How should my S-Corp K-1 income be classified: Passive versus Nonpassive on Schedule E?

This is definitely something you should address. As the only employee actively participating in the S-Corp, your income should almost certainly be classified as nonpassive income on your Schedule E. The IRS has specific rules about this - when you materially participate in the business (which it sounds like you clearly do), the income should be nonpassive. The misclassification does matter even though you didn't have losses. As you correctly identified, passive income is subject to the Net Investment Income Tax (3.8%) on Form 8960 if your income is above certain thresholds. Nonpassive income from an S-Corp where you materially participate should not be subject to this tax. You should consider filing an amended return (Form 1040-X) for the previous year to correct this error and potentially get a refund for the overpaid NIIT. The statute of limitations for claiming a refund is generally 3 years from the filing date, so you likely still have time.

After dealing with similar S-Corp classification issues, I found an amazing service called taxr.ai (https://taxr.ai) that helped clear up all my confusion. I uploaded my K-1 and other tax documents, and their AI system immediately flagged the passive vs. nonpassive classification issue on my Schedule E. What I really liked was that they explained exactly why my S-Corp income should be classified as nonpassive since I materially participate in the business. They even calculated the potential tax difference and helped me determine if filing an amended return made financial sense based on the overpaid NIIT. Their system showed me the specific IRS regulations that apply to S-Corp owners and material participation tests. Made me feel way more confident when discussing the issue with my tax preparer!

Just wanted to follow up that I tried taxr.ai after seeing the recommendation here. Wow, it actually caught several issues with my tax return beyond just the passive/nonpassive classification! I have three different business entities (two S-Corps and an LLC), and it correctly identified that one of my S-Corps should have been nonpassive income while my limited partnership interest was correctly classified as passive. It even flagged that my tax preparer had missed some eligible home office deductions because I work from home for one of my businesses. The documentation it provided made it super easy to talk to my CPA about these issues. No more feeling confused when trying to explain tax concepts I only partially understand. Definitely worth checking out if you have any S-Corp or business income classification questions.

After dealing with a similar Schedule E classification issue, I was trying to reach the IRS to get clarification on the passive vs nonpassive rules. Spent HOURS on hold and kept getting disconnected. Then I found Claimyr (https://claimyr.com) - they have this service that gets you through to an actual IRS agent without the endless hold times. You can see how it works here: https://youtu.be/_kiP6q8DX5c I was skeptical, but they got me through to an IRS representative in about 15 minutes! The agent confirmed that as an active S-Corp owner who materially participates in the business, my income should definitely be classified as nonpassive on Schedule E. They also explained the process for filing an amended return to recover the NIIT I'd overpaid. Honestly saved me so much frustration compared to the usual IRS phone nightmare.

OK I need to admit I was totally wrong about Claimyr. After my skeptical comment, I decided to try it myself because I've been trying to reach the IRS for WEEKS about my amended return status. I was absolutely shocked when they got me through to an IRS agent in about 12 minutes. I've NEVER been able to get through that quickly on my own - usually I waste an entire afternoon on hold only to get disconnected. The IRS agent was able to check the status of my amended return and also confirmed what others have said here - that S-Corp income is nonpassive when you materially participate in the business (which basically means you're regularly involved in operations). She explained that this misclassification is actually pretty common and worth fixing through an amended return because of the NIIT implications. Guess I shouldn't have been so quick to dismiss something just because it sounded too good to be true!

Just to add some specifics around "material participation" since that's the key factor for passive vs nonpassive classification: There are 7 tests for material participation, and you only need to meet ONE of them: 1. You work 500+ hours in the activity during the year 2. You do substantially all the work in the activity 3. You work 100+ hours and no one else works more than you 4. The activity is a "significant participation activity" and you work 100-500 hours 5. You materially participated in 5 of the last 10 years 6. The activity is a personal service activity and you materially participated in any 3 prior years 7. Based on facts and circumstances, you participate regularly, continuously, and substantially As the only employee in your S-Corp, you almost certainly meet multiple tests. This is why your income should be nonpassive.

Has anyone actually gone through the process of amending a return for this specific issue? I'm in a similar situation but wondering if the hassle of amending is worth it. How long did it take to get your refund for the overpaid NIIT?

I went through this exact same situation a couple years ago! My tax preparer had been classifying my S-Corp income as passive for THREE years before I caught it. Like you, I'm the sole owner-employee doing all the work - there was nothing passive about it. The material participation tests that Connor mentioned are key here. Since you're the only employee, you almost certainly qualify under multiple tests, especially the "substantially all the work" test (#2) and likely the 500+ hours test (#1) as well. I ended up filing amended returns for all three years I was eligible to amend (you have 3 years from the original filing date). The total NIIT refund was substantial - over $12,000 combined. Each amended return took about 4-5 months to process, but it was absolutely worth it. One tip: when you meet with your EA about this, bring documentation showing your hours worked and level of involvement in the business. Even though it should be obvious that you materially participate, having records helps support the classification change. Also, make sure they understand this affects both your Schedule E AND your Form 8960 calculation. Don't let them brush this off as "not important" - the NIIT savings alone make it worth correcting, and you want to make sure it's done right going forward.