Tax reform likely has you considering your business’s tax structure. We’ll show how you can use a spousal partnership to reduce your tax hit compared with a sole proprietorship. And here’s the real surprise: you can possibly save more money with this type of partnership compared with the S corporation.
Strategy Overview
It works like this:
1) You own an existing sole proprietorship or want to start a new business.
2) You and your spouse form a general partnership or limited liability company to manage the business.
3) You and your spouse provide cash or property for your interests in the new business.
4) Your spouse does not participate in any way in the business. He or she is merely an investor.
Here are the tax benefits to you:
– Your spouse’s income is free from self-employment tax.
– You and your spouse both still qualify for the new pass-through income deduction under Section 199A.
– The IRS audits partnerships at a much lower rate than proprietorships (Schedule Cs).
– You don’t have to worry about the costs or hassle of running payroll or determining your reasonable
compensation as you would if you operated the business as an S corporation.
Here are the potential issues:
– The passive activity rules limit your spouse’s use of any losses against regular income.
– Your cost of preparing a partnership return (but you’d have this cost with an S corporation, too).
No Self-Employment Tax?
Limited partners in a partnership don’t pay self-employment taxes on their share of partnership net income. To make your limited-partner situation crystal clear to the IRS, make sure your spouse meets the limited-partner requirements by:
– providing no services to the partnership
– complying with the limited partnership statute of your state
– and signing a document delegating management authority of the LLC to you.
Proposed regulations originally issued in 1996 would clarify who is a limited partner for self-employment tax purposes, but the Treasury Department never finalized them. Under the proposed regulations, a limited partner can’t have personal liability for the debts of the partnership by reason of being a partner, have authority to contract on behalf of the partnership, or participate in the partnership’s business for more than 500 hours during the partnership’s taxable year. (Note. Above, we recommended no participation for the spouse.)
Planning note. Although the IRS has not finalized the proposed regulations, you should follow them because they represent substantial authority and protect you from the substantial underpayment penalty.
Pass-Through Deduction
Tax reform gave you a new 20 percent pass-through deduction starting in 2018. Partnership pass-through income qualifies for Section 199A, but partnership guaranteed payments do not. Guaranteed payments compensate partners for services to the partnership and are self-employment income to the partner, and deductible as a business expense by the partnership. Unlike S corporations, which require reasonable compensation by salary for owner/employees, the tax law has no requirement that a partnership make guaranteed payments to its partners. Therefore, in your spousal partnership, you and your spouse can take cash distributions of the partnership profits and no guaranteed payments in order to maximize your pass-through deduction. Another bonus: unlike an S corporation, where shareholder distributions must be pro rata based on ownership interest, partnerships have no such requirement.
Example. Louis and Lisa, a married couple, have a partnership. Louis is a 60 percent partner and Lisa is a 40 percent partner. The partnership has net income of $100,000, and none of the Section 199A limitations apply to them. With no guaranteed payments, they get a $20,000 Section 199A deduction. If the partnership pays Louis a $50,000 guaranteed payment, then only the $50,000 partnership net income qualifies for the Section 199A deduction, reducing that deduction to $10,000 (20 percent of the net income).
Passive Loss Issues
Under the passive loss rules, a passive loss can only offset passive income. A limited partner’s interest in a partnership is automatically passive regardless of participation level. If it’s unlikely your business will suffer a loss, then this isn’t a major concern. If your business does have a loss, you’ll have to
carry forward the loss until there is passive income that can absorb it. If you have activities that create passive losses (a rental activity, for example), then the passive income created by this strategy could allow you to use your losses in the current tax year.
Example. John is a limited partner in his spouse’s business. The partnership passes through $10,000 of passive net income to John. John also owns a rental property that generates a $5,000 passive loss. John can net the partnership income and the rental loss and only pay taxes on the $5,000 of net passive income. This income offset works with privately held partnerships, but not with publicly traded partnerships, where the tax law requires separate application of the passive loss rules.
By the Numbers
Jean wants to start a graphic design business. She has three options:
1) Form a single-member LLC with herself as sole owner
2) Form a multimember LLC with her husband, Tom, who would have no involvement in the business
3) Form a single-member LLC or corporation and elect S corporation status
Let’s assume that the business nets $50,000 in the first year of operation, Jean’s S corporation reasonable compensation is $35,000, and they are in the 22 percent tax bracket. Here’s a comparison of four options.
Jean pays the least amount of taxes on the structure where her husband is a 40 percent limited partner. Note that the S corporation results in more tax than the single-member LLC taxed as a sole proprietorship because the increased pass-through deduction from the sole proprietorship negates the payroll tax savings from the move to the S corporation.
Takeaways
Tax planning after tax reform has mostly focused on C and S corporation tax strategies. But as you have just seen, in the right circumstances a spousal partnership can:
– provide optimal tax reduction over the sole proprietorship and S corporation,
– eliminate the need for payroll and reasonable compensation determinations, and
– reduce your overall risk of an IRS audit.
By running your partnership as a limited liability company, you also leave the door open to electing a different tax treatment in a later year if business changes make the S corporation a better tax strategy for you.