Tax Tips for Husband and Wife Business Partners

Self Employment Tax

A heavy Self Employment tax (SE tax) is levied on small businesses that are run by married couples. Sometimes, these SE tax bills exceed the Federal Income Tax bills. The husband–wife business that functions as a partnership or as a limited liability company (LLC) must file an annual form 1065 (US Return of Partnership Income) with the IRS for the Federal taxes. Every year, both the partners receive a separate Schedule K-1 that splits the business income and tax deductions between the two partners. Further, another joint form 1040 that combines the separate Schedule K-1 amounts also must be filed.

The total SE income from partnership or LLC is equally divided between the two partners, and the SE tax is separately calculated as per the tax rule. The share of partnership SE income is equal to the amount shown on Schedule K-1 multiplied by 0.9235. For the year 2009, 15.3% SE tax is levied on the first $ 106,800 of SE income, of which 12.4% goes for Social Security tax and 2.9% for Medicare tax. If the SE income crosses $106,800, only 2.9% tax is charged for the additional amount. The SE taxes of both the husband and wife are added up and entered in joint form 1040.

For example, if an LLC has $300,000 SE income in 2009, this amount is equally divided between the husband and wife. Since each one has to pay 15.3% SE tax on the first $ 106,800, an additional payment of $16,340.4 is made towards the SE tax in comparison to the SE tax paid by a sole proprietor. Following are two methods to reduce the SE tax payment.

Method 1: Create an LLC with a Modest Guaranteed Payment

As an initial step of SE tax saving, convert the existing husband–wife partnership to husband–wife LLC by registering with the respective state authority (the Secretary of State). As far as the Federal Income Tax is concerned, both partnership and LLC are treated in the same manner. In the case of husband–wife LLC, it protects the personal assets of both the partners from business-related liabilities. Both the husband and wife are classified as Limited Partners for SE tax purposes. The Limited Partners are eligible for guaranteed payments. Guaranteed payment is a fixed amount paid monthly or quarterly, and this amount does not depend on the income from business. The SE tax is calculated only on the guaranteed payment. In Schedule K-1 and joint form 1040, only the guaranteed payments are entered as SE income. The remaining income of husband–wife LLC can be withdrawn as cash when it is available.

Let us see how this SE tax saving plan works by using the above mentioned example. According to $ 300,000 SE income on partnership business in 2009, each partner has to pay $ 17,593.2, and hence, the total SE tax becomes $ 35,186.4. Assume that a guaranteed payment program is implemented from 1 January 2009 on the husband–wife LLC by making a payment of $ 5,000 per month. In such case, each of them has to collect $60,000 as guaranteed payment. Further, each partner has to pay only $ 9,180 SE tax, and therefore, the combined total becomes $18,360. This tax saving plan reduces the SE tax by $16,826.4.

METHOD 2: Appoint One of the Partners as an Employee

In this plan, convert the husband–wife partnership or husband–wife LLC to single member LLC. When one of the partners owns the proprietorship, the other partner is treated as an employee with a reasonable cash salary (say about $50,000). From this salary, 7.65% is withheld to cover the employee’s Social Security and Medicare taxes. The proprietor also contributes an equal amount to pay 15.3% SE tax altogether toward Social Security and Medicare taxes. The partner’s salary and the employer’s contribution fall under business expenses. Entering all these in the sole proprietorship Schedule C form filed with the joint form 1040 reduces the SE income and hence the SE tax bill. Sole proprietorship also reduces SE tax as 15.3% SE tax is calculated only once for the SE income up to $106,800. By applying this plan, a considerable reduction in the amount paid to wards Social Security and Medicare taxes can be obtained.

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