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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.
Example: Self-employment Tax Hit on Profitable Husband-Wife Partnership
Your husband-wife partnership will produce $250,000 of net self-employment income in 2020 (after applying the 0.9235 factor that reduces net income to taxable self-employment income on Schedule SE).
Assume the $250,000 is properly split 50/50 between you and your spouse ($125,000 for each). You owe $19,125 of self-employment tax (15.3 percent x $125,000), and so does your spouse, for a combined total of $38,250.
The problem with husband-wife partnership status in your situation is that the maximum 15.3 percent self-employment tax rate hits $125,000 of net self-employment income not once but twice (first on your Schedule SE and again on your spouse’s separate Schedule SE).
In contrast, if you could say that your business is a sole proprietorship run only by you, only you would be on the hook for the self-employment tax.
You would pay the maximum 15.3 percent self-employment tax rate on the first $137,700 of your 2020 net self-employment income, but the self-employment tax hit would be “only” $24,325 [(15.3 percent x $137,700) + (2.9 percent x $112,300) = $24,325]. That’s a lot better than the $38,250 self-employment tax hit if your business is classified as a 50/50 husband-wife partnership.
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:
1. the agreement of the parties and their conduct in executing its terms;
2. the contributions, if any, that each party makes to the venture;
3. control over the income and capital of the venture and the right to make withdrawals;
4. whether the parties are co-proprietors who share in net profits and who have an obligation to share losses; and
5. whether the business was conducted in the joint names of the parties and was represented to be a partnership.
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).