Do you and your spouse operate a profitable unincorporated small business together? If so, here are the tax issues you will face.
Unincorporated Business - The Tax Implications
1. Filing as a Partnership
An unincorporated business with your spouse is classified as a partnership for federal income tax purposes, unless you can avoid that treatment. Otherwise, you must file an annual partnership return, on Form 1065. In addition, you and your spouse must be issued separate Schedule K-1s, which allocates the partnership’s taxable income, deductions, and credits between the two of you.
2. Filing as Self-Employed (SE)
The SE tax is how the government collects Social Security and Medicare taxes from self-employed individuals. For 2023, the SE tax consists of 12.4% Social Security tax on the first $160,200 of net SE income, plus 2.9% Medicare tax. Once your 2023 net SE income surpasses the $160,200 ceiling, the Social Security tax component ends. However, the 2.9% Medicare tax component continues until it reaches 3.8% - which happens once the combined net SE income of a married joint-filing couple exceeds $250,000.
With your joint Form 1040, you must include a Schedule SE to calculate the SE tax on your share of the net income passed through to you from your spousal partnership. The return must also include a Schedule SE for your spouse to calculate the tax on your spouse’s share of net income. This can result in a big SE tax bill.
For example, let’s say you and your spouse each have a net 2023 SE income of $150,000 ($300,000 total) from your profitable 50/50 partnership business. The SE tax on your joint tax return will be calculated as ($150,000 x 15.3% x 2) = $45,900. That’s on top of regular federal income tax.
Unincorporated Business - The Tax Solutions
1. Minimize SE tax in a Community Property State
Under the IRS Revenue Procedure 2002-69, for federal tax purposes, you can treat an unincorporated spousal business in a community property state as a sole proprietorship operated by one of the spouses. By effectively allocating all the net SE income to the proprietor spouse, only the first $160,200 of net SE income is hit with the 12.4% Social Security tax. This can cut your SE tax bill.
2. Convert your Spousal Partnership into an S Corporation & Pay Modest Salaries
If you and your unincorporated spousal business aren’t in a community property state, consider converting the business to a S corporation to reduce Social Security and Medicare taxes. That way, only the salaries paid to you and your spouse will get hit with the Social Security and Medicare tax, collectively called FICA tax. You can then pay modest, but reasonable, salaries to you and your spouse as shareholder-employees while paying out most or all remaining corporate cash flow to yourselves as FICA-tax-free cash distributions.
3. Get Rid of your Partnership and Hire your Spouse as an Employee
You can disband the existing spousal partnership and begin running the operation as a sole proprietorship operated by one spouse. Then hire the other spouse as an employee of the proprietorship and pay your spouse a modest cash salary. Do note, you must withhold 7.65% from the salary to cover the employee-spouse’s share of the Social Security and Medicare taxes. The proprietorship must also pay 7.65% as the employer’s half of the taxes. However, since the employee-spouse’s salary is modest, the FICA tax will also be modest.
With this strategy, you file only one Schedule SE — for the spouse treated as the proprietor — with your joint tax return. That minimizes the SE tax, because no more than $160,200 (for 2023) is exposed to the 12.4% Social Security portion of the SE tax.
If you find yourself in this predicament, please consult your VAAS Pro Consultant. Ignore the headache and allow us to handle this process for you. Regardless the solution you choose, we are here to help process the paperwork and ensure you do not experience any tax implications, as listed above, on your 2023 tax returns. Begin working on your tax-saving strategies today!