Your Spouse As A Business Partner (Happy Happy Joy Joy)

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Should you immediately form an LLC with your spouse? No. Don’t you see enough of each other at the house? All kidding aside, there are two primary reasons for adding your spouse to the entity as an owner are-

• Leverage the minority owned small business benefits (usually with government contracts). This is getting less and less lucrative, and doesn’t apply to rental properties. There might be some other real estate investment opportunities.

• Asset protection through Charging Orders and the associated rules with multi-member LLCs (attorney stuff).

• Your spouse suggests it one lovely evening over dinner, and upon reflection of considerable collateral damage, you surrender. A solely owned entity such as an LLC or corporation is still a marital asset in most jurisdictions and as such will be part of any divorce action regardless (might not be the same in estate planning however since Operating Agreements might dictate).

We tricked you there into thinking there were only two primary reasons. Gotta have some fun with this material, right?!

Back to the question of adding your spouse to the entity as an owner; please note how tax savings or other big “wow” things are not listed. In other words, adding your spouse as an owner only has two super narrow bands of benefits.

Two Options

If you and your partner are married, and want to become the next power couple, you have two basic options-

• Report your rental property activities on your individual tax returns as if no entity exists, or

• Form an entity, treat the entity as a partnership and file accordingly on Form 8825 (like a Schedule E rental property form) within Form 1065 (the actual tax return).

How you arrive at these two options will vary depending on your state’s property laws. There are two types of states beyond red and blue; community property and common law property. Here is some gee whiz information. Community property laws stem from Spanish law whereas common law property states originate from the English law system. Therefore, it makes sense that most of the community property states are in the southwest portion of the United States plus the odd ducks up there in Wisconsin, Washington and Idaho.

Community property states dictate that the income is added into a “community” pot, and then divided equally between the joint taxpayers. Federal laws will usually follow the state laws in terms of income joining and splitting, with some exceptions here and there. On a jointly filed tax return this is moot, but if you need to file a separate tax return this gets complicated (separate tax returns are occasionally needed for second marriages or prenuptial agreements). But regardless of the taxation issues, there are also some procedural issues with business ownership.

Community Property State

Two people, married, in a community property state are not a partnership unless they elect to be treated as such. Electing to be treated as a partnership will complicate things from a tax preparation perspective, does not provide any added tax benefit, and forces you into one of two situations, which are both ultimately equal. You could prepare a partnership tax return and create separate K-1s for you and your spouse at 50% each, or prepare a partnership tax return and create a joint K-1.

Sidebar: We just said, “no added tax benefit.” This is technically true in the purest sense. However, reporting your rental property and real estate investment activities within a partnership tax return provides two big benefits (audit risk and tax basis tracking) that we discussed earlier Rental Properties in Partnerships.

Please recall that a K-1 is the byproduct of a pass-through entity (PTE) tax return which summarizes various business and rental activities that are later presented on the owners’ individual tax returns (Form 1040). Additionally, Box 1 on a K-1 is for ordinary business income, Box 2 is for net rental real estate income and Box 3 is for other net rental income.

What the heck is a joint K-1? Rare, Yes, but the K-1 would be issued to the primary taxpayer’s SSN but read “Bob and Sue Smith, JTWROS”. When your individual tax returns are prepared, this joint K-1 gets spread among both you and your spouse equally, and therefore the income might be taxed with additional, unnecessary Social Security taxes.

Don’t like that idea?

A husband and wife owning an LLC in a community property state can be considered one owner, or in the case of an LLC, one member and therefore becomes a disregarded entity as opposed to a partnership. The rental property and real estate investment activities are then reported on Schedule C or E of your Form 1040. However, if you properly prepare your individual tax returns, you will split the business activities equally between you and your spouse.

Sidebar: An individual tax return is a bit of a misnomer. It is synonymous with Form 1040, and may be filed as one person or two married people (married filing jointly). In both situations, the tax return is called an individual tax return. Many of us think of the word individual as numerical such as one or single. But in the case of tax returns, individual is better known as person or human. Furthermore, a married couple is considered one in so many walks of legal life, hence the singular use of individual in referencing a tax return.

Let’s run through these three tax return scenarios once more when a married couple own a business together in a community property state-

• Elect partnership with separate K-1s at 50% each, or

• Elect partnership with joint K-1, or

• Remain a disregarded entity (single member LLC) and evenly split activities on two Schedule Cs or Es (you and your spouse), and report them collectively on your individual tax returns (Form 1040).

All three of these scenarios are identical from an income tax perspective.

Common Law Property State

Similar to community property states, a husband and wife (or same-sex couples) living in a common law property state have two options- file a partnership tax return or elect to be a qualified joint venture.

Two major differences to note here right away; in common law property states, the presumption is that you and your spouse are a partnership. In community property states, the opposite is true. The presumption is that your business entity is essentially a qualified joint venture.

The other major difference is that in a common law property state, you can chop up the business activities based on a pro-rated basis of involvement / interest in the business. This might not be relevant for most real estate investors, but, and as an example, your husband supports your consulting business by handling the books; perhaps his involvement is only 15%. This is converse to community property states which generally divide things equally (whoever thought a marriage was a 50-50 relationship was fooled long ago, but here we are).

Some other details allowing married business partners to be a qualified joint venture include the following-

• You and your spouse are the only members (owners) of the joint venture, and

• You file a joint tax return (Form 1040), and

• You both materially participate in the business operations (which has legal IRS definitions attached to it such as number of hours and activities), and

• You are not operating the business (or rental property venture) as a limited liability company (what?!).

The last one is the deal breaker for most people. According to IRS rules, if you and your spouse operate a multi-member LLC, whereby each of you are members of the LLC, then you must file as a partnership using Form 1065 in common law property states. Most people are confused on this including attorneys and other CPAs. Don’t believe us? No worries, refer to these wonderful IRS resources-

wcginc.com/5401

There is a flimsy reason why a qualified joint venture for a husband-and-wife team might make sense over a partnership. A disregarded entity (single-member LLC) or a husband-and-wife team that elect to be a joint venture can theoretically have unlimited losses reported on Schedule C of your joint Form 1040 (assuming the money invested is at-risk).

This contrasts with a partnership where your losses cannot reduce a partner’s basis below zero. In other words, if you invest $5,000 in a partnership you can only lose $5,000. Without going into crazy detail, this is different than a partner’s capital account (for example, you inject property into the partnership that is worth $10,000 but you only paid $2,000 for it, your capital account will show $10,000 but your basis in only $2,000). Sorry for the diversion.

Having said all this, WCG still prefers to file partnership tax returns even for married couples in community property states since it allows us to track your capital accounts and other basis information. As mentioned elsewhere, this is a valuable presentation when deducting large rental property losses because of accelerated depreciation. Also, if you sell the business or get divorced or bring on a new partner, then this history is readily available. Otherwise, you must rebuild this information.

Additionally, the audit rate risk is much lower for partnership tax returns than individual tax returns. This does not mean you can be cavalier with your tax positions, but it certainly provides comfort in having a lower risk in defending them. We expand on this in a bit.

If a narrow reason exists, the qualified joint venture election can be made on Form 8832. Here is a quick summary table for married couple teams-

Entity	Common Law Property	Community Property
Sole Proprietor	May be qualified joint venture (Schedule C for each, Form 1040).	May elect to be partnership (Form 1065). May elect to be disregarded entity (Schedule C, Form 1040)
Limited Liability Company	Must be a partnership (Form 1065). May be taxed as an S corporation (Form 1120S).	May elect to be partnership (Form 1065). May elect to be disregarded entity (Schedule C, Form 1040). May be taxed as an S corporation (Form 1120S).

You might be saying to yourself, Yeah, but there must be some good reasons to add my spouse to the ownership. Here are some considerations.

Disadvantaged Business

Women are a protected class, and therefore might receive favorable government contracts or grants as small business owners. Same sex couples might see increased favorable treatment as well. Don’t forget about Veterans and other groups of people whose status might be leveraged.

There are several acronyms out there-

DBE	Disadvantaged Business Enterprise (California uses this often)
MBE	Minority-Owned Business Enterprise
WBE	Women-Owned Business Enterprise
DVBE	Disabled Veterans Business Enterprise
WGBE	White Guy Business Enterprise

Yeah, okay, the last one was a joke. You should always explore these opportunities especially if you are engaging with governments. There are also businesses who will certify your entity as one of the above since there has been a lot of fraud lately. Shocking. Say it isn’t so!

Charging Orders

When you have a multi-member limited liability company, and there is a judgement against a member of the LLC, the creditor must obtain what is called a charging order from a court. Theoretically this forces the creditor to only receive distributions from the LLC rather than the LLC’s assets. Adding a spouse creates a multi-member LLC situation, but there are some caveats. A later chapter has more information on the concept of charging orders (spoiler alert: it is flimsy legal defense for owners who are married to each other).

Audit Rates

According to IRS data for the 2019 tax year (the most recent data set), 9.3 million partnership and S corporation tax returns combined (Forms 1065 and 1120S) were filed. Of those, 17,543 were audited for an audit rate of less than 0.2%. This further breaks down to 15,852 as a field audit (face to face at your place of business) and 1,691 as a correspondence audit (letters). The IRS is slow to compile and release this data, but we doubt the trend has shifted.

Of those audited by a field audit, 35% resulted in a no-change audit whereas correspondence audits resulted in a no-change audit 52% of the time. This is a blended rate, and digging deeper into the data reveals that partnerships generally result in a no-change audit about half of the time, whereas the same result for an S corporation happens about 33% of the time.

Audit rates for individual tax returns (Form 1040) for the 2019 tax year for adjusted gross income between $50,000 and $200,000 was 0.1%, whereas $200,000 through $1,000,000 was 0.4%. These rates increase to 0.6% and 1.0% respectively with Schedule C and Schedule E. Therefore, if you are in this second band of income range, a partnership or S corporation tax return will have half the IRS scrutiny as your individual tax return. To say half is a bit misleading, right? In practical terms, your audit rate risk goes from microscopic to tiny… both scenarios are favorable, but you get the general idea.

Ownership Transfer with Married Couple Teams

If you are concerned about ownership transfer in case of death, we suggest taking care of this issue within your estate planning. Transfer of assets between spouses during death is generally seamless in most states. Contact an estate planning attorney for more comprehensive analysis and advice.

If you are concerned about separation of property during divorce, our experience and observation show that a single owner will still be required to obtain a business valuation from an expert and the business becomes a marital asset. This becomes tricky in a rental property situation since you have income-producing assets but the assets themselves also have value. Generally, you cannot use both the asset approach and the income approach, and commonly the asset approach is the highest and best representation of the value. Having said that, in some commercial settings or severely depressed property values, the income approach is more representative of the value.

Business valuations for divorces sounds like fun, doesn’t it? A real hoot. WCG CPAs & Advisors is heavily involved in forensic accounting and business valuations, so if you need help let us know. Remember, the goal of any divorce is to ensure both parties are equally upset. No one should be high-fiving as they leave the courtroom.