Many small businesses are family businesses. So if you file taxes for small businesses clients, you should be prepared to encounter a variety of family businesses and help them navigate the tax implications of hiring family members. In this post, we’re covering one of the most common types of a family business: two spouses working together. Whether they’re business partners or employer/employee, here’s what you should know to help them handle their taxes correctly.
When Spouses are Business Partners
When spouses run a business together, the way their taxes are handled will depend on their business structure and whether they file as a partnership or qualified joint venture.
They would likely be considered partners in a partnership in most cases – even if they’ve never signed a formal partnership agreement. Instead of filing with Schedule C (Form 1040) and listing one spouse as the sole proprietor, they should instead use Form 1065 U.S. Return of Partnership Income. Note that income from a partnership is considered “pass-through” income, meaning the partnership itself won’t pay income taxes. Instead, the income passes through to each partner who reports it and pays taxes on their tax returns.
Being a partnership will require them to keep up with federal record-keeping guidelines for partnerships, ensuring that each spouse gets the Medicare and Social Security credit they deserve. (On the other hand, if they incorrectly filed as a sole proprietorship, only one spouse would get credit for the Medicare and Social Security taxes. The other spouse’s Social Security benefits would be far lower than they should be when they retire.)
In some cases, spouses can choose not to treat their business as a partnership and treat it as a Qualified Joint Venture.
Qualified Joint Venture
If a couple chooses to be treated as a qualified joint venture, they do not have to file as a partnership and both spouses will still get appropriate credit for paying Medicare and Social Security Taxes. In order to elect to be treated as a qualified joint venture, they must meet the following requirements:
- “The only members are a married couple who file a joint return,
- Both spouses materially participate in the trade or business, and
- Both spouses elect not to be treated as a partnership.
- The business must be owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company)”
Under a qualified joint venture, both spouses are treated as sole proprietors for tax purposes, and each spouse must file their own Schedule C for their share of the business’s profits and losses. If the business already has an EIN, the spouses should not use it when filing their individual returns. Instead, each spouse should file with their Social Security number, and the EIN should remain with the partnership. It will only be used to file in years where the business does not meet the requirements to be considered a qualified joint venture.
When One Spouse Employs Another
The tax situations above apply if the spouses are equal business partners, but what if one spouse runs the business and employs the other? In this case, the employed spouse will be treated almost the same as any other employee for tax purposes. Their income is still subject to income tax and Medicaid/ Social Security taxes, and the spouse who owns the business will still be responsible for paying all payroll taxes, including the employer portion of Medicaid and Social Security taxes.
There is one major exception to tax treatment for individuals employed by their spouse: their wages are not subject to Federal Unemployment Tax Act (FUTA) taxes.
How to Determine if Spouses are Partners or Employer/ Employee
In some cases, the lines between a partnership and an employer/ employee relationship can be blurry when spouses work together. The IRS offers guidelines to help you and your clients determine their roles properly.
The spouses should be regarded as employer/employee if “the first spouse substantially controls the business in terms of management decisions and the second spouse is under the direction and control of the first spouse.”
But if the second spouse’s role in the business is so significant that they have “an equal say in the affairs of the business, provide substantially equal services to the business, and contribute capital to the business,” then the spouses should be regarded as partners for tax purposes and not employer/ employee.
The information in this article is up to date for tax year 2021 (taxes filed in 2022).