Husband-Wife Partnerships: The Tax Angles
When both members of a married couple participate in an unincorporated business venture, must it be treated as a husband-wife partnership for federal tax purposes? Answer: maybe, or maybe not. Figuring out the answer is important because it can have a huge impact on the couple’s self-employment tax situation.
Husband-wife partnerships must also file annual federal returns on Form 1065 along with the related Schedules K-1. As you know, partnership returns can be a pain. For these reasons, you generally want to avoid husband-wife partnership status when possible.
When Does the Husband-Wife Partnership Actually Exist for Tax Purposes?
Good question. As you can see from the preceding example, the self-employment tax can make the husband-wife partnership an expensive proposition. Of course, the IRS would love it if you had to treat it that way.
Not surprisingly, several IRS publications attempt to create the impression that involvement by both spouses in an unincorporated business activity usually creates a partnership for federal tax purposes.
IRS Publication 334 (Tax Guide for Small Business) says the following:
If you and your spouse jointly own and operate an unincorporated business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement.
In other words, you don’t have to believe that you have a husband-wife partnership to have a husband-wife partnership for tax purposes.
Similarly, IRS Publication 541 (Partnerships) says:
If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065.
But in many (if not most) cases, the IRS will have a tough time prevailing on the husband-wife partnership issue. Consider the following direct quote from IRS Private Letter Ruling 8742007:
Whether parties have formed a joint venture is a question of fact to be determined by reference to the same principles that govern the question of whether persons have formed a partnership which is to be accorded recognition for tax purposes. Therefore, while all circumstances are to be considered, the essential question is whether the parties intended to, and did in fact, join together for the present conduct of an undertaking or enterprise.
The following factors, none of which is conclusive, are evidence of this intent:
In many (if not most) real-life situations where both spouses have some involvement in an activity that has been treated as a sole proprietorship, or in an activity that has been operated using a disregarded single-member LLC that has been treated as a sole proprietorship for tax purposes, only some of the five factors listed in Private Letter Ruling 8742007 will be present. Therefore, in many such cases, the IRS may not succeed in making the husband-wife partnership argument.
Regardless of the presence or absence of the other factors listed above, the husband-wife partnership (LLC) argument is especially weak when (1) the spouses have no discernible partnership agreement and (2) the business has not been represented as a partnership to third parties (for example, to banks and customers).
C corporations cause double taxation for business owners, so you probably think you want to avoid them at all costs.
And for many of you, this is true, as the S corporation often provides the lower overall tax outcome.
But for some of you, the C corporation could provide the best tax outcome because it bypasses the $10,000 state and local tax (SALT) deduction cap, which was introduced by the Tax Cuts and Jobs Act (TCJA).
Prior to the TCJA, you could deduct as itemized deductions on your Form 1040, Schedule A—without limit—the following foreign, state, and local taxes:
Tax reform took two direct actions against your Form 1040 itemized deductions for foreign, state, and local taxes. Beginning in tax year 2018,
If you operate your business as an S corporation, the S corporation passes its net income to your individual tax return. This causes you, the individual, to pay state income taxes on the S corporation income. Those state income taxes are subject to the $10,000 cap.
C Corporation Loophole
But there is an exception: This $10,000 limit applies only to individuals—meaning, taxes deducted on your Form 1040, Schedule A. The limit does not apply to C corporations.
If you operate your business as a C corporation, then your C corporation pays state income taxes on its net income and deducts those taxes on its corporate income tax return.