The ability to work with family members is one of the perks of small business ownership.
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Small businesses are especially attractive to husband and wife teams who are interested in combining their family and work relationships. But you might be surprised to learn that your spousal relationship can have significant tax consequences for your company.
The IRS is keenly aware of the fact that many small businesses function as husband and wife operations. Although they have no objections to a spousal business arrangement, they are concerned about how the business is structured and the roles each spouse plays in the company.
The reasons behind the IRS' concern primarily involve the issue of social security taxes. A spouse's social security reporting and payment method can vary depending on the role he or she plays in the business. As such, the IRS has published clarifying guidelines specifically geared toward husband and wife small businesses.
From the IRS' perspective, it is important for small business owners to designate the role a spouse plays in the company. The IRS is especially concerned about whether or not the spouse has been classified as an employee for tax purposes. To be classified as an employee, the first spouse must be in clear control of the management decision-making process, and the second spouse (the employee) must be under the direction and control of the first spouse – at least at the workplace.
If a spouse has been classified as an employee, then that spouse is subject to social income tax and FICA (Social Security and Medicare) withholdings and reporting. But if the spouse is not considered an employee, then the business is classified as a partnership relationship and needs to be reported accordingly.
Qualified Joint Ventures
At first glance, it would seem that a spouse must be classified as either an employee or a partner. However, in 2007 the Small Business and Work Opportunity Tax Act created another category for small business spouses. Under this new legislation, husband and wife small businesses can be categorized as qualified joint ventures if they meet certain IRS criteria.
To be classified as a qualified joint venture, (1) the only members of the joint venture must be the husband and wife, (2) both spouses must materially participate in the business, and (3) both spouses must elect to be classified as a qualified joint venture.
If the business is classified as a qualified joint venture, it is not required to file as a partnership and it does not need to withhold employee taxes for one of the spouses. Instead, the company's income, losses, deductions, and credits are divided between the two spouses, creating a tax scenario in which each spouse files as a sole proprietor.
Reporting for a qualified joint venture requires each spouse to file their own Schedule C. Under this arrangement, each spouse would represent his or her respective share of income, expenses, deductions, and credits on their own form. By doing this, the business' total tax burden remains the same, but each spouse gets credit for their own share of social security earnings.