September 2003

Minimizing Social Security Taxes in Spousal Businesses

By Garo Kalfayan

Both spouses will usually work in a small, family-owned business and participate toward its success. Most spouses simply divide up the work without questioning how federal tax law will characterize their relationship with the business.

The tax issues regarding a spousal small business are usually secondary to the primary focus of making money. Also, for income tax purposes, the issue of which spouse is assigned the new business income is usually not relevant because most spouses file a joint income tax return where their income is combined.

For Social Security tax purposes, however, it may be important for the spouses to plan the nature of their participation before they actually launch a new business. Unlike income taxes, where the spousal income is usually combined through a joint return, the Social Security tax views each spouse as having their own self-employment income and Social Security tax obligation even when the spouses file a joint return.

Often, a new spousal business is initially started without a formal state filing because the spouses wish to determine the long-term viability of the business before incurring the cost and logistical burden of creating, and possibly terminating, such an entity. Even when their small business is not a distinct separate tax entity, planning spousal participation during the taxable year could be helpful, especially when one or both spouses continue their regular employment at their preexisting job.

Planning Strategies: One Spouse Exercises Control

If the business does not require both spouses to work on a continual basis, the spouses should plan for only the higher-earning spouse to work in the business as a sole proprietor. (As explained below, the IRS can reclassify a spousal sole proprietorship as a partnership if both spouses work in the business and the spouses fail to establish that the lower-earning spouse is an employee rather than a partner.) In the absence of a partnership, the net self-employment income from a spousal sole proprietorship is allocated solely to the spouse who carries on the trade or business. (Revenue Ruling 82-39, 1982-1CB 119, equates the treatment for community property spouses to that of non–community property spouses. See also Jones, 67 TCM 1194-230, p. 3000.) The same rule applies to spouses in community property states, where the income from a business is allocated solely to the spouse exercising substantially all of the management and control even though it may be community income.

Selecting only the highest-earning spouse to exercise substantially all the management and control may enable the couple to limit the overall Self-Employment Contributions Act (SECA) tax liability related to the new business income.

Example 1. Assume Husband and Wife are currently employed. Husband’s wages are $35,000 and Wife’s wages are $90,000. The spouses desire to operate a new business that they anticipate will generate net self-employment income of $50,000. If possible, the spouses should plan to have Wife exercise substantially all the management and control of the business and attribute the net self-employment income to her. Because she already has Federal Insurance Contribution Act (FICA) earnings in excess of the $87,000 (2003) Old Age Survivors & Disability Insurance (OASDI) limit, she would be taxed at only the Medicare Hospital Insurance (HI) rate rather than the full SECA rate. Any part of the $50,000 net self-employment income attributable to Husband would be subject to the full SECA rate because his FICA earnings are below the $87,000 OASDI limit.

If Husband provides more than nominal services to the business, the business may have to pay him a salary as an employee to have the allocation respected. (As explained below, if a participating spouse is not actually paid, the spouses risk equal reallocation of the net self-employment income. For occasional, noncontinuous services, such as consulting, the business may be able to argue that the nonowner spouse is an independent contractor, minimizing payroll paperwork. Even as an independent contractor, however, the recipient spouse will be required to pay SECA tax on receipts from the spousal business.)

Both Spouses Exercise Control

The taxpayer goal of allocating the new business income entirely to the spouse whose other earnings exceed the OASDI limit is probably not attainable when both spouses are actively working in their unincorporated business. The rulings in this area [Zampa, 60 TCM 1990-561; Gilreath, 57 TCM 1989-445; DiMauro, 347 F.Supp. 683, DC-DE (1972), 72-USTC 9508] provide that the spouses cannot allocate all the income to one spouse on a Schedule C when both spouses actively conduct the business. The courts have reallocated self-employment income to both spouses by finding that the spouses were conducting a partnership, not a sole proprietorship.

Example 2. Husband and Wife start a business. Both of their names are on suppliers’ documents and invoices, and the suppliers jointly list them on each
year’s 1099. Husband signs up new distributors while Wife controls product distribution, training, and bookkeeping. Although in essence the spouses represent themselves as joint operators of their business to suppliers, customers, and distributors, with each year’s tax return they file a Schedule C (sole proprietorship) that attributes all business income to Husband.

With facts similar to the above example, the Tax Court in Zampa reallocated the net self-employment income to both spouses, holding that the business was a partnership rather than a sole proprietorship. The Zampa court rejected the taxpayer’s argument that one spouse was the owner and the other an employee. The spouses did not provide any documentary evidence (no employment agreement, no payroll checks, no W-2 statements) to indicate that they intended Wife to be an employee rather than a partner.

When the courts recharacterize an unincorporated spousal business from a sole proprietorship to a partnership, they determine that the spouses are equal partners. Consequently, the income for SECA tax is allocated equally to each spouse.

An unincorporated business where both spouses actively work need not automatically be treated as a partnership, if proper evidence to the contrary exists. If the spouses desire sole proprietorship status, they should properly structure their business relationship so that only one spouse is the owner while the other spouse is an employee. The owner spouse documents to all third parties (including contracts, bank accounts, and governmental filings) that he or she is the sole owner. In addition, the business enters into an employment agreement with the employee spouse, pays wages to the employee spouse, and files all appropriate payroll returns.

For spouses that solely own an unincorporated business as community property, the IRS has expressly stated that it will respect the spouses’ treatment of a business as either a partnership or a sole proprietorship (Revenue Procedures 2002-69 and 2002-45, IRB 831). But merely acquiescing to the spouse’s initial filing as a sole proprietorship does not imply that the IRS will allow all the income to be allocated solely to the designated owner spouse when the other spouse is actively working in the business. If payments are not made to the employee spouse, the government should be able to attribute a salary (earnings) to that spouse. This effectively allocates the income for Social Security tax purposes to both spouses.

The question of whether an unincorporated spousal business is really a partnership or a sole proprietorship is less important than the premise that it is not reasonable to allocate all the self-employment income to one spouse when both spouses are actively conducting their business. In DiMauro, the court was willing to treat the wife as either a sole owner or an equal partner, as long as not all of the self-employment income was reallocated to the husband. The court acquiesced to the government’s position, which allocated the net self-employment income equally to each. For spouses that desire business treatment as a sole proprietorship, paying the employee spouse a salary from the outset can provide some control over the amount of income allocated to each spouse.

Example 3. Assume Husband and Wife are currently employed. Husband’s wages are $35,000 and Wife’s wages are $90,000. The spouses operate a new business that they anticipate will generate net self-employment income of $50,000. They both plan to work in the business; however, they structure their activities so it is clear to all third parties that Wife is the sole owner and that Husband is an employee. Assume Husband is paid a reasonable salary of $12,000, leaving the remaining $38,000 as Wife’s Schedule C self-employment income at year-end. (This ignores minor adjustments for other business payroll costs.) Consequently, only the $12,000 salary paid to Husband is subject to the full Social Security tax. The $38,000 net self-employment income attributable to Wife is limited to the SECA HI rate because Wife already has FICA earnings in excess of the $87,000 (2003) OASDI limit.

If Husband were instead to receive no salary, and the entire $50,000 was reported as Wife’s net self-employment income at year-end, they would risk, upon audit, that the government would successfully establish that the income should be allocated equally between Wife and Husband. Consequently, more of the business income would be taxed at the full SECA tax rate. (In a non–community property state, the spouses would be treated as equal partners. A community property state would probably treat the unpaid spouse as constructively receiving half of the business income as wages subject to FICA.)

Treating the Solely Owned Business as a Partnership

According to Treasury Regulations section 1.1402(a)-1(a)(2) and (b), a partner’s net earnings from self-employment include her distributive share of partnership business income and any guaranteed payments received for services.

According to Treasury Regulations section 1.1402(a)–8(b), when both spouses work in their solely owned business and file as a partnership, both spouses are treated as partners and are allocated their own portion of partnership income (distributive share). The issue is whether spouses who are the only partners can have unequal amounts of self-employment income or whether they are forced to share partnership profits equally. The family partnership rules of IRC section 704(e) and Treasury Regulations section 1.704-1(e) provide little guidance beyond reiterating that family member partners must receive reasonable allocations for provided services and capital.

The court in Zampa was not very receptive to the spouses’ argument that they had an unequal partnership. The spouses argued that the wife contributed substantially less effort to the business than her husband; therefore, were the court to recast their “sole proprietorship” as a partnership, the wife should be only a minor partner, with accordingly minor self-employment income. The court disagreed, stating, “Petitioners submitted no evidence to prove that the … [business’] profits were unequally divided between them, or that their roles were anything other than equally important.”

If audited, working spouses will probably not be able to establish that they are unequal partners if they originally allocated all self-employment income to one spouse as a sole proprietorship. At the outset of the business, however, the spouses should be able to plan on being partners where they have an unequal allocation of partnership income.

At the outset of a spousal business, the spouses could enter into a written partnership agreement limiting the role and duties of one spouse and expanding the role and duties of the other. The agreement could also provide for guaranteed payments to the higher earning spouse. This planning would provide preaudit documentary evidence that the spouses had different roles, much like an employment agreement in a spousal sole proprietorship. By actually making periodic guaranteed payments to the higher-earning spouse, the spouses are reaffirming their position that the higher-earning spouse is actually providing a greater contribution to the success of the business. Zampa indicated that an unequal allocation among spousal partners might be acceptable if the evidence indicated that the spouses actually made unequal contributions to the success of the business. At year-end, the spouses would file a partnership return. This arrangement can result in allocating a larger portion of the business net self-employment income to the spouse whose other earnings exceed the OASDI limit.

Example 4. Assume Husband and Wife are currently employed. Husband’s wages are $35,000 and Wife’s wages are $90,000. The spouses operate a new business that they anticipate will generate net income of $50,000. They both plan to work in the business. Prior to starting the business, they enter into a written agreement limiting Husband’s duties and role in the business. For Wife’s extra duties and role, the business guarantees Wife $1,500 per month, or $18,000 per year. At year-end, they file a partnership return (1065) showing a net income of $32,000 ($50,000 – $18,000 guaranteed payments). Assuming they distribute the profits equally ($16,000 each), only the $16,000 allocated to Husband will be subject to the full SECA tax rate. The $34,000 ($16,000 distributive share + $18,000 guaranteed payment) of net self-employment income allocated to Wife is limited to the SECA HI rate, because Wife already has FICA earnings in excess of the $87,000 (2003) OASDI limit.

Actual periodic guaranteed payments lend more credence that one spouse’s duties and responsibilities are more valuable to the overall success of the partnership. If the payments are periodic from the outset, it indicates that the spouses always intended to divide up income unequally rather than as an afterthought at year-end.

Garo Kalfayan, JD, LLM, CPA, is a professor of accountancy at the Craig School of Business, California State University, Fresno.

William Bregman, CFP, CPA/PFS

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