properties are gonna be in their own LLC separate from our active business. Now we're gonna determine, and an attorney can help you with this, how many different rental properties you wanna put into one LLC.

[00:15:25] Sometimes we see people with 1, 2, 3 properties in an LC, sometimes we see people with a really, really nice rental property. Maybe it's a short-term rental, something like that. And that. They want a separate, they, they want that in their one separate LLC, whatever it is that's on the passive side, and we wanna keep those on that side.

[00:15:41] They're gonna have their own LLC. That's separate from our active income. The next type of business structure is, you know, we're talking about this S corporation and LLCs and DBAs and we talked about the, the importance of LLCs and how it can really provide some legal protection for you. But now I wanna talk about an instance where maybe we don't look at an LC instead, we look at a sole proprietorship, [00:16:00] and this is mainly for a tax planning opportunity.

[00:16:03] You know, we talk about on our podcast, on our YouTube channel, this concept or tax strategy of hiring your kids in your business and how if you hire your kids in your business, there's potential. Where you get a business deduction and your kids pay no taxes on that income. Now the key thing with that is that if you do that in an S corporation, you would still have to pay FICA taxes.

[00:16:22] That's Social Security and Medicare, which is roughly 15%. So you pay your kids $10,000, you're gonna have self uh uh, FICA taxes of $1,500. But if we pay our kids out of a sole proprietorship. Now we don't have to withhold for FICA taxes if they're under the age of 18. So we might have one specific entity or one line of business that we organize as a sole proprietorship.

[00:16:45] And we use that sole proprietorship to be our tool to hire our kids in our business. That's the one instance where maybe we're gonna step away from our preferred structure, but we're doing it for tax planning purposes and we're not doing it with all of our income. C corporations is another one.

[00:16:59] [00:17:00] Oftentimes C corporations get looked down upon. Because there's double taxation. The profits taxed at the corporate level, and then when they give that to you as owners as W2 or dividends, it's taxed again to you. And they call it double taxation. But there's certain opportunities. There are certain instances where we want to do a C corporation for tax planning purposes.

[00:17:19] Maybe it's some type of health reimbursement and a way that you can get a deduction for all of your healthcare costs, um, over and above. Just your health insurance, but you can get a full business deduction for those costs. There's planning opportunities around that. Sometimes that involves using a C corporation, or maybe you're looking to take advantage of fringe benefits.

[00:17:37] We might look at a C corporation, or maybe you're a business that's generating a lot of income, but you don't need all that income to live off of, and you're retaining that cash, whether you're using it for investments or different areas. We might look at a C corporation sometimes, and the reason being is that a C corporation is taxed at 21%, so the profits in that C corporation is taxed at [00:18:00] 21% and then you're taxed again when you withdraw it.

[00:18:03] But if you wanna leave cash in there, you might say, Hey, if you're in the 32% tax bracket is an example you might say. I don't wanna pay 32% taxes. I'd rather pay 21, keep those, keep that profit in the C corporation, and then work on, uh, you know, invest it, work on that, put that money to work within that C corporation.

[00:18:21] And then I'm not paying that double tax until I actually withdraw it, but at least I'm not, you know. Putting a bunch of my money, putting a bunch of my profits away for taxes. I'm only doing that 21%. That might be a strategy that we do, that we talk about, and essentially that's where you can defer personal taxes by leaving after tax profits in the corporation, and then maybe you withdraw from them later where you're in a lower tax bracket.

[00:18:44] Maybe you're in the 10% tax bracket, you know, 20 years from now, and then you start to withdraw it at the 10%. Tax bracket, that could potentially be a good planning strategy. You know, oftentimes too, we see the C corporation with older business owners, they might hold profits inside that C [00:19:00] corporation until death, which would then allow their heirs to inherit the assets tax free because they get a step up in basis on the date of death.

[00:19:08] There's different planning opportunities around a C corporation. We don't typically recommend a C corporation, but sometimes when we look at different tax strategies, we might bring that strategy into, uh, into the picture. Now, with all of these different things, especially if we're doing the family management company, the C corporation, these different entities, and, uh, they're gonna be separate from our, our preferred structure, which is the S-corp.

[00:19:30] With the LLCs, any active businesses underneath it. The biggest thing is that we need a clear business purpose. So we can't just create a C corporation and then just funnel money over there. We need to have a clear business purpose. So maybe if we look back at that business coach, maybe that training program that they're putting together that they're actively involved in, maybe we do that.

Final Takeaways and What To Do Next

[00:19:47] As a C corporation if we want to use that, or maybe we do that as our sole proprietorship that we can hire our kids out, but everything else is gonna be in our preferred structure. Or maybe we create an agreement where maybe we have a C corporation or a family management [00:20:00] company that's providing services to our holding company, to our main as corporation, and we have a clear business purpose on the services that they're providing along with agreements and various other things that help back that up.

[00:20:11] The key here is correct implementation. Whenever we talk about tax strategies, we want to have correct. Implementation because you can take a tax strategy that's completely legal in the iris code and you can turn it legal simply by not implementing it correctly. So we wanna make sure we're dotting our I's and crossing our T's when we're looking at these different strategies.

[00:20:30] So how do you decide, when should you create a new entity? When does an entity make sense? The first question I think we need to ask ourself is, is it pass? Is it passive? Or is it active income? If it's passive income, it's gonna go on this side of our life. It's, it's, if it's active income, it's gonna go on this side of our life.

[00:20:47] And if it's active income. Then we're gonna have a holding company, an LLCS Corp holding company. We need to determine does this need to be a new entity within that? Can it be a DBA? Within that, we [00:21:00] might ask, is there partners involved in that? If there's partners involved with it, then we wanna do it as an LLC, but our ownership percentage in that LLC is gonna be via.

[00:21:09] Our S corporation, our holding company. Again, this is for active businesses. If it's an active business, we need to determine, doesn't need to have a separate LLC for liability purposes, or is A DBA fine. The biggest key here is that you want to determine the most tax. Efficient setup as well as a full picture, a full structure that plays into not only the tax planning, but also the the legal side of, of your structure as well.

[00:21:33] You know, most business owners set up one LLC and try to fit everything inside of it like a Swiss Army knife, but the iris doesn't care how simple your setup is. They care how it's classified on paper, whether it's real estate. Hiring your kids or launching your second or third income stream, how you separate your activities can change everything from your tax bill to your audit risk.

[00:21:55] So if you found this helpful, don't forget to subscribe. Hit that like button and share it with a [00:22:00] business owners who's sick of paying too much in tax. And if you want help from our team of tax professionals implementing strategies like this along with many other strategies, visit tax ome.com. That's www.taxelm.com, or click the link in description.

[00:22:15] For a free discovery call, we are helping people like you legally lower your tax bill every single day. Thanks for joining, and I'll see you on the next one. Thanks for tuning in to the Small Business Tax Savings Podcast. We hope today's episode sparked some brilliant ideas to help you save on taxes and grow your wealth.

[00:22:36] If you loved what you heard, hit the subscribe button and share the wealth with fellow entrepreneurs. For a treasure trove of tax saving resources, visit tax savings podcast.com. There you'll find tools, guides, and all the info you need on reducing your taxes. Let's elevate your business to new heights together.

[00:22:56] Remember, the insight shared here are for educational purposes and not [00:23:00] specific tax or legal advice. Always consult with a qualified professional for your unique situation. Until next time, keep thriving and saving.