Spouse-Run Businesses Have Unique Tax Challenges

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Do you and your spouse run a successful unincorporated small business together? If so, you face some challenging tax issues.

The partnership issue for spouse-run businesses

An unincorporated business with your spouse is classified as a partnership for federal income tax purposes, unless you can avoid that treatment. If not, you must submit a Form 1065 annual partnership return. Additionally, separate Schedule K-1s must be issued to you and your spouse, which divide the partnership’s taxable income, deductions, and credits between the two of you. The unpleasant responsibilities associated with tax compliance have just begun.

The issue with self-employment taxes

The government collects Social Security and Medicare taxes from self-employed people through the SE tax. The SE tax for 2023 consists of a 2.9% Medicare tax on top of a 12.4% Social Security tax on the first $160,200 of net SE income. Your 2023 net SE income will no longer be subject to Social Security tax once it reaches the $160,200 cap. However, if the total net SE income of a married couple filing jointly exceeds $250,000, the 2.9% Medicare tax component continues before rising to 3.8% — thanks to the additional 0.9% Medicare tax — if so.

You must submit a Schedule SE with your joint Form 1040 in order to compute SE tax on your portion of the net SE income that your spousal partnership transferred through to you. The return must also include a Schedule SE for your spouse to calculate the tax on your spouse’s share of net SE income passed through to him or her. A significant SE tax bill may result from this.

Let’s imagine, for illustration purposes, that your successful 50/50 partnership business will generate net 2023 SE income of $150,000 for each of you (a total of $300,000). Your joint tax return’s SE tax totals a staggering $45,900 ($150,000 multiplied by 15.3% times two). That’s on top of regular federal income tax.

Tax reduction strategies for spouse-run businesses

Strategy 1: Utilize a technique authorized by the IRS to reduce SE tax in a state with community property.

According to IRS Revenue Procedure 2002-69, a community property state’s unincorporated spousal business can be treated as a sole proprietorship run by one of the spouses for federal tax purposes. Only the first $160,200 of net SE income is subject to the 12.4% Social Security tax as a result of effectively assigning all net SE income to the proprietor spouse. This may lower your SE tax liability.

Strategy 2: Pay modest compensation and convert a spousal partnership into a S corporation.

Consider changing your unincorporated spousal business to an S corporation if you and your spouse don’t live in a state that recognizes community property in order to pay less in Social Security and Medicare taxes. In this method, the Social Security and Medicare tax, also known as the FICA tax, is only applied to the salaries that you and your spouse get. Then, as shareholder-employees, you and your spouse can get small but appropriate salaries while receiving the majority of the remaining business cash flow as FICA-tax-free cash distributions.

Strategy 3: The third option is to dissolve your partnership and hire your spouse on as an employee.

You can dissolve the current spousal partnership and begin operating as a sole proprietorship. After that, hire the other spouse to work for the proprietorship and pay them a modest cash salary. To satisfy the employee-spouse’s portion of the Social Security and Medicare taxes, 7.65% of the wage must be withheld. Additionally, 7.65% of the taxes owed by the employer must be paid by the proprietorship. However, because the employee-spouse’s pay is low, the FICA tax will be too.

With this method, you just submit one Schedule SE with your joint tax return—for the spouse who is being treated as the proprietor. Because just $160,200 (for 2023) is subject to the 12.4% Social Security share of the SE tax, this minimizes the SE tax.

Discover tax-saving methods for spouse-run businesses

Having a profitable unincorporated business with your spouse that’s classified as a partnership for federal income tax purposes can lead to compliance headaches and high SE tax bills. Together, let’s decide on the best tax-saving measures.