Embarking on a business venture with your spouse can be exciting, combining talents and entrepreneurial drive. However, it's crucial not to overlook tax implications. Read on to gain the necessary knowledge to navigate aspects like choosing a business structure and understanding tax advantages and challenges effectively.

KEY TAKEAWAYS

• Spouses in partnerships choose separate or joint tax returns.
• Multi-member LLCs with both spouses require a partnership tax return, except in community property states.
• To simplify filing, have only one spouse be a member of the LLC and the rental or business activity can be reported on the individual tax return vs. having to file a separate partnership return in addition to your individual tax return.
• Business-owning spouses report income on personal returns and pay self-employment taxes.
• Payroll optimization, particularly in S-Corps, can reduce self-employment taxes and maximize the QBI deduction.
• Audit triggers include income imbalance, insufficient documentation, unusual deductions, home office claims, and excessive expenses.

Merging love and entrepreneurship is rewarding yet presents unique tax challenges. Navigating the tax code can be daunting, but fear not! Whether deeply into your journey or just starting, understanding tax implications helps make informed decisions and maximize financial benefits. This article offers valuable insights and practical tips to navigate the complex tax landscape and optimize your business's financial health.

PUTTING THINGS IN ORDER

Working with a spouse adds complexity, especially in terms of tax implications. Addressing potential tax consequences is crucial to maintaining a healthy relationship amid business demands. Proactively discussing and understanding tax implications enables informed decisions and clear agreements before starting the joint venture. Navigating tax considerations enhances the prospects of success for both the business and marriage, ensuring a harmonious and prosperous future.

Before starting, you and your spouse should jointly determine several crucial aspects, such as:

1. Which legal structure will you adopt for the business?
2. Will both spouses be co-owners?
3. Will both spouses actively participate in managing the business?  

Let us dive into more detail below.

WHO WILL OWN THE BUSINESS and THE TAX IMPLICATIONS ATTACHED?

Determining the business owner and whether both spouses will serve as managers dictates the business type needed.

Pro tips: If one spouse has income exceeding the FICA tax limit, assigning ownership and tax reporting at that spouse's level can save on taxes for the household.

Couple Ownership

If both spouses opt for ownership and active management, selecting the right business structure is crucial. Options include a partnership, a limited liability company (LLC), or a corporation (including an S corporation), where each spouse holds a respective share, membership share, or shareholder position.

No LLC:

Spousal partnerships must file income taxes separately on Form 1065, but a husband-wife partnership might qualify as a qualified joint venture under specific circumstances, allowing for alternative filing. In non-legally incorporated spousal partnerships, like LLCs (discussed below), hiring minor kids can be a strategy to avoid payroll taxes.

Tax Filing: The business activities are reported in the personal return (1040) – Schedule C with qualified venture election.

LLC:

For a multi-member Limited Liability Company (LLC) with a spouse, partnership tax returns may be necessary unless in a community property state with an additional IRS election. If advised against establishing a separate LLC by an attorney, it's recommended to avoid having a multi-member LLC to minimize tax compliance costs.

Tax Filing: LLC files as partnership: Reported in partnership tax return form 1065.

LLC elected to as qualified joint venture - The business activities are reported in the personal return (1040) – Schedule C (two separate schedules for each spouse).

S-Corp:

If you elect to be taxed as an S-Corp to save self-employment taxes, you are required to file a separate tax return. Whether you choose to have an LLC (taxed as an S-Corp) or not is not a relevant point. Since the owner can also be an employee in an S-Corp, you can optimize payroll wages to maximize the QBI deduction.

Tax Filing: Reported in separate tax return – 1120S.

Sole Ownership (also single member LLC - SMLLC)

Opting for S-Corp taxation to reduce self-employment taxes mandates filing a separate tax return, regardless of having an LLC or not. As the owner can also be an employee in an S-Corp, optimizing payroll wages becomes a strategy to maximize the Qualified Business Income (QBI) deduction.

Tax Filing: The business activities are reported on the personal return (1040) – Schedule C.

AUDIT TRIGGERS IN A SPOUSAL BUSINESS

Certain factors in a spousal partnership business may increase the likelihood of a tax audit. While audits can be random or based on specific criteria, here are potential triggers:  

1. Disproportionate Income Distribution: Significant imbalances in income distribution between spouses may raise suspicions of tax avoidance, prompting scrutiny by tax authorities.
2. Inconsistent or Inadequate Documentation: Poor record-keeping, missing documents, or inconsistent financial statements can trigger audits. Maintaining accurate records is essential to substantiate income, expenses, and deductions.
3. Unusual Deductions or Losses: Claiming excessive deductions or consistent losses may attract attention. Uncommon or high-value deductions should be supported by proper documentation.
4. Home Office Deductions: If both spouses claim home office deductions for the same residence, tax authorities may scrutinize their validity. Ensuring accurate calculation and proper documentation is crucial.
5. Excessive Business Expenses: Unusually high business expenses relative to the business's size and nature may raise suspicion. Proper documentation for all business expenses is essential.

BREAKING UP

Operating a business with a spouse necessitates careful consideration of implications in case of a breakup. Options include continuing the partnership, maintaining original ownership percentages, one party buying out the other, or selling the business and dividing proceeds. Be aware of significant tax implications, such as declaring capital gains from selling the business. To ensure a smooth transition and mitigate risks, it's highly recommended to create a comprehensive post-breakup financial plan for the business. While undesirable, it is a prudent step to take.

CONCLUSION

In conclusion, the fusion of love and entrepreneurship offers both opportunities and challenges, especially in managing tax complexities. Whether opting for couple ownership or sole ownership, it's crucial to choose the right business structure and fulfill tax obligations accordingly.

Investor Friendly CPA® consists of teams of professionals who can offer you guidance and expertise to ensure that you make the right decision for your business. Whether you are seeking advice on financial planning, tax optimization, or other financial matters, our experts are here to support you every step of the way. Our main objective is to help you make informed decisions beneficial to your business.