When calculating their AGI for taxing purposes, it is imperative that taxpayers differentiate between active (also called nonpassive) and passive activities. Generally, passive losses are not deductible as losses against active income items. Because a taxpayer can only deduct passive losses from passive activity income, any passive losses greater than the passive income are carried over until the following year. This situation poses the question of whether an activity, and the resulting income, is active or passive. According to the IRS, any income that results from an "activity or business in which the taxpayer does not materially participate" is passive income. Whether taxpayers are classified as active or passive could potentially make a tremendous difference in their tax liability.

Consider the following scenario:

You are preparing taxes for Tim, a business investor, and must calculate his adjusted gross income. Tim invested $10,000 in a business (only slightly less than the other investors) but is claiming a loss of $24,000. He spends 5 hours a week participating in business-related activities. Only one other investor spends more time on business activities than he does. Tim is confused about his characterization and believes he is both an active and passive investor. Why would an investor believe he is both? Consider how you would determine whether an investor is active or passive.