Your Spouse as a Partner (Happy Happy Joy Joy)
Posted May 5, 2019
You might be one of three situations. First, you have a partner in your business already and there’s no getting around it unless someone meets with an accident. Or, you work alone and don’t see that ever changing. Or, you have options- either to add a partner now as you form your business or down the road. Let’s assume you have the choice for now and you are considering your spouse.
Husband and Wife as Owners
Should you form an LLC with your spouse? No. Don’t you see enough of each other at the house? All kidding aside, there are two scenarios at play here. First, adding your spouse as an owner and second, adding your spouse to payroll. Just because your spouse is an owner does not mean he or she needs a salary, and he or she does not need to be an owner to receive a salary.
We’ll look at ownership first, and touch on the payroll component in a later chapter. Two primary reasons for adding your spouse to the business as an owner are-
- Leverage the minority owned small business benefits (usually with government contracts).
- Asset protection through Charging Orders and the associated rules with multi-member LLCs (attorney stuff).
If you and your partner are married, and you can actually tolerate each other’s existence for the foreseeable future, you have two basic options-
- Elect to be treated as a qualified joint venture (as defined and allowed by the IRS), and file on Schedule C on your individual tax returns, or
- Form an entity, treat the entity as a partnership and file accordingly (either Form 1065 or 1120S).
How you arrive at these two options will vary depending on your state’s property laws (community property versus common law property).
There are two types of states, 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 dictates that the income is added into a “community” pot, and then divided equally between the joint taxpayers. And 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. 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. If you are not electing S corporation status now or in the near future, we would advise not to elect to be a treated as a partnership. Keep it simple.
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.
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 personal 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.
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 become a disregarded entity as opposed to a partnership. The business activities are then reported on Schedule C of your Form 1040. However, if you properly prepare your individual tax returns, you would split the business activities equally between you and your spouse.
Let’s run through these three scenarios once more-
- Elect partnership with separate K-1s at 50% each, or
- Elect partnership with joint K-1, or
- Remain a disregarded entity and evenly split activities on two Schedule Cs (you and your spouse), and report them collectively on your individual tax returns (Form 1040).
All three of these scenarios are identical from a self-employment and income tax perspective. Remember, each person has to pay Social Security taxes which is the bulk of the self-employment tax equation up to $132,900 of income (for the 2019 tax year). So if you are forced to push income equally to you and your spouse, you could easily pay more self-employment taxes than necessary. You may avoid this by being a single-member LLC.
Remember grammar school, may is permissive and might refers to chance. You may go to the bathroom. It might rain today.
Two scenarios to drive home this point-
- Scenario A- The business earns $200,000 in net income. You pay Social Security taxes up to $132,900 for 2019, and Medicare taxes on the whole amount.
- Scenario B- The business earns $200,000 in net income. You and your spouse pay Social Security taxes up to $100,000 each if your spouse is also a member or partner in the business (Yes, an S corporation could alleviate some this, but you get the idea).
The only way to avoid this equalization in a community property state is to file separate tax returns and claim that you did not know about the community income (seems farfetched, Yes). You could always move to a common law property state such as Colorado which is lovely (we promise).
Or, prove to your family and friends that you are trainable by reading this book, and not add your spouse to the business entity. Most elegant and preferred choice when living in a community property state, and wanting to avoid the additional Social Security tax as illustrated above.
Or, eclipsing the threshold where an S corporation election makes sense, which we will explore in fascinating detail.
Note: Making an S Corp election can prove problematic if your spouse is a nonresident alien or if your spouse does not consent to the election (even if he or she does not own the business with you). More on this later.
Common Law Property State
Similarly to community property states, a husband and wife (or same-sex couples) 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. For 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, 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 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-
Two reasons why a qualified joint venture for a husband and wife team might make sense over a partnership. First, 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 and your joint Form 1040 (assuming the money invested is at-risk). This is in contrast to 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, there’s only one reason. Oops.
Having said all this, the Watson CPA Group still prefers to file partnership tax returns even for married couples since it allows us to track your capital accounts and other basis information. If you sell the business or get divorced or bring on a new partner, then this history is readily available. Otherwise you have to rebuild this information.
The qualified joint venture election can be made on Form 8832. Here is a quick summary table for husband and wife 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 are saying to yourself, Yeah, but there have to be some good reasons to add my spouse to the ownership. You would be correct and here are some considerations
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 that 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.
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 obtain distributions from the LLC rather than the LLC’s assets. Adding a spouse creates a multi-member LLC situation, but there are some caveats. The end of Chapter 1 has more information on the concept of charging orders.
According to IRS data, 8.8 million 2016 partnership and S corporation tax returns combined (Forms 1065 and 1120S) were filed in 2017. Of those, 28,723 were audited for an audit rate of 0.33%. This further breaks down to 21,174 as a field audit (face to face at your place of business) and 7,549 as a correspondence audit (letters).
Of those audited by a field audit, 35% resulted in a no-change audit where 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 for the 2016 tax year for adjusted gross income between $50,000 and $200,000 was 0.4%, whereas $200,000 thru $500,000 was 0.7%. 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.
If your spouse is an inactive owner of the business, then the operating spouse’s salary might be reduced. For example, one of the criteria the IRS will use to determine if your salary is reasonable is the comparison to shareholder distributions. As we will discuss further in our chapter titled reasonable shareholder salary, one of the jumping off points is 1/3 of net business income after expenses and from there we massage the number to suit the operating spouse specifically.
But if this 1/3 number is based on an ownership percentage less than 100% (such as 80% for the operating spouse and 20% for the inactive / investing spouse), then there might be some savings.
1/3 of 80% of $100,000 is $26,600
1/3 of 100% of $100,000 is $33,300
A $6,000 reduction in salary could save you over $900 in payroll taxes! Again, a later chapter has more information on this within the reasonable salary determination arguments.
Another way to look at this is this; if the IRS uses distributions as compared to salary as one of the determinants of reasonableness, you lower your distribution by siphoning some to your inactive spouse. So your ratio of distributions to salary is lower which is good. Note the words “some” and “inactive.” Some being reasonable like 20% or less. Inactive being an owner who does not materially participate in the business and can warrant not collecting a reasonable shareholder salary.
Husband and Wife Problems
If you are trying to classify your spouse as an inactive investor of the business, then you cannot pay a salary. This ultimately prevents your spouse from participating in a 401k plan, and expensing business meals and travel becomes challenging since inactive shareholders don’t normally attend conferences or meetings, hence the word inactive.
Another concern are certain professions- law, medical and accounting do not allow non-professionals to be owners in most states. For example, to be an owner of medical practice requires that you are also a medical doctor. There are some minor exceptions here and there, and each state is different. The overall theme is to double check with your local regulatory agencies first. For example, in Colorado a non-CPA can be an owner of a CPA firm, but the majority (51%) must be CPA’s.
So you need to pick your poison, but you can always ask us for help.
Net-Net Spouse Summary
On one hand you have the option of making your spouse an inactive shareholder which theoretically could defend a lower reasonable salary. For mid-range salaries ($30,000 to $50,000), your savings could be $900 to $1,500. Okay, that’s one side of the coin.
The other side is adding the spouse as a shareholder and employee (or just employee), and sharing more expenses and adding to solo 401k plans. What does that get you in terms of money? At a 25% marginal tax rate, if you were to reduce taxable income by $10,000 because of additional business deductions, you save $2,500.
So the ultimate answer is weighing the payroll tax reduction (inactive shareholder) versus the income tax reduction (spouse as employee). Remember that the income tax deduction is not generated by solely giving your spouse a wage (assuming you file a joint individual tax return). The income deduction is generated by justifying increased business spending and solo 401k plan deferrals.
The best trick is to find a legal way to take the money you already spend and turn it into a small business tax deduction. Employing your spouse might help.
Spouse As Independent Contractor
You might also consider paying your spouse as an independent contractor. Why the heck would you want to do that? Well, there could be a situation where you don’t want your spouse to be an owner or that person cannot be (in the case of a law firm, for example), yet you want your spouse to be able to contribute to his or her 401k. Furthermore, by putting your spouse on the payroll of your business, you might jeopardize other fringe benefits such as Health Reimbursement Arrangements (HRAs).
You might also want to pay your children as contractors so they can have a 401k without making your business implement a full-blown company-sponsored 401k plan. This stuff can get tricky, but please understand that you have some options.
Ownership Transfer with Husband and Wife 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. Most courts use a method such as excess earnings to determine the value to the operating spouse, not necessarily the fair market value.
For example, a one-person consultant with a single client might not be able to sell the business because no one else could do the work. However, the business remains valuable to the operating spouse. This is the same as the POS you drove in college- you could sell it for $50, but to you the car was worth a zillion dollars. It ran well, the heater worked, etc.
Business valuations for divorces sounds like fun, doesn’t it? A real hoot. The Watson CPA Group 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.
Taxpayer’s Comprehensive Guide to LLCs and S Corps : 2019 Edition
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