Tax and Financial Concerns for Cohabitating Co-Owners
It’s not uncommon for spouses and significant others to go into business together. Obviously, the arrangement entails many personal issues that need to be addressed. However, there are also tax and financial concerns to be aware of. Here are some key points to consider.
While marriage ideally is a 50-50 arrangement, business ownership by spouses or significant others need not be equally divided. It depends on what each person brings to the table. When fixing ownership interests, consider capital contributions, skills, and the impact on the relationship of having one person as a “junior” partner.
In some cases, one person is the owner of the business while the other is an employee with no ownership interest. Usually this occurs when one spouse is the star of the business while the other merely serves in a supporting role. This arrangement may have certain benefits when the business is unincorporated:
- The business deducts wages and payroll taxes for the employee-spouse;
- Health insurance premiums for the couple can be a business deduction rather than as an above-the-line personal deduction. As long as the spouse is a bona fide employee, the owner can provide health insurance for employees (including the spouse) and employees’ spouses (including the owner) and dependents, and deduct the premiums as a business expense.
Reporting Profits and Losses
Profits and losses are divided according to ownership interests. Whether the business is run as a partnership, limited liability company, or S corporation, profits and losses are allocated to each owner on a Schedule K-1.
Special rule for husband-wife partnerships. Instead of filing a partnership return and two Schedule K-1s to allocate partnership items to each spouse, the couple can opt to file separate Schedule Cs. Each spouse reports his or her share of partnership items; each pays self-employment tax on the share of net profits. This option can be used only if both spouses materially participate in the business. This option is not available to same sex spouses, domestic partners, or other significant others in business together.
Spouses in community property states and domestic partners as faux business partners. Even though only one person owns an unincorporated business—a sole proprietorship or one-member limited liability company—federal income tax rules split the income between the parties:
- For spouses in community property states, each spouse reports half of the net income or loss on a Schedule C; only the owner pays self-employment tax on all of the net earnings from the business.
- For registered domestic partners in states such as California, Oregon, and Washington, each partner reports half of the net income or loss from the business on a Schedule C; each registered domestic partner owes self-employment tax on half of the net earnings of the business.
Planning for a Split
A business partnership is like a marriage that theoretically lasts until death. As a practical matter, however, a partnership is as vulnerable to a split as a marriage. Therefore, plan ahead for possible problems. Just like having a prenuptial agreement, spouses should have a partnership agreement or shareholder agreement that spells out what happens if:
- The couple cannot agree on business decisions but want the co-ownership arrangement to continue;
- The couple divorces. Sometimes couples can continue to work successfully together in the business even though their marriage ends;
- One spouse wants to leave the business;
- The couple wants to bring in an additional owner or owners.
Crafting a partnership or shareholder agreement at the start of the arrangement, when feelings and expectations are at their highest, is the best time to act. However, if spouses are already in business, it’s never too later to address concerns by creating or updating a partnership or shareholder agreement.
Any couple that wants to work together and be co-owners of a business should review their arrangement with tax and legal advisors. For interested couples, the IRS provides information on husband and wife businesses.