Choosing which tax return to file when married taxpayers own a business

It is not uncommon for spouses to jointly own businesses. However, it is common to question how these jointly owned businesses should file tax returns. When not operating in corporate form, businesses with multiple owners must usually file as partnerships, but the filing rules for businesses owned by spouses contain several exceptions to the partnership filing rules. Although these exceptions are intended to simplify filing issues for spouses, in many cases they do just the opposite. The difficult part is knowing when the exceptions apply, how to implement them, and if they are worth the effort to elect.

Qualified joint ventures

Unincorporated businesses owned by more than one person normally are required to file a partnership tax return. However, there is a specific exception for qualified joint ventures when that status is elected under Sec. 761(f). Under this provision, a qualified joint venture consists of a partnership whose only partners are spouses who file a joint tax return and who both materially participate in the business. Material participation is defined under Sec. 469(h), but for this purpose spouses do not attribute activity.

Businesses that meet the definition of qualified joint venture may elect to file two Schedules C, Profit or Loss from Business, Schedules E, Supplemental Income or Loss, for rental real estate (see below), or Schedules F, Profit or Loss from Farming, if a farm, with the couple’s joint tax return, instead of filing a partnership tax return. Each Schedule C or F should report one half of the business income and expenses for each spouse. The purpose of reporting half the income or loss for each spouse is to properly allocate self-employment income, and self-employment tax, to each spouse.

Given the additional effort involved in filing two Schedule C or F forms, some businesses may decide it is easier to file a single Form 1065 partnership tax return and report the business on a pair of Schedules K-1, Partner’s Share of Income, Deduction, Credit, etc., on Schedule E.

Once made, the Sec. 761(f) election is revocable only with the consent of the IRS. However, if the qualifications for the election cease to be met, it would no longer apply, and the business would resume filing tax returns as a partnership or sole proprietorship, as appropriate. For example, were one spouse to no longer qualify as materially participating in the business, the business would resume filing tax returns as a partnership.

Likewise, were one spouse to cease participation in the business entirely, the remaining spouse would continue to file on his or her Schedule C as a sole proprietor, now reporting all the business activity him or herself. If circumstances change again, and the business once again meets the definition of a qualified joint venture, the business may elect Sec. 761(f) treatment once more.

If the election under Sec. 761(f) is made for a business that is already filing as a partnership, the partnership tax return for the year prior to making the election should be filed as a final tax return in order to terminate the partnership. Further, after the election, neither spouse may continue to use the same tax identification number on their respective Schedules C, or F, as in the prior partnership filing(s).

Unfortunately, limited liability companies (LLCs) do not qualify for the Sec. 761(f) election. Businesses operated in the name of a state law entity, e.g., LLCs, limited liability partnerships (LLPs), and limited partnerships (LPs), are ineligible for the Sec. 761(f) election, regardless of their existing tax status as a partnership or otherwise qualifying as a qualified joint venture. These entities must follow the tax filing status they previously elected upon formation or elect a new status they qualify for. As a multi-owner entity, this will mean filing as a partnership if corporate tax status, S or C, is not elected. These rules are summarized under Regs. Secs. 301.7701-2 and 301.7701-3.

Rental real estate activities owned by spouses can also meet the definition of a qualified joint venture. When these activities qualify for the election under Sec. 761(f), the IRS allows joint filers to file as a single Schedule E activity. With no self-employment income or tax to be assigned to either taxpayer, there is no reason to separate ownership. Unfortunately,  rental real estate activities rarely meet the criteria of a qualified joint venture because of the material participation requirement.

Tenancy-in-common interests

Fortunately, real estate investments have their own exception to filing partnership tax returns when directly owned by multiple parties. Tenancy-in-common interests may be separately reported by each individual owner, on Schedule E, without filing a partnership tax return, for each owner’s respective share of income and expenses. This exception is available to all partnerships, not merely partnerships owned exclusively by spouses. Under Regs. Sec. 301.7701-1(a)(2), joint undertakings that merely share expenses are not considered to rise to the level of a separate business and do not require filing tax returns as a partnership.

However, Rev. Proc. 2002-22 limits this treatment to activities customarily performed in connection with operating a rental activity. To qualify for this exception, the real estate must be owned by each party as tenants in common. It cannot be owned as a joint tenancy and, as such, possesses no right of survivorship. For property owned by spouses, this will usually require planning in advance. Further, the owners of the real estate must elect to treat the property interest as a tenancy in common from the beginning, and not have previously elected to file partnership tax returns for the rental activity.

For a married couple owning a piece of real estate as a pair of tenants in common, this would necessitate filing a pair of Schedules E with their tax return if they wished to avoid filing tax returns as a partnership. Each spouse would report their separate representative share of the rental activity on their respective Schedule E. Also, since this exception only applies when the real estate is owned directly by the partners as tenants in common, it cannot apply when the partnership entity itself owns the real estate directly, be it a general partnership, LP, LLP, or LLC.

Community property

Another wrinkle occurs in the case of businesses considered to be owned by both spouses as a community property asset in a community property state, such as California or Texas. While the business may be titled in the name of one spouse, under state law it is considered the property of both spouses. As a business with two owners, this would normally necessitate filing tax returns as a partnership. In 2002, Treasury published Rev. Proc. 2002-69 to address this issue: If a business is considered a partnership solely because of its status as a community property asset in a community property state, the IRS will accept the business as reported by the taxpayer as either a partnership or sole proprietorship. This rule applies regardless of how the business was formed, as long as the business entity is owned by spouses as community property, no one other than one or both spouses would be considered an owner for federal tax purposes, and the business entity is not treated as a corporation under Regs. Sec. 301.7701-2.

Planning

There are other ways to avoid filing tax returns as a partnership for businesses owned by spouses, some of which still reap the benefits of an LLC electing partnership treatment, but they require advance planning and a significant increase in complexity.

If the intent was to retain the right of survivorship and to maintain a liability shield, this could be accomplished through the judicious use of trusts. For example, if a business is operated as a disregarded entity LLC held by a grantor trust, with one spouse named as grantor, and the other spouse as a residual beneficiary, it would maintain most of the benefits of filing as an LLC electing partnership treatment without being required to file tax returns as such. The grantor status of the trust allows the grantor to function as the sole owner of the activity, filing as a sole proprietor on Schedule C, E, or F.

The disregarded entity LLC would create a liability shield, and the residual beneficiary status of the second spouse would maintain the right of survivorship, bypassing probate upon the grantor’s death. Should the beneficiary spouse die first in this scenario, the business was never his or her property and tax filing continues for the grantor as if nothing occurred. However, this scenario would involve significant additional setup costs and forethought. Also, it is likely more complex than many business owners would be comfortable with.

Most of these exceptions require advance planning or beneficial happenstance to apply. Without advance planning, a married couple can find themselves required to prepare an unexpected additional tax filing, and potentially subject to additional annual tax preparation fees. This additional tax filing can result in comparatively significant recurring annual administrative expenses for small or marginally profitable businesses. Further, if a partnership tax return is required and the activity is improperly reported on the taxpayers’ personal tax returns, penalties for failing to file could be imposed. At $210 per partner per month, to a maximum of 12 months, plus interest, this can mount quickly, especially if partnership tax returns have not been filed for years.

In summary, when servicing clients who own a business together, care needs to be taken to advise and properly comply with filing requirements for these activities.

— Damien Falato, CPA, CGMA, MST, is a tax director at Paresky Flitt & Company LLP, Wayland, Mass. For comments on this article or suggestions of other topics, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.