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New Tax Rule for Married Business Owners
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July 7, 2008
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SAY YOU AND your spouse jointly own and operate an unincorporated business and share in the profits and losses. For federal tax purposes, you may have a husband-wife partnership on your hands — even if you don’t have a formal partnership agreement.
When you do have a husband-wife partnership, the general rule says you are supposed to follow the partnership tax rules. These include the requirement to file an annual Form 1065 partnership tax return and issue an annual Schedule K-1 to both you and your spouse. The Schedules K-1 report your respective shares of tax items from the business, which are then taken into account on your Form 1040. The same guidelines apply to a husband-wife LLC that’s classified as a partnership for federal tax purposes.
Unfortunately, partnership tax status can create headaches. The partnership tax provisions are complicated, and preparing Form 1065 and Schedule K-1 is no fun.
Thankfully, for 2007 and beyond, a special simplification rule allows an election out of partnership status — for federal tax purposes — for certain unincorporated husband-wife businesses (state tax rules may vary). To be eligible for the election out, you and your spouse must file jointly, and your husband-wife business must be a qualified joint venture (defined below).
For example, you would report income and expenses from an eligible husband-wife business (other than farming) on separate Schedules C filed with your joint Form 1040. You would report income and expenses from a farming activity on separate Schedules F. Similarly, you and your spouse must calculate your respective self-employment (SE) tax bills by filling out separate Schedules SE and filing them with your Form 1040. You and your spouse will then receive credit for your shares of SE income for Social Security benefit eligibility purposes.
Key Point: Electing out won’t change your joint federal income tax liability or your joint SE tax liability. However, electing out will eliminate the hassle of having to comply with complicated federal tax rules and file partnership returns with the IRS.
1. The husband and wife are the only members of the venture.
2. Both spouses materially participate in the venture.
3. An election out of partnership tax status is made for the venture in the manner explained above.
This seems pretty clear, but the waters can get muddy in real-life circumstances. Two recent developments provide some clarity on exactly what types of husband-wife businesses can be qualified joint ventures. One development is good news while the other is not. Good news first.
To make the election out for a rental real estate business, the IRS currently instructs you and your spouse to report your respective shares of income and expenses on separate Schedules C filed with your joint Form 1040. This is unusual, because income and expenses from rental real estate activities are typically reported on Schedule E (not on Schedule C). The distinction is important. Net income from a Schedule C activity is generally subject to SE tax and should be reported on Schedule SE. In contrast, net income from a Schedule E rental real estate activity is not subject to SE tax and should not be reported on Schedule SE.
Unfortunately, reporting your share of rental real estate income and expenses on Schedule C may cause the IRS to expect to see a related Schedule SE for you, as well as one for your spouse, even though no Schedules SE are actually required. To address this little problem, the IRS issued supplemental 2007 Form 1040 filing instructions. They can be found on page 15 of Publication 553 (available on the IRS web site). If you carefully follow the supplemental instructions, IRS personnel should know that no SE tax is due on net rental income that’s reported on your Schedule C or your spouse’s Schedule C.
Some tax experts (including me) think the IRS is dead wrong about this, but arguing the point is probably not worth it. If no partnership return is filed for a husband-wife LLC, the IRS could decide to assess a failure-to-file penalty. The penalty amount is $85 per month for each spouse for up to 12 months (or until a partnership return is filed). The maximum penalty is $2,040 ($85 x 2 x 12 = $2,040).
• A Tip for Small-Business Owners
When you do have a husband-wife partnership, the general rule says you are supposed to follow the partnership tax rules. These include the requirement to file an annual Form 1065 partnership tax return and issue an annual Schedule K-1 to both you and your spouse. The Schedules K-1 report your respective shares of tax items from the business, which are then taken into account on your Form 1040. The same guidelines apply to a husband-wife LLC that’s classified as a partnership for federal tax purposes.
Unfortunately, partnership tax status can create headaches. The partnership tax provisions are complicated, and preparing Form 1065 and Schedule K-1 is no fun.
Thankfully, for 2007 and beyond, a special simplification rule allows an election out of partnership status — for federal tax purposes — for certain unincorporated husband-wife businesses (state tax rules may vary). To be eligible for the election out, you and your spouse must file jointly, and your husband-wife business must be a qualified joint venture (defined below).
Electing Out of Partnership Status Means Simpler Tax Filings
After electing out of partnership tax status, you and your spouse must separately report your respective shares of business income and expense items on the appropriate IRS forms.For example, you would report income and expenses from an eligible husband-wife business (other than farming) on separate Schedules C filed with your joint Form 1040. You would report income and expenses from a farming activity on separate Schedules F. Similarly, you and your spouse must calculate your respective self-employment (SE) tax bills by filling out separate Schedules SE and filing them with your Form 1040. You and your spouse will then receive credit for your shares of SE income for Social Security benefit eligibility purposes.
How to Elect Out
Making the election out of partnership tax status is easy. Starting with the year that you want to elect out, you and your spouse must separately report your respective shares of income and expenses from the business and separately calculate your respective SE tax bills in the manner explained above. Also, you must stop filing partnership returns for the business. That’s it.Key Point: Electing out won’t change your joint federal income tax liability or your joint SE tax liability. However, electing out will eliminate the hassle of having to comply with complicated federal tax rules and file partnership returns with the IRS.
Only Qualified Joint Ventures Can Elect Out
A qualified joint venture is an unincorporated business activity that meets the following description.1. The husband and wife are the only members of the venture.
2. Both spouses materially participate in the venture.
3. An election out of partnership tax status is made for the venture in the manner explained above.
This seems pretty clear, but the waters can get muddy in real-life circumstances. Two recent developments provide some clarity on exactly what types of husband-wife businesses can be qualified joint ventures. One development is good news while the other is not. Good news first.
Rental Real Estate Business Can Be Qualified Joint Venture, but Beware of Tricky Tax Filing Instructions
The IRS recently admitted that an unincorporated husband-wife rental real estate business can meet the definition of a qualified joint venture and thus be eligible for the election out of partnership tax status. Previously, it was unclear if the election out was allowed for a rental real estate activity. So far, so good, but now it gets tricky.To make the election out for a rental real estate business, the IRS currently instructs you and your spouse to report your respective shares of income and expenses on separate Schedules C filed with your joint Form 1040. This is unusual, because income and expenses from rental real estate activities are typically reported on Schedule E (not on Schedule C). The distinction is important. Net income from a Schedule C activity is generally subject to SE tax and should be reported on Schedule SE. In contrast, net income from a Schedule E rental real estate activity is not subject to SE tax and should not be reported on Schedule SE.
Unfortunately, reporting your share of rental real estate income and expenses on Schedule C may cause the IRS to expect to see a related Schedule SE for you, as well as one for your spouse, even though no Schedules SE are actually required. To address this little problem, the IRS issued supplemental 2007 Form 1040 filing instructions. They can be found on page 15 of Publication 553 (available on the IRS web site). If you carefully follow the supplemental instructions, IRS personnel should know that no SE tax is due on net rental income that’s reported on your Schedule C or your spouse’s Schedule C.
IRS Says Husband-Wife LLC Cannot Be Qualified Joint Venture
Now for the bad news. In a recent article on its web site, the IRS says a husband-wife business that’s operated as an LLC and that’s currently treated as a husband-wife partnership for federal tax purposes does not meet the definition of a qualified joint venture. So electing out of partnership tax status is not allowed. Therefore, a husband-wife LLC must continue to follow the burdensome partnership tax rules and return filing requirements with no relief in sight.Some tax experts (including me) think the IRS is dead wrong about this, but arguing the point is probably not worth it. If no partnership return is filed for a husband-wife LLC, the IRS could decide to assess a failure-to-file penalty. The penalty amount is $85 per month for each spouse for up to 12 months (or until a partnership return is filed). The maximum penalty is $2,040 ($85 x 2 x 12 = $2,040).
The Bottom Line
When available, qualified joint venture status can be helpful for a husband-wife business, because it eases the task of complying with the federal tax rules. This article explains two recent developments on the qualified joint venture front — one regarding real estate, the other LLCs. As always, the IRS could change the rules (which might provide more relief for husband-wife LLCs) so stay tuned.
Bill Bischoff, a certified public accountant with more than 25 years of experience, has authored books and training courses for tax professionals, and frequently writes about consumer and small-business tax matters.
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