Your Spouse as a Partner (Happy Happy Joy Joy)
By Jason Watson, CPA
Posted Tuesday, July 6, 2021
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. Now the remaining situation allows for a fork- either to add a partner now as you form your business or down the road. 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.
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 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.
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).
- Your spouse suggests it one lovely evening over dinner, and upon reflection of considerable collateral damage, you surrender.
We tricked you there in 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.
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 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 (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.
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.
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.
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. We 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 $142,800 of income (for the 2021 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… 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 $200,000 in net income. You pay Social Security taxes up to $142,800 for the 2021 tax year, 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. 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-
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 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 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 have to 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.
In a narrow reason exists, 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 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.
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. Say it isn’t so!
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).
According to IRS data for the 2016 tax year, 8.8 million 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). 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 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 (Form 1040) for the 2016 tax year for adjusted gross income between $50,000 and $200,000 was 0.4%, whereas $200,000 through $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. 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.
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 husband and wife 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.
Husband and Wife 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 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 accounting 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 fair.
The overall theme is to double check with your local regulatory agencies first.
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, 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.
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