When is a Husband and Wife Business a Partnership for Tax Purposes?

When you operate a business as husband and wife, the business may be treated as a sole proprietorship or a partnership for federal income tax purposes, unless you have set up the business as a corporation. Whether the business is considered a sole proprietorship or partnership has implications in terms of federal income tax reporting and self-employment tax. According to the IRS, how the business is treated depends on how much control each spouse has in management decisions.

If one spouse substantially controls the business and the other spouse is under the control and direction of the first spouse, the second spouse would be considered an employee. As an employee this spouse would be subject to withholding of social security and Medicare (FICA) and federal income taxes. But if both spouses have an equal say in management decisions and the affairs of the business, the relationship would be considered a partnership.

As a partnership, you would have to file Form 1065, U.S. Return of Partnership Income. This return is an informational return. A partnership is a pass-through entity for federal income tax purposes and does not pay taxes directly. Based on Form 1065 you would prepare Schedules K-1 showing each spouse's share of the partnership's income, deductions and credits. Then each spouse would report his or her share on an individual income tax return. You could still file a joint return and combine your net income from the partnership.

But as a husband and wife business you can choose to be treated as a joint venture for tax purposes and not have to file a partnership return. You would qualify to be treated as a joint venture if you are the only members and you both materially participate in the business. In this case the business would be treated as a sole proprietorship. All the income, gains, losses, deductions are credits would be divided according to your interests in the business.

By filing as a joint venture instead of a partnership you can avoid the need to file a partnership return. Also, each spouse will get credit for social security and Medicare coverage. If you file a Schedule C for the business as a sole proprietorship under the name of just one spouse, only that spouse will get credit by filing a Schedule SE, Self-Employment Tax.

To choose to file as a qualified joint venture instead of a partnership, you have to file a joint return and separate schedules to show each spouse's share of the income from the business. This would be reported on separate Schedules C. If you have a farming business you would file separate Schedules F or Forms 4835 for farm rental income and expenses. And you would file separate Schedules SE, Self-Employment Tax.

The self-employment tax may be a consideration in deciding how to treat your husband and wife business for tax purposes. If you file as a qualified joint venture, each spouse would be subject to the social security portion of the self-employment tax on net earnings of up to $106,800 (for 2011). The Medicare portion of the tax applies on all your net earnings. The self-employment tax rate for 2011 was reduced to 13.3%, consisting of 10.4% for social security and 2.9% for Medicare. The normal rate is 15.3%, which includes 12.4% for social security and 2.9% for Medicare. You can claim half the self-employment tax as a deduction in calculating your net income subject to federal income tax.

As indicated by Finn Orfano on the Bright Hub website, you could reduce your self-employment tax liability by treating one of the spouses as an employee, paying a salary and deducting FICA tax. Or you could set up the business as a limited liability company and make guaranteed payments that are less than the maximum amount subject to self-employment tax. In these cases, you would have to file a partnership return since you would not qualify to file as a husband and wife joint venture.

An article in Inc. points out that there may be advantages to filing a tax return for your husband and wife business as a sole proprietorship under the name of just one spouse. The other spouse can informally work in the business without being classified as a business partner, employee, or independent contractor. That spouse would not get credit for social security and Medicare, but you would not have to pay FICA tax or self-employment tax on that spouse's share of the earnings.

Sources:

Election for Husband and Wife Unincorporated Business, IRS

Finn Orfano, Tax Tips for Married Business Partners, Bright Hub

Form 1065, U.S. Return of Partnership Income, IRS

Form 4835, Farm Rental Income and Expenses, IRS

Husband and Wife Business, IRS

Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship), IRS

Schedule F (Form 1040), Profit or Loss from Farming, IRS

Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc., IRS

Schedule SE (Form 1040), Self-Employment Tax, IRS