Tip of the Month for March 2006

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TIP: Tackling the Self-Employment Tax Burden on Husband-and-Wife Business Owners
A married couple, whose partnership also involves running an unincorporated business together, face some special tax challenges. The way the federal self-employment tax (SE tax) currently operates leaves many married business owners with a double hit on their business revenue, resulting in SE tax bills greater than their federal income tax bills. There are some options that can help alleviate the tax burden, but in any of these situations it pays to consult your professional tax advisor before committing to any plan of action.

The problem
If you and your spouse operate your business as a partnership or a husband-and-wife Limited Liability Company (LLC), the IRS treats it as a partnership for federal tax purposes and requires you to file an annual Form 1065. Both spouses receive separate Schedule K-1’s on which the business income and deductions are split between both partners, who both then are likely to incur the maximum 15.3 percent SE tax rate on the first $94,200 of SE income (for 2006). The rate drops to 2.9 percent on income above $94,200. In this scenario, the household gets hit not once, but twice, with the maximum SE tax rate.

You might consider dismantling your current partnership arrangement and operating the business as a sole proprietor or as a single-member LLC. Once this is done, you can hire your spouse as an employee. Remember you will be withholding 7.65 percent from their wages, and paying the same amount as the employer to cover Social Security and Medicare taxes; so set a modest - but realistic - cash salary for your spouse.

You’ll realize two major tax savings from this approach:
  1. As sole proprietor, you will file just one Schedule SE, and you and your spouse will pay only the maximum SE tax rate on $94,200 worth of SE income (2006 numbers) once - a big improvement over paying the top rate on $188,400 (two amounts of $94, 200) if you and your spouse remained joint owners; and

  2. You can also take your spouse’s cash salary and your employer portion of Social Security and Medicare taxes as deductions on your sole proprietor’s Schedule C (filed with your joint Form 1040).
Another option, though more complex and more aggressive, is to operate as a husband-and-wife LLC that pays you and your spouse reasonable - but modest - guaranteed payments or fixed amounts at set intervals (e.g. monthly or quarterly). These amounts are not contingent on the business’s level of income. According to current IRS codes, limited partners owe SE taxes only on these guaranteed payments. Under this scenario, you also may withdraw random cash from the business, but be aware, it is very important that any such withdrawals are not so predictable as to suggest to the IRS that they, too, are guaranteed payments. Obviously, the expertise of a professional tax advisor is needed to evaluate each individual case in the light of current tax laws, precedents, and recent IRS attitudes to this particular strategy.

Bottom line: SE taxes can hit married business partners disproportionately hard. It makes sense for husband-and-wife owners to explore various strategies - with solid support in the tax code - to minimize their tax burden.


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