If you are in a business, particularly a partnership, you need to know about passive activity loss rules, because they affect your income tax liability. First, I will describe what "passive activity" in a business means, and how to determine if your participation in a business is active or passive, then I will talk about how this activity affects your business taxes.
What is Passive Activity?
Ted is a partner in a veterinary clinic which operates as a partnership. He works within the partnership as a veterinarian and he also has responsibilities in relation to the partnership: hiring and managing employees, marketing, financial oversight, and other similar duties. Ted is an active partner, and he is materially participating in the business (because his participation in the business is regular, continuous, and substantial). Ted is not a passive partner. I guess you could say it is "active activity," but the IRS doesn't have a category for this. Check out my article describing material participation for more details on what this term includes.
In another case, Kelly is a partner in an accounting firm. She has invested money in the partnership, but she does not activity participate in running the business. Kelly is a passive partner, and any income she receives from the partnership is passive income.
By the way, rental activities are always passive, unless you are a real estate professional.
Active Losses vs. Passive Losses
The IRS says that if you materially participate in the partnership, and the business has a loss, you can deduct the full amount of the loss on your tax return. If you do not materially participate (that is, your activity is passive), you cannot deduct losses in the same way as if you were materially participating. This makes sense; you cannot just sit back and watch the partnership incur a loss and do nothing to help the business, then take that loss on your tax return. Specifically, the IRS says: "Generally, losses from passive activities that exceed the income from passive activities are disallowed for the current year. Unused passive losses are carried forward to all future years."
In Kelly's case, the amount of loss she can deduct cannot exceed the income of the partnership. Let's say the partnership gross income (before expenses) is $100,000, Kelly owns 1/3 of the shares of the partnership, and the partnership expenses are $150,000. Kelly cannot deduct her share of $150,000; she can only deduct 1/3 of $100,000.