For many spouses who run a profitable, unincorporated small business together, filing taxes can be confusing.
Here are some of the most common challenges to look out for.
Classification: the partnership issue
In many cases, the federal government classifies unincorporated businesses owned by two spouses as a partnership. This means you’ll need to file an annual partnership return on Form 1065.
In order to allocate the partnership’s taxable income, deductions, and credits, you and your spouse must also both be issued separate Schedule K-1s.
Once that paperwork is covered, you should also expect to complete additional compliance-related tasks.
Calculating self-employment (SE) tax
The government collects Medicare and Social Security taxes from self-employed people via self-employment (SE) tax.
This year, you should expect to owe 12.4% for Social Security tax on the first $160,200 of your income, as well as an additional 2.9% Medicare tax.
Beyond that $160,200 ceiling, you won’t owe additional Social Security tax. But the 2.9% Medicare tax component continues before increasing to 3.8%—thanks to the 0.9% additional Medicare tax—if the combined net SE income of a married couple that files jointly exceeds $250,000.
You must include a Schedule SE with your joint Form 1040 to calculate SE tax on your share of the net SE income passed through to you by your spousal partnership. In addition, you’ll need to submit a Schedule SE for your spouse to calculate their share of net SE income.
All in all, this can result in a larger SE tax bill than you might expect.
For example, say you and your spouse each have a net SE income of $150,000 ($300,000 total) in 2023 from your profitable 50/50 partnership business. The SE tax on your joint tax return is a whopping $45,900 ($150,000 x 15.3% x 2). That’s on top of regular federal income tax.
Potential tax saving solutions
Option 1: Minimize SE tax in a community property state via an IRS-approved method
IRS Revenue Procedure 2002-69 allows you to treat an unincorporated spousal business in a community property state as a sole proprietorship operated by one of the spouses for tax purposes.
This allocates all of the net SE income to one spouse, so that only the first $160,200 of net SE income from your business will be subject to the 12.4% Social Security tax.
This can dramatically reduce your SE tax bill.
Option 2: Make your business into an S-Corp that pays you and your spouse modest salaries as shareholder-employees
If you don’t live in a community property state, you still have options. By converting your business to an S-Corporation, you can lessen the amount of Social Security and Medicare taxes you’ll owe.
Only the salaries paid to you and your spouse will be hit by the Social Security and Medicare tax, collectively called FICA tax. From there, you can pay out most or all remaining corporate cash flow to yourselves as FICA-tax-free cash distributions.
Option 3: End your partnership and hire your spouse as an employee
For some couples, running the operation as a sole proprietorship operated by one spouse may make more sense than continuing with a spousal partnership.
In this scenario, you’d hire your spouse as an employee of the proprietorship with a modest cash salary and withhold 7.65% of that salary to cover their share of the Social Security and Medicare taxes. The proprietorship must also pay 7.65% as the employer’s half of the taxes.
As long as the employee-spouse’s salary is modest, the FICA tax will also be modest.
With this strategy, you file only one Schedule SE with your joint tax return (for the spouse treated as the proprietor). A maximum of $160,200 (for 2023) will be exposed to the 12.4% Social Security portion of the SE tax.
Questions? Smolin can help.
If you’re looking for tax-saving strategies for your small business, contact Smolin. We’ll help you determine how to minimize compliance headaches and high SE bills so you can get back to running your business with less tax-induced stress.