As you may remember from one of my recent letters to you, when you operate a husband-wife partnership, you likely are paying far more than you need to pay in self-employment taxes.
Here are three strategies that can reduce your self-employment taxes.
Strategy No. 1: Use IRS-Approved Drill to Minimize Self-Employment Tax Hit on Husband-Wife Business in Community Property State
IRS Revenue Procedure 2002-69 stipulates that the IRS will respect your treatment of an unincorporated husband-wife business in a community property state as either
- a sole proprietorship operated by one of the spouses, which would include a single-member LLC treated as a sole proprietorship for tax purposes, or
- a husband-wife partnership, which would include a husband-wife LLC treated as a husband-wife partnership.
Put another way, in a community property state, you and your spouse can choose to treat your unincorporated husband-wife business as a sole proprietorship operated by one spouse for federal tax purposes.
The IRS will never object, even when both you and your spouse are very active in the business. As you will see, this sole proprietorship treatment could save you serious money on your self-employment tax bill.
Example. Self-employment tax savings from converting a husband-wife partnership to a sole proprietorship.
Pursuant to Revenue Procedure 2002-69, you and your spouse (married residents of a community property state) change the federal tax treatment of a qualified entity that you’ve been treating as a 50/50 husband-wife partnership.
You “convert” the qualified entity into a sole proprietorship operated by you for federal tax purposes (or into a single-member LLC treated as a sole proprietorship for federal tax purposes). You do that by filing an initial Schedule C (or E or F, if appropriate) for the conversion year. Easy!
Naturally, you must consider all the other federal tax consequences of converting. You usually find no negative federal tax consequences from this conversion.
Say your husband-wife business produces 2020 net self-employment income of $250,000 (after applying the 0.9235 factor). You and your spouse have no self-employment income from other sources.
The conversion from 50/50 husband-wife partnership status into sole proprietorship status reduces your 2020 self-employment tax bill by a cool $13,925 [($125,000 × 0.153 × 2) = $38,250 before the conversion, compared with ($137,700 × 0.153) + ($112,300 × 0.029) = $24,325 after the conversion].
This is not a one-time tax-saving benefit. Similar annual self-employment tax savings (or better) can be reaped in future years if your business maintains or exceeds its current profitability.
You accomplish the conversion by liquidating the assets, if any, of your former husband-wife partnership (LLC) into the “new” post-conversion sole proprietorship (single-member LLC) considered to be operated by you.
Key point. Not having to file any more of those complicated Form 1065 partnership returns and related Schedules K-1 is the cherry on top. Just file Schedule C (or E or F, if appropriate) for your “new” proprietorship from now on.
Strategy No. 2: Convert Husband-Wife Partnership into S Corporation, and Pay Modest Salaries to Yourselves
If you and your unincorporated husband-wife business are not in a community property state, consider converting the business into S corporation status to reduce the Social Security and Medicare tax hits.
Example 3. Husband-wife partnership converts to S corporation and pays modest salaries.
Pursuant to sage advice, you and your spouse convert your 50/50 husband-wife partnership into an S corporation. If you had left your business in husband-wife partnership status, it would have produced 2020 net self-employment income of $250,000 (after applying the 0.9235 factor), and you would have had a self-employment tax bill of $38,250 [($125,000 × 0.153 × 2) = $38,250]. Ouch!
But now you run your husband-wife business as an S corporation and pay yourself and your spouse salaries of $60,000 each. Now the FICA tax bill will be only $18,360 ($60,000 x 15.3 percent x 2 = $18,360). So, you save $19,890 in Social Security and Medicare taxes by operating as an S corporation ($18,360 versus $38,250). Nice!Again, this is not a one-time tax-saving benefit. Similar annual Social Security and Medicare tax savings (or better) can be reaped in future years if your business maintains or exceeds its current profitability (assuming the FICA tax rules for S corporations stay the same as they are today).
Potential Negative Side Effect on Retirement Plan Contributions
Beware of the potentially unfavorable side effect of paying modest salaries to yourself and your spouse as S corporation shareholder-employees. It can result in reduced allowable deductible contributions to your tax-favored retirement plan.
Strategy No. 3: Disband Husband-Wife Partnership and Hire Spouse as Employee
Consider this strategy for your existing husband-wife partnership if you are not in a community property state and you don’t love the S corporation idea.
Step 1. Disband the existing husband-wife partnership or husband-wife LLC treated as a partnership for federal tax purposes, and start running the operation as a sole proprietorship operated by one spouse (or a single-member LLC treated as a sole proprietorship for federal tax purposes).
Step 2. Hire the other spouse as an employee of the new proprietorship. Pay that spouse a modest cash salary out of the business checking account, and withhold 7.65 percent from the salary checks to cover the employee-spouse’s share of the FICA tax. As the employer, the proprietorship must pay another 7.65 percent directly to the government to cover the employer’s half of the FICA tax. However, since the employee-spouse’s salary is modest, the FICA tax hit is also modest.
Step 3. Consider setting up a medical expense reimbursement plan as a fringe benefit for the employee-spouse. Use the plan to cover the family’s out-of-pocket medical expenses, including health insurance premiums, by making reimbursement payments to the employee-spouse out of the proprietorship’s business checking account.
Deduct the plan reimbursements as a business expense on the sole proprietorship Schedule C filed with your joint Form 1040. On the employee-spouse’s side of the deal, the reimbursements are free of federal income, Social Security, and Medicare taxes because the plan is considered a tax-free employee fringe benefit.
Step 4. On the proprietorship’s Schedule C (or E or F, if applicable), deduct the medical expense reimbursements made under the plan, the employee-spouse’s cash salary, and the employer’s share of the FICA tax. These deductions also reduce the proprietor’s net self-employment income and thus the self-employment tax bill.
Step 5. Include only one Schedule SE—for the spouse who is treated as the proprietor—with your joint Form 1040. This minimizes the self-employment tax hit, because the maximum 15.3 percent self-employment tax rate applies to no more than $137,700 of net self-employment income (for 2020), versus up to $275,400 if your business is operated as a 50/50 husband-wife partnership.
Warning. The employee-spouse’s modest cash salary plus the reimbursements from the medical expense plan must together amount to reasonable compensation for his or her work in the business.
Following this strategy should substantially reduce the total amount you pay for Social Security and Medicare taxes (via self-employment tax for the proprietor-spouse and FICA tax for the employee-spouse). Deducting the medical expense plan reimbursements on the proprietorship’s Schedule C (or E or F) will reduce your federal income tax bill too.
Having your profitable unincorporated husband-wife business classified as a partnership for federal tax purposes can lead to alarmingly big bills for Social Security and Medicare taxes.
The good news is that you don’t have to sit still for that. Choosing one of the three following three strategies, as discussed in this letter, will save you some serious self-employment tax money:
- Stop filing husband-wife partnership returns, and file as a sole proprietor or a single-member LLC if you live in a community property state.
- Convert your husband-wife partnership to an S corporation.
- Hire your spouse as an employee.
Source: Bradford Tax Institute