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Entity Selection and Tax Considerations for Spouses Co-Owning a Business

July 2017

By Erick Cutler

Spouses who are used to doing everything together may find that it’s not so simple to start a business together. From taxes to Social Security to protecting yourself in the event of a divorce, how you plan your business structure is just as important as how you plan the other aspects of your business.

Selecting Your Business Entity Type

Solo business owners often choose to use less formal types of business structures rather than incorporating. Married couples have similar choices but need to consider additional factors.

1. Sole Proprietorships 

A sole proprietorship is a business with a single owner who reports the profits and losses on his or her own tax return. The problem with a sole proprietorship for married couples is that there can only be one official owner. The couple is free to split the profits as they choose, but the business’s earnings must be reported under a single spouse’s name. This means that only one spouse gets credit for Social Security and Medicare contributions unless the couple takes the extra step of making the other spouse an employee and paying payroll taxes.

From a legal standpoint, the designated owner would be considered to be in charge and able to overrule the other spouse on any business decisions. In a divorce, a judge deciding who should remain in control of the business or how to divide the business’ assets may favor the designated owner over the spouse who was “just an employee.”

2. Single-Member LLC

A single-member LLC gives increased liability protection over a sole proprietorship. As a general rule, an LLC owner is not personally liable for business debts and, for example, could generally not lose his or her house in a lawsuit against the business. This includes all of the LLC owner’s personal property whether it is owned individually or as part of a marriage, so the liability protections effectively cover both spouses even if only one is an owner of the LLC.

From a tax standpoint, a single-member LLC has many of the same problems as a sole proprietorship. Single-member means that only one spouse is the designated legal owner of the LLC. The other spouse would not have the authority to make business decisions or receive credits for Social Security or Medicare unless the spouse was on the payroll as an employee.

3. Partnership

partnership is similar to a sole proprietorship but with multiple legal owners. The key difference is that both spouses can be considered owners with equal legal authority. Both may also personally claim business profits or losses on their tax return. This allows both to receive Social Security and Medicare credits on business earnings without either having to be designated as an employee.

The downside is an additional tax reporting burden. A partnership must file its own tax return on Form 1065. Each spouse would then report their share of the profits and losses on Schedule K-1. This process is significantly more time-consuming and often more costly than filing a Schedule C for a sole proprietor.

4. Qualified Joint Venture

qualified joint venture is a special tax provision that allows spouses to file business taxes as if they were sole proprietors. Rather than forming a partnership and completing a partnership tax return, the spouses may each report their own share of the profits and losses on a Schedule C.

To qualify, the business

  • can’t be a corporation,
  • can’t have owners other than the married couple, and
  • must have both spouses actively involved in managing the business.

LLCs are generally also excluded from using this provision. However, in community property states such as Texas, the IRS allows an LLC owned only by a married couple to elect to be taxed as a qualified joint venture.

More on Community Property

The legal ownership of a business also impacts each spouse’s rights to the business during a divorce. If one spouse is the single owner and the other is an employee, a judge in an equitable property division state might find it appropriate to award the owner all or substantially all of the business and find that the employee is entitled to only what’s within the terms of their employment agreement. In a community property state, both spouses are generally considered to equally own all of their property even in a situation where a business is only in a single spouse’s name.

Texas is a community property state, but special provisions may apply if your business is registered in another state, you used to live in another state or you move to another state. You should discuss these legal issues with an attorney to ensure that both you and your spouse are properly protected.

Additional Tax Considerations

The IRS interprets the tax law using a rule known as “substance over form.” This means how you operate your business can override how you structure it on paper. If the tax treatment you choose requires both spouses to be actively involved in the business, you must be able to prove that they both actually are. Similarly, if you pay one or both spouses a salary, that salary must be reasonable for the work performed.

If the IRS finds that you are breaking the substance over form rule and underpaid your taxes, you may be subject to back taxes, interest, and penalties on your last three to six years’ worth of tax returns depending on the severity of the underpayment.

To ensure that your business is structured properly in a way that minimizes your tax burden while remaining in compliance with the tax code, talk to an experienced tax advisor before you make any decisions.

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article. 

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