Tax Tactics is a bi-monthly column devoted to technical tax topics and strategies. Written by a recognized expert, this is a must-read for tax planners.
S corporations are typically the best tax entity for businesses generating ordinary income. That’s because they minimize employment tax on your income. However, S corp owners face a particular challenge determining a reasonable salary and ensuring that the S corp actually achieves its goal of minimizing employment tax. And S corporations face the red tape hurdle of managing payroll and complying with payroll tax requirements. Partnering with a spouse, instead of establishing an S corporation, may help your clients accomplish the same goal of minimizing SE tax.
Partnerships can include two types of members. There are general partners, who actually run the business. And there are limited partners, who merely invest in it without actually working in it. The general partners’ income is subject to self-employment tax, but the limited partners’ income is not. This treatment reflects the premise that business owners can get rewarded from their business in two ways, as employees and as owners.
To qualify as a limited partner, your spouse can’t “materially participate” in the business. This generally means they can’t work more than 500 hours per year in the business.
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Splitting a sole proprietorship into a partnership consisting of one or more general partners and one or more limited can also accomplish the goal of minimizing employment tax as an S corp. It’s just that, instead of having a salary income subject to employment tax and a net income interest exempt from it, your client will have a general partnership interest subject to SE tax and their spouse will have a limited partnership interest that’s not.
Let’s say your client is a real estate agent, operating an LLC taxed as a sole proprietor, netting $80,000 per year. That’s a pretty nice income, and there may be plenty of planning opportunities. But it may be just on the cusp of justifying an S corp when you consider the cost of managing a payroll and preparing a separate return for the new entity. It’s certainly not the slam-dunk it would be if the client were netting, say, $150,000.
Instead, your client can establish an LLC, assign 50% of their ownership interest to their spouse, and elect to be taxed as a partnership. At the end of the year, assuming the spouse doesn’t materially participate, there will be $40,000 of income subject to SE tax, and $40,000 of income not subject. Voila, you’ve avoided half of that tax, or almost $6,000. (It doesn’t have to be exactly 50% going to the passive spouse. But be reasonable – don’t make it 99% either!)
Now, this isn’t quite as powerful as an actual S corp. For starters, you won’t have the same control over your employment tax bill as you do with an S corp. That’s because the amount you pay SE tax on is determined as a percentage of the entity’s net income, and not a specific number you designate.
You also need to be aware how your SE tax will fluctuate with your overall income. In the real estate agent example above, this may work great for a year when you net $80,000. But if your income doubles in a year – which is hardly unknown in real estate sales – your client’s SE tax bill could double, too, and they may have been better off that year with an actual S corp.
Having said that, partnering with your spouse can create some really nice employment tax savings even if an S corp turns out to be more firepower than you need, or more expensive than the savings it creates.
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