Tax Considerations for Small Businesses Jointly Owned by a Husband and Wife

The purpose of this short tutorial is to answer a question that many encore entrepreneurs are likely to face. Let's imagine that you and your spouse decide to start a business together, a joint venture between the two of you.

Fast forward, then, to tax season. How do you report the income from your business? Since you and your spouse may be filing a joint return, and since both of you have income from the business, which of you should report the income from the business? And how should it be reported? The answer is, "It all depends." Historically the IRS treated any husband-wife joint venture (other than a corporation) as a partnership. This included LLCs owned jointly and entirely by a husband and wife. Even if your never formed an LLC or drafted a partnership agreement, your mere agreement to do business together makes you a partnership in the eyes of the courts. And IRS treated you accordingly. (See more on this in our tutorial on partnerships.) Because your business was viewed as a partnership, it had to file Form 1065 (the annual information return required of all partnerships). The business also had to issue both the husband and wife a K-1 showing their portion of the partnership income. When the couple filed their 1040, they attached separate Schedule Es reporting their respective share of company profits.

Qualified Joint Ventures

Today another option is available for many couples. IRS rulings in 2002 and a Congressional law in 2007 have granted them greater latitude in reporting income from a jointly owned business which is neither a corporation, an LLC, nor a limited partnership. The net effect of these changes has been to create what is known as a "qualified joint venture," (or QJV). A QJV is not a legal entity, but rather a classification for tax purposes. Under the new rules, the two parties in any qualified joint venture can opt to file income taxes as sole proprietors. This permits them to report their business income on Schedule C rather than Schedule E. Why would they choose to do so? Because it exempts them from the more cumbersome record-keeping and filing procedures for partnerships. No longer do they have to file a 1065. And there is no longer a need for the business to issue K-1 earnings statements. Moreover, it is commonly conceded that completing a Schedule C is far less daunting than completing a Form 1065. No special paperwork is required to be treated as a qualified joint venture. Simply report the company's earnings on Schedule C and the classification is triggered automatically. Once made, the decision to be treated as a QJV is quasi-permanent. That is, you cannot choose this option one year, not the next, then again the next. Reverting to partnership filings is only possible in years when, for whatever reason, the company does not qualify as a QJV.

Eligibility Criteria for Filing as a Qualified Joint Venture

Not every husband-wife business can meet the criteria which the IRS requires of a qualified joint venture. Husbands and wives who have incorporated their business cannot qualify. Neither can a husband-wife partnership other than a general partnership. This then rules out couples whose business is a limited partnership or some form of a limited liability partnership. Also excluded is any company whose revenue is primarily from passive income, such as owning rental properties. To be eligible for QJV status, a company must actively produce and market a product or service, Limited liability companies (LLCs) are a special case under these new provisions. Fundamentally LLCs are excluded from exercising the QJV option. But there is an exception for LLCs in community property states. (At present these states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.) In community property states, an LLC has the same opt-in privileges as a husband-wife general partnership. In summary, then, here are the conditions that determine whether a business has the QJV option:

1. The business must not be a corporation, either C-Corp or S-Corp.
2. If the business is a partnership, it must be a general partnership.
3. Except in community property states the business cannot be an LLC.
4. The husband and wife must be the only owners of the business.
5. They must file a joint income tax return.
6. Both of them must participate materially in the running of the company (under the IRS's definition of material participation)
7. They must individually agree to forego treatment as a partnership, a requirement which is fundamentally met by both of them filing a personal Schedule C.

Once a couple chooses QJV status, the income and expenses of the business are allocated between them, much as in a general partnership. Then, when completing their 1040, they file separate Schedule Cs reflecting this allocation. If this apportionment creates a self-employment liability for either or both parties, the affected party files a Schedule SE for himself or herself. Each party's Schedule C income from the business also determines whether that person is eligible (and the extent of the eligibility) to contribute to company-related retirement programs. (It may also limit any retirement contribution made by the company on the individual's behalf.) If the party in question has no income apart from the company, his or her Schedule C income will also determine the maximum contribution possible to personal IRAs (other than Roths), SIMPLEs, and SEPs.

Special Filing Considerations

There are certain considerations to take into account when filing taxes under the QJV provisions. Since both parties are now filing as sole proprietors, they are not required to have a Federal Employer Identification Number (FEIN). Instead, like sole proprietors, they can file their Schedule C using their personal social security number. There are exceptions to this rule, however. Sole proprietorships must have an FEIN if they are required to file excise, employment, alcohol, tobacco, or firearms returns. This same requirement extends to QJVs. So if the QJV has employees other than the owners themselves, an FEIN is likely required. And both parties should obtain one individually if they are going to apportion employee salaries or expenses between them. The two parties in the qualified joint venture will then use their personal FEIN when completing their Schedule C. (Of course, even if the company has only owner-employees, these same FEIN procedures must be followed if the company is subject to excise, alcohol, tobacco, or firearms returns.) For a business that has previously filed as a partnership, the company should have already obtained an FEIN. When filing under the QJV option, neither party should use this existing FEIN to file a Schedule C. The existing FEIN should be reserved exclusively for the partnership, to be used for filings which may be required in the future should the company lose its QJV eligibility. Other special considerations can be found on this IRS web page.

A Caution for Startups

It's not unusual for people to move into business ownership having no prior experience with business law, particularly business tax law. If they are not careful, they can unwittingly take actions that have far-reaching effects that they never intended. One of these potential pitfalls is in the way a husband-wife business reports income on a Schedule C. As we have noted, to take advantage of the QJV provisions, both parties should file a Schedule C. However, a new husband-wife startup — especially one with limited income — might see no harm in simplifying the filing process by having only one party file a Schedule C. In essence, all of the company's income and expenses on being reported on this single form. The problem with this approach is three fold. First, it violates the QJV filing requirements, which specifically state that both the husband and wife should file a Schedule C. Second, the non-filing party forfeits any social security and Medicare credits for the year based on personal income from the business. Since there is a one-to-one relationship between Schedule C and Schedule SE, only the filing party will be able to pay self-employment tax on company earnings. You cannot file self-employment tax for two people on the same Schedule SE. The result is that the filing party lays claim to all of the social security and Medicare contribution credits which business profits have created for that filing period. A third unintended consequence is that the non-filing party cannot use earnings from the company to establish eligibility for contributions to personal IRAs (other than Roths), SIMPLEs, or SEPs. (The non-filing party is still eligible for a spousal IRA based on the other person's income.) This same exclusion from participation also applies to any company-sponsored retirement program, such as a 401K, that the non-filing party would otherwise be eligible for.