Usually, to qualify as a sole proprietorship, a business can only have one owner. There is an exception to this rule for spouses who own a business together. They can elect to have their jointly-owned business treated as a sole proprietorship as long as they follow certain rules. The rules for electing sole proprietor tax status differ depending on whether the couple live in a community property state or not.
Spouses in all states who jointly own and manage a business together can elect to be taxed as a “qualified joint venture” and treated as sole proprietors for tax purposes. To qualify as co-sole proprietors, the married couple must be the only owners of the business and they must both “materially participate” in the business—be involved with the business’s day-to-day operations on a regular, continuous, and substantial basis. Working more than 500 hours during the year meets this requirement. So does working over 100 hours if no one else works more. It’s likely that many couples will not be able to satisfy the material participation requirement.
A couple elects to be treated as a qualified joint venture by filing a joint tax return (IRS Form 1040). Each spouse files a separate Schedule C to report that spouse’s share of the business’s profits and losses, and a separate Schedule SE to report his or her share of self-employment tax. That way, each spouse gets credit for Social Security and Medicare coverage purposes. If, as is usually the case, each spouse owns 50% of the business, they equally share the business income or loss on their individual Schedule Cs. The couple must also share any deductions and credits according to their individual ownership interest in the business. If the business has employees, either spouse may report and pay the employment taxes due on any wages paid to the employees. The spouse must report taxes due using the Employer Identification Number (EIN) of the sole proprietorship.
Spouses in any of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) may elect qualified joint venture status. However, couples in these states can also choose to classify their business as a sole proprietorship simply by filing a single Schedule C listing one spouse as the sole proprietor. For many couples, this is easier to do than the qualified joint venture status because there is no material participation requirement. The only requirements are that:
One drawback to this election is that only one spouse (the one listed in the Schedule C) receives credit for Social Security and Medicare coverage purposes.
If a couple doesn’t choose or qualify for sole proprietor status, their jointly owned business will be classified as a partnership for federal tax purposes, assuming they have not formed an LLC or corporation. This means they must file a partnership tax return for the business. Each spouse should carry his or her share of the partnership income or loss from Form 1065, Schedule K-1, to their joint or separate Form 1040. Each spouse should also include his or her share of self-employment income on a separate Form 1040, Schedule SE.
Instead of being co-owners of a business, spouses can have an employer-employee relationship—that is, one spouse solely owns the business (usually as a sole proprietor) and the other spouse works as his or her employee. In this event, there is no need to worry about having to file a partnership tax return. One Schedule C would be filed in the name of the owner-spouse. The non-owner spouse’s income would be employee salary subject to income tax and FICA (Social Security and Medicare) withholding.
However, a spouse is considered an employee only if there is an employer/employee type of relationship—that is, 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. If the second spouse has an equal say in the affairs of the business, provides substantially equal services to the business, and contributes capital to the business, that spouse cannot be treated as an employee.
Excerpted from Deduct It! Lower Your Small Business Taxes, by Stephen Fishman (Nolo).