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You are here: Home > Taxpayers Guide to LLCs and S Corps > Chap 2 - Customized Entity Structures > Your Spouse as a Partner (Happy Happy Joy Joy)
  • Taxpayers Guide to LLCs and S Corps

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2023
      • Quick Reference 2024
      • Quick Reference 2025
    • Chap 1 - Business Entities, LLCs

      • Basic Business Entities
      • Sole Proprietorship
      • Single Member Limited Liability Company
      • Multi-Member Limited Liability Company
      • Partnerships
      • Being Considered a Passive Business Owner
      • Rental Partnerships
      • C Corporations
      • Personal Service Corporation
      • Professional Corporations and LLCs
      • S Corporations
      • Section 199A Qualified Business Income Tax Deduction
      • S Corp Versus LLC
      • LLC Popularity (Hype)
      • Formation of an LLC or S Corp
      • Nevada Fallacy of an LLC (or Delaware or Wyoming!)
    • Chap 2 - Customized Entity Structures

      • Your Spouse as a Partner (Happy Happy Joy Joy)
      • Family Partners
      • Real Estate Holding Company and Operating Company
      • Parent-Child Arrangement (Income Flows "Up")
      • Parent-Child Arrangement (Income Flows "Down")
      • Multi-Member LLC That Issues Invoices
      • Things to Work Through with Multiple Entities
      • Recap of Benefits with Multiple Entities
      • State Apportionment with Multiple Entities
      • California Multi-Member LLC S Corp Twist
      • C Corporation as Mothership
      • Holding Company versus Management Company
      • Pure LLC Holding Company
      • Economic versus Equity Interests
      • Structuring Deals with Angel Investors
      • ESOPs and S Corporations
      • Another Employee Ownership Situation
      • Medical C Corp
      • Fleischer Tax Court Case
      • Joint Ventures
      • Loans or Capital Injections
      • Using a Trust in Your Formation Considerations
      • Operating Agreements
      • Exit Plans, Business Succession
      • Liability Protection Fallacy of an LLC
      • Charging Orders
      • Using a Self-Directed IRA to Buy a Rental, Start A Business
    • Chap 3 - S Corporation Benefits

      • Avoiding or Reducing Self-Employment SE Taxes
      • Tax Savings with Health Insurance
      • S Corp Hard Money Facts, Net Savings
      • Ancillary Benefits with S Corporations
      • Officer Compensation with Solo 401k Plan Deferral
      • W-2 Converted to 1099
      • Net Investment Income, Medicare Surtax and S Corps
      • Being a Passive Business Owner
      • Three Types of Income
    • Chap 4 - The 185 Reasons to Not Have an S Corp or LLC

      • Chapter 4 Introduction
      • Additional Accounting Costs
      • Additional Payroll Taxes
      • SEP IRA Limitations
      • Trapped Assets
      • Distributing Profits, Multiple Owners
      • Other W-2 Income
      • State Business Taxes (Not Just Income Taxes)
      • Deducting Losses, Trapped Cash
      • Distributions in Excess of Shareholder Basis
      • Stock Classes
      • Vesting and Expanding Ownership
      • Bad Loans to the S Corp
      • Social Security Basis
      • Payroll Taxes on Children
      • C Corp to S Corp Problems
      • Going Concern
      • Recap of S Corp Downsides
      • Growing Business, Debt Service
    • Chap 5 - State Nexus Problems

      • Chapter 5 Introduction
      • Chapter 5 Disclaimer
      • Wayfair Case Part 1
      • Nexus Theory
      • Constitutional and Legislative Standards
      • Sales and Use Tax, Income Tax
      • Physical and Economic Presence, Nexus Attached
      • Wayfair Case Part 2
      • Services and Tangible Personal Property (TPP)
      • Costs of Performance, Market-Based Approach
      • Allocation and Throwback
      • FBA, Drop Shipments, Trailing Nexus Revisited
      • Recap of State Tax Issues
      • State Tax Issues and Nexus
    • Chap 6 - S Corporation Election

      • Formation (Election) of an S-Corp
      • Electing S-Corp Filing Status, Retroactive for 2025
      • Another Option, Dormant S Corp
      • Missing Payroll, Now What
      • Mid-Year Payroll
      • Nuts and Bolts of the S Corp Election
      • Ineffective S Corp Elections
      • S Corp Equity Section
      • Terminating S Corp Election
      • Distributed Assets
      • 5 Year Rule
      • Life Cycle of an S Corporation
    • Chap 7 - Section 199A Deduction Analysis

      • Section 199A S Corp Considerations
      • Calculating the Qualified Business Income Deduction
      • Section 199A Defining Terms
      • Specified Service Trade or Business (SSTB) Definitions
      • Trade or Business of Performing Services as an Employee
      • Services or Property Provided to an SSTB
      • Section 199A Deduction Decision Tree
      • Section 199A Reasonable Compensation
      • Section 199A Pass-Thru Salary Optimization
      • Cost of Increasing Shareholder Salary
      • Section 199A Rental Property Deduction
      • Negative Qualified Business Income
      • Qualified Property Anti-Abuse
      • Aggregation of Multiple Businesses
      • Section 199A W-2 Safe Harbors
      • Additional Section 199A Reporting on K-1
      • Section 199A Frequently Asked Questions
    • Chap 8 - Section 199A Examples and Comparisons

      • S Corp Section 199A Deduction Examples
      • Section 199A Side by Side Comparisons
      • Section 199A Basic Comparisons
      • Section 199A Health Insurance Comparison
      • Section 199A 200k Comparison
      • Section 199A 250k Comparison
      • Section 199A Specified Service Business Comparison Part 1
      • Section 199A Specified Service Business Comparison Part 2
      • Section 199A Phaseout
      • Section 199A Recap
      • Section 199A Actual Tax Returns Comparison
    • Chap 9 - Reasonable Shareholder Salary

      • Chapter 9 Introduction
      • IRS S Corp Stats
      • Reasonable S Corp Salary Theory
      • IRS Revenue Rulings and Fact Sheet 2008-25
      • Tax Court Cases for Reasonable Salary
      • Risk Analysis to Reasonable Shareholder Salary
      • Reasonable Salary Labor Data
      • Assembled Workforce or Developed Process Effect
      • RCReports
      • W-2 Converted to 1099 Reasonable Salary
      • S Corp Salary Starting Point
      • Multiple Shareholders Payroll Split
      • Additional S Corp Salary Considerations
      • Reasonable Salary Recap
    • Chap 10 - Operating Your S Corp

      • Chapter 10 Introduction
      • Costs of Operating an S Corp
      • New S Corp Puppy, What Do I Do Now
      • Accounting Method
      • 1099-NEC Issued to Your SSN
      • Take Money Out of the S Corp
      • Processing S Corp Payroll
      • Minimum Payroll with December Bonus
      • Taking Shareholder Distributions
      • Reclassify Shareholder Distributions
      • Accountable Plan Expense Reimbursements
      • Accountable Plan Requirements
      • Shareholder Distributions as Reimbursements
      • S Corp Tax Return Preparation
      • Distributions in Excess of Basis
      • Minimize Tax or Maximize Value (Economic Benefit)
      • Tracking Fringe Benefits
      • Other Tricks of the Trade with S Corps
      • Adding Your Spouse to Payroll
      • Chap 10 - Comingling of Money
    • Chap 11 - Tax Deductions, Fringe Benefits

      • Chapter 11 Introduction
      • Four Basics to Warm Up To
      • Section 199A Deductions – Pass Through Tax Breaks
      • 185 Business Deductions You Cannot Take
      • Depreciation
      • Small Business Tax Deductions Themes
      • Value of a Business Tax Deduction
      • Deductions the IRS Cannot Stand
      • Automobiles and LLCs, S Corps
      • Business Owned Automobile
      • Section 179 and Bonus Depreciation
      • You Own the Automobile, Get Reimbursed By The Mile
      • You Own the Automobile, Take Mileage Deduction
      • You Own the Automobile, Lease Back to Your Company
      • Automobile Decision Tree
      • Home Office Deduction
      • Tax-Free Rental of Your Home
      • Tax Home
      • Business Travel Deduction
      • Deducting Business Meals
      • Sutter Rule
      • Cohan Rule
      • Capital Leases versus Operating Leases
      • Putting Your Kids on the Payroll
      • Educational Assistance with an S-Corp - Section 127
      • Summary of Small Business Tax Deductions
      • Business Tax Return Preparation
      • Comingling of Money
      • Reducing Taxes
    • Chap 12 - Retirement Planning

      • Retirement Planning Within Your Small Business
      • Self Employed Retirement Plan Basics
      • Retirement Questions to Ask
      • Tax Savings and Tax Deferrals
      • Using a 401k in Your Small Business Retirement Options
      • The Owners-Only 401k Plan
      • Having Staff with a Solo 401k Plan
      • Self-Directed 401k Plans
      • Company-Sponsored 401k Plan
      • 401k Plan Safe Harbor Provision
      • Roth 401k Plans
      • Roth 401k Versus Traditional 401k Considerations
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
      • 401k Loans and Life Insurance
      • 401k Plans and Roth IRA Conversions
      • Turbo Charged 401k Plans
      • SIMPLE 401k
      • SEP IRA
      • SEP IRA, Roth IRAs and the Roth Conversion
      • Controlled Groups
      • Owner Only 401k Plans in MMLLC Environment
      • Spousal Attribution and Controlled Groups
      • Non-Qualified Deferred Compensation Plan
      • Exotic Stuff
      • Expatriates or Expat Tax Deferral Planning
      • Small Business Retirement Planning Recap
    • Epilogue

      • WCG Fee Structure
      • More About WCG
      • Consultative Approach
      • Core Competencies
      • No BS
      • Expectations of Our Clients
      • Final Words
    • Chap xx - Health Care

      • Disclosure and Updates
      • Gaming the HSA System
      • Health Care Summary
      • Health Savings Accounts (HSAs)
      • Long-Term Care
      • Multiple Employees
      • One Person Show or Husband-Wife Team, S Corporation
      • Section 105 Health Reimbursement Arrangement (HRA)
      • Section 125 Cafeteria Plans and Flex Spending (FSA)
      • Sole Proprietors and Single Member LLCs
    • Chap yy - Business Valuations, Sale, Exit Planning

      • Business Valuation Techniques
      • Buy-Sell Agreements
      • Deal Structure
      • Debt Service
      • Exit Plans, Succession
      • Purchase Price Allocation
    • Chap zz - Other S Corp Thoughts

      • 1099 Income as Other Income, No Self-Employment (SE) Taxes
      • Audit Rates and Risks with an S-Corp
      • Recap of S-Corps
      • Rental Losses with an S-Corp
      • Rentals Owned by an LLC Fallacy
      • W-2 or 1099-MISC That Is The Question
  • Expat and Expatriate KB

    • Expat FAQs

      • Are there any downsides to claiming the foreign earned income exclusion?
      • Are there exceptions to the bona fide residence or physical presence tests?
      • As an ExPat, do I need to file a State tax return?
      • Can I deduct mortgage interest paid on my foreign home?
      • Do I have to pass the same test each year?
      • Does voting through an absentee ballot mess up my bona fide foreign residency?
      • How do fluctuating currency values affect my taxes?
      • How do I handle my foreign rental property?
      • How do I qualify for the foreign earned income exclusion?
      • How do moving expenses affect my exclusion?
      • How do partial years work with the foreign earned income exclusion?
      • How do tax treaties affect my ExPat situation?
      • How does the foreign housing exclusion or deduction work?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If I don't qualify for the housing deduction, can I still deduct expenses?
      • May I still make contributions to my IRA as an ExPat?
      • What amount can I deduct for foreign earned income exclusion?
      • What happens if my host country has a form of social security?
      • What is a tax home or abode, and how do they relate to each other?
      • What is considered foreign earned income?
      • What is foreign earned income exclusion?
      • What is the bona fide residence test?
      • What is the difference between foreign tax credit and deduction?
      • What is the physical presence test?
  • Rental Property KB

    • Rentals FAQs

      • Can I claim my residence as a rental, sell it for a loss and deduct the loss?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Can I deduct the taxes associated with public improvements?
      • Can I rent out half a duplex or a room in my house?
      • Do I need receipts for my rental expenses?
      • Do rental properties offer good tax sheltering?
      • How are repairs and improvements different?
      • How do I handle my foreign rental property?
      • How do passive loss limitations affect me?
      • I purchased a rental property last year. What closing costs can I deduct?
      • If I don't have any rental income can I still claim a loss?
      • If I move back into my rental, how does that work?
      • If my employer provides a cell phone, is that income?
      • Is depreciating my rental a good thing?
      • My rental sale was a huge loss. What can I do?
      • Rentals Owned by an LLC Fallacy
      • What are tax issues with an LLC owning a rental property?
      • What are the exceptions to rental activities?
      • What are the rules on a home office deduction?
      • What is active participation versus material participation?
      • What is considered rental income?
      • What rental property expenses can I deduct?
    • Real Estate Pros

      • Are rental activities always passive activities?
      • Are there downsides to the real estate professional designation?
      • Are there specific material participation tests for real estate professionals?
      • Do I need to group my rental activities together?
      • How do I record the hours spent as a real estate professional?
      • If I meet the 750-hour test, do I also meet the 500-hour material participation test?
      • What activities count and don't count?
      • What are some of the IRS tricks to deny my real estate professional designation?
      • What are some of the tax court cases for real estate professionals?
      • What are the general tests for material participation?
      • What is active participation versus material participation?
      • What is the definition of real estate professional?
      • Why designate myself as a real estate professional?
  • Other Tax Information KB

    • Audits

      • Can I ignore an IRS notice or claim I never received it?
      • How can I pay my taxes or my notice of deficiency?
      • How can I prepare for my face to face or interview field audit?
      • How do I appeal the collections of unpaid taxes?
      • How does a joint return get handled during an audit?
      • How does bankruptcy affect my unpaid taxes?
      • How much is interest and penalty on taxes owed?
      • How should I respond to an IRS notice or letter?
      • What are my chances of being audited?
      • What are some of the types of IRS notices and letters?
      • What can the IRS do if I don't pay my taxes- what is the collections process?
      • What causes or triggers an IRS audit?
      • What if I cannot pay my taxes?
      • What IRS publications deal with audits?
      • What is the appeals process?
      • What is the period of limitations for an audit?
      • What types of audits could I face?
      • Who can be with me at my IRS audit or conference?
    • Charitable Contributions

      • Are there ways to earmark money for an individual?
      • Do I need receipts for my donations?
      • Does deducting charitable contributions cause an audit?
      • How do I determine the value of my donation?
      • What are some of the donations I can deduct?
      • What are some other charitable deductions?
      • What are the limits of my donations?
      • Who qualifies as a charity?
      • Why give to charities?
    • Education, Tuition Deductions

      • Are Educational Savings Accounts Worth It
      • Are There Tax Breaks for Going to College
      • Are There Tax Savings When My Employer Pays for My Education
      • Can I deduct the cost of sports, games or hobbies while in college?
      • IRAs and Savings Bonds To Help With Higher Education Costs
      • What College Expenses Can I Deduct From My Income
      • What constitutes a full-time student for tax purposes?
    • Homes and Real Estate FAQs

      • Can I deduct the loss on my primary residence?
      • Can I deduct the taxes associated with public improvements?
      • Can I exclude the gain on my home sale?
      • How does a Federal Disaster affect my casualty loss?
      • My home was destroyed- what deduction can I take? How do casualty losses work?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What are the rules on a home office deduction?
      • What is Cancellation of Debt? Is it taxable income?
    • Medical, Health Insurance

      • What are qualified medical expenses?
      • Why can't I deduct health insurance premiums?
    • Mortgages, Bad Debts

      • Can I deduct a bad debt on my tax return?
      • Can I deduct the loss on my primary residence?
      • Is cancellation of debt always taxable?
      • The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
      • What is Cancellation of Debt? Is it taxable income?
    • Recordkeeping

      • Are there specific records I need to keep?
      • Do I need receipts for my expenses?
      • How does proper recordkeeping affect my audit results?
      • How long do I have to keep records?
      • How should I maintain my tax records?
      • What are the requirements for mileage records?
      • Why should I keep tax records?
    • General Tax Questions

      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • If my employer provides a cell phone, is that income?
      • Tax Brackets Misconceptions- Should I earn more money?
      • What is the marriage penalty and how does it affect our tax returns?
  • Small Business KB

    • Small Biz FAQs

      • Hobby Versus Business

        • 3 out of 5 Test
        • Hobby Versus Business Testing
        • Philosophy of Business Losses
        • Private Track Coach Deducts Business Losses for Eight Years, Court Says OK
        • WCG (formerly Watson CPA Group) Philosophy on Hobby Losses
      • Independent Contractors

        • Behavioral Control
        • Colorado's Criteria for Contractor Status
        • Employee or Independent Contractor
        • Employee or Independent Contractor Status
        • Financial Control
        • IRS Determination, Form SS-8
        • Misclassified Workers Can File Social Security Tax Form
        • Salespeople As Contractors
        • Sample Response to CO Unemployment Claim
        • Statutory Employee and NonEmployees
        • Tax Court's Checklist
        • Type of Relationship
      • LLC and S-Corps (superseded)

        • As a one-person show, should I still form an LLC? An S-Corp?
        • Automobiles and LLCs, S Corps (superseded)
        • Can I call my 1099 other income which avoids employment taxes?
        • Determining the S-Corp Payroll Amount
        • Estimated Tax Payments, Withholdings Issues for an S-Corp
        • How do I convert my LLC to an S-Corp?
        • How does an LLC or S-Corp's income affect my taxes?
        • If the S-Corp taxation is what I ultimately want, should I form an LLC or C-Corp?
        • Is there a way to avoid Self-Employment tax?
        • Should I convert my LLC to an S-Corp (Sub-S Election)?
        • Should I form an LLC with my spouse?
        • The S-Corp Grind, Operational Hassles
        • The Zero Dollar Paycheck
        • What are the operational hassles of an S-Corp LLC?
        • What is an Accountable Plan?
        • The Money Trail for S-Corp Elections
        • 185 Reasons NOT to S-Corp, Downsides to S-Corp Election
      • Can I call my 1099 other income which avoids employment taxes?
      • Can I deduct country club dues as a business expense?
      • Can I deduct internet expenses?
      • Can I deduct my cell phone charges?
      • Health Care Expenses, Premiums, HRAs, HSAs - Section 105
      • Hobby Versus Business Article
      • How can I avoid or reduce Self-Employment (SE) taxes?
      • If I am a self-employed ExPat, what taxes am I responsible for?
      • If my employer provides a cell phone, is that income?
      • LLCs and S-Corps
      • Retirement Planning within an S-Corp
      • S-Corp Hard Money Facts, Net Savings
      • Turn Your Vacation Into a Tax Write Off
      • What are tax issues with an LLC owning a rental property?
      • What are the rules on a home office deduction?
      • What business or corporate expenses can I deduct?
      • What do I do with a 1099-K?
      • What is the difference between a hobby and a business?
      • What is the difference between an LLC, S-Corp and a C-Corp?
      • Why can't I deduct health insurance premiums?
  • Archive

    • Articles coming soon
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  • WCG
  • Taxpayers Guide to LLCs and S Corps
  • Chap 2 - Customized Entity Structures
  • Your Spouse as a Partner (Happy Happy Joy Joy)
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Your Spouse as a Partner (Happy Happy Joy Joy)

adding your spouseBy Jason Watson, CPA
Posted Sunday, December 29, 2024

You might be in 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 like Lone Wolf McQuade (first Chuck Norris reference) and don’t see that ever changing. Now the remaining situation allows for a fork in the road- either to add a partner now as you form your business or later after things stabilize a bit. Regardless of having a choice or your spouse allowing you to believe that you do, you contemplate adding your spouse as if it was your idea all along.

Married Couple as Owners

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 scenarios at play here. First, adding your spouse as an owner and second, adding your spouse to payroll as an employee only. 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. While those scenarios are commonly combined, it remains a choice, and each has very specific objectives.

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). This is getting less and less lucrative.
  • 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 small business is still a marital asset in most jurisdictions and as such will be part of any divorce action regardless.

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

Back to business; 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-

  • 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. 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. 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.

Please recall that a K-1 is the byproduct of a pass-through entity tax return which summarizes various business activities that are later presented on the owners’ individual tax returns (Form 1040).

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? Sure, an S Corp election solves the issue above, but here is an alternative that saves you some tax preparation fees since you avoid the partnership tax return but remains “tax expensive-“

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 business activities are then reported on Schedule C 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 (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 $176,100 of income (for the 2025 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. Read that last tidbit again. As mentioned just a bit ago, splitting up your income might actually increase your overall tax liabilities. Remember grammar school; may is permissive and might refers to chance. You may go to the bathroom. It might rain today. It’s a bit laughable when flight attendants state that your nearest exit may be behind you as if the exit submitted a proposal for its desired location. Oh well.

Back to more business; two scenarios to drive home this point-

  • Scenario A- The business earns $300,000 in net income after expenses (profit). You pay Social Security taxes up to $176,100 for the 2025 tax year, and Medicare taxes on the whole amount.
  • Scenario B- The business earns $300,000 in net income. You and your spouse pay Social Security taxes up to $150,000 each if your spouse is also a member or partner in the business, or about $17,000 in unnecessary taxes which is cash out of your pocket. (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. This is the 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

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. 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 (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 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. 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 have to 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.

Reduced Salary

Assuming an S corporation, 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 shifting 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.

Net-Net Spouse Summary

Again, assume an S Corp. 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 expanding business tax deductions such as business meals, and adding contributions to solo 401k plans. What does that get you in terms of money? At a 24% marginal tax rate, if you were to reduce taxable income by $10,000 because of additional business deductions, you save $2,400.

Therefore, 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. By the way, a solo 401k plan is available to a married couple team which is contradictory to the word solo… unless you both have one heartbeat and all that mushy stuff T-Swift sings about.

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. Thumb through your family expenditures and see if you could have attached a business purpose them.

Married Couple Problems

Staying with the S Corp version of adding your spouse as an owner, 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.

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. Over the past several years, however, ownership rules are loosening in all professions. For example, the medical industry has learned that doctors make lousy business administrators and are allowing medical practices to leverage smart Harvard MBA types to run the business.

Here is another example; in Colorado a non-CPA can be an owner of a CPA firm, but the majority (51%) must be CPA’s. There are also supervisory and control rules as well. This is a reflection of the times since CPA firms are now offering so many services such as software implementation and real estate consulting. To say that a person cannot be a partner because he or she does have a CPA credential but yet are very valuable to the success of the firm is not equitable.

The overall theme is to double check with your local regulatory agencies first.

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. 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, got you to class or work on-time, etc.

Business valuations for divorces sounds like fun, doesn’t it? A real hoot. WCG 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.

Jason Watson, CPA, is a Senior Partner of WCG CPAs & Advisors, a boutique yet progressive tax, accounting
and business consultation firm located in Colorado serving small business owners and taxpayers worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

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