If you and your spouse own a business together, you are supposed to file a partnership tax return with the IRS. There is no tax due at the partnership level, the profit or loss flows out on a Schedule K-1 to your individual income tax return where it is combined with other sources of taxable income and deductions then ultimately taxed.
However, what usually happens is that one spouse claims the income and expenses from the business on Schedule C of Form 1040. Because there is only one slot for a Social Security number on Schedule C and Schedule SE, only one spouse receives funding to his or her Social Security and Medicare accounts. The other spouse is shortchanged for all those years of hard work.
For tax years beginning after Dec. 31, 2006, the Small Business and Work Opportunity Tax Act of 2007 (Public Law 110-28) provides that a “qualified joint venture,” whose only members are a husband and a wife filing a joint return, can elect not to be treated as a partnership for Federal tax purposes. Your business qualifies for this election if:
- the husband and wife are the only two partners;
- both spouses materially participate;
- the spouses file a joint tax return;
- both spouses agree to the election.
A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners. A business held in the name of a state law entity, including a limited partnership or limited liability company, does not qualify for the election.
Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. We’re talking rental real estate for the most part. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse's interest in the business. Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.
The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules).
If the election is made, both spouses file a Schedule C declaring their percentage of income and expenses. The profit then flows out to separate Schedules SE where the self-employment tax is calculated and credited to each spouse’s Social Security and Medicare accounts.
There may be legal reasons to not make the election. Perhaps your attorney has advised that you maintain a bona fide partnership and file partnership tax returns. Check with your attorney and tax pro before deciding whether or not to make the election. Also note that you may or may not save a bit in tax preparation fees. You may escape partnership tax return preparation fees, but don’t think you’ll necessarily save any money. After all, It may require more work and therefore be more expensive for your tax pro to manually allocate the income and expenses according to the partner percentages and prepare two Schedules C. Preparing a partnership return is far simpler. You input the data and the partners’ percentages and the tax software allocates accordingly.
No EIN (Employer Identification Number) is required for sole proprietorships. But If you have an EIN and have been filing partnership income tax returns then make the election, you will likely receive a letter from the IRS asking for your Form 1065, partnership income tax return. Simply call the number on the notice or write a letter to the address listed and inform them that you have made the election and have filed two Schedules C. The EIN remains intact in case there are years in which you do not qualify under the election.
Once you make the election, it can only be revoked with the permission of the IRS.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know." Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.