Husband and Wife Unincorporated Businesses Should Consider a Special Tax Election
A married couple can own a business together in a variety of ways, including through a corporation, a partnership, or a limited liability company (LLC). However, some married couples may engage in business, without the use of a state law entity, through the use of jointly owned assets. In this case, the business should be classified as a partnership for income tax purposes.
Nevertheless, in cases where one spouse is the primary participant in the business and/or when the couple decides it is inconvenient to treat the business as a partnership for tax purposes, the spouses may choose to treat the business as a sole proprietorship. In such a case, because the couple is reporting income as a sole proprietorship, the primary participant spouse is likely the only spouse who will report the payment of self-employment taxes. Therefore, since only one spouse will be named on Schedule C and Schedule SE, only that spouse will receive credit for social security purposes.
The Small Business and Work Opportunity Tax Act of 2007 (signed into law on May 25, 2007), establishes another alternative for couples owning unincorporated businesses of which you or your clients may not be aware. Under Code Section 761(f), a husband and wife owning a “qualified joint venture” (i.e., a business whose only members are the husband and wife who both materially participate in the business and who do not want to be treated as a partnership), can elect to be treated as joint sole proprietors for income tax purposes. “Material participation” has the same meaning in this case as it does for purposes of determining passive activity losses and credits under Code Section 469. This option allows the spouses to treat the business as being jointly owned for income tax purposes, thereby allowing both spouses to receive credit for the payment of self-employment tax, but also removes the requirement that the spouses treat the business as a partnership. One potential disadvantage of this strategy is that the spouses could pay more “self-employment” tax than if they did not make this election.
Spouses make this election on a jointly filed Form 1040 by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse’s respective interest in the joint venture. Each spouse must also file with the 1040 a separate Schedule C and a separate Schedule SE.
It should be noted that this election does not apply to spouses that own a business in the name of a state law entity (including a general or limited partnership or limited liability company), but rather, only a business owned and operated by spouses as co-owners. From a state law liability perspective, it is generally advisable that couples establish a limited liability entity such as a corporation, limited liability partnership or limited liability company in order to protect the spouse’s personal assets from the business’s creditors and other litigants. However, for those couples who do not wish to change their current unincorporated business structure, who both materially participate in their business and who have been reporting self-employment taxes in the name of only one spouse, this election may prove beneficial to the couple. Indeed, this election may enhance a spouse’s eventual social security benefits, which are calculated based on an individual’s best 35 years of reported earnings (adjusted for inflation). By reporting separately the share of all the businesses’ income and expenses on Schedule C, both spouses will receive credit for social security benefits to be used upon retirement, or in the event of disability or death.
A couple currently engaged in business together who are filing only a joint 1040 should consider the viability of making this election. However, it is recommended that the spouses consider other options such as organizing a limited liability company or corporation in order to minimize the risk of personal liability. In addition, the couple should consider the pros and cons of the various options from an employment tax perspective. For example, the use of a subchapter S corporation may be advisable because it often allows owners to pay less self-employment taxes than would otherwise be paid through the use of a limited liability company or sole proprietorship. While this may not enhance a spouse’s social security benefits (since the couple will pay less taxes), it may free-up more cash flow that the couple can use for the payment of premiums on disability insurance and/or life insurance.