If you and your spouse are working together in your own business, and have not set up your business as a corporation, you may have either a sole proprietorship or a partnership for U.S. income tax and social security tax purposes. The way in which the business is treated will determine each of your social security obligations and how each of you earn social security benefits.
When you work for an employer, you have social security taxes deducted from your pay, and the employer pays a corresponding amount. When you are in business for yourself, you report your earnings for social security purposes when you file your annual federal income tax return, and pay the tax directly to the Internal Revenue Service (IRS). For self-employed persons, the self-employment tax is the equivalent of the social security and Medicare tax. If you have $400 or more in net earnings from self-employment during the year, you must file Schedule SE, Self-Employment Tax, along with your federal income tax return. Depending on how much tax you expect to owe at the end of the year, you may also have to make quarterly estimated tax payments during the year, to cover your federal income tax and self-employment tax liabilities.
One Spouse As An Employee of the Family-Owned Business
If one spouse substantially controls the business in terms of management decisions, and the second spouse is under the direction and control of the first spouse, it could be deemed that there is an employer/employee relationship. In that case, the second spouse is an employee subject to income tax and FICA (social security and Medicare tax) withholding. In this employer/employee relationship, it would be necessary to define the second spouse’s salary or wages, in order to determine how much should be withheld and reported for federal, state, and local income tax purposes, and for social security tax purposes. As an employer, the business would have to file Form 941, Employer’s Quarterly Federal Tax Return, to report and pay the payroll taxes.
Spouses As Partners In The Business
If both spouses share equally in decision-making regarding the affairs of the business, both spend substantially the same amount of time working in the business and both contribute capital, then there would probably be a partnership type of relationship. If the spouses carry on the business together, and share in the profits and losses, they may be deemed to have a partnership, even if they do not have a formal partnership agreement.
If there is a formal partnership agreement, or if a partnership type of relationship is deemed to exist, then the income from the business should be reported on Form 1065, U.S. Return of Partnership Income, rather than on Schedule C of Form 1040 for individuals. Each spouse would then carry his or her share of the partnership income or loss from Form 1065, Schedule K-1, to either their joint or separate individual income tax returns (Form 1040).
Each spouse should report his or her respective share of self-employment income from the partnership on a separate Form 1040 Schedule SE, Self-Employment Tax, even if they file a joint income tax return. This gives each spouse credit for the earnings on which retirement benefits will be based. Spouses should agree on what proportion of the net earnings from the business each will report on his or her individual Schedules SE. The earnings can be split evenly or in some other reasonable proportion.
If one spouse works for the other in an employer/employee relationship, the employee spouse would be subject to income tax withholding, and social security and Medicare tax, but not federal unemployment (FUTA) tax. But if the business is set up as a corporation or a partnership, a spouse who is an employee of the corporation or partnership would also be subject to federal unemployment tax.
How Much is the Self-Employment Tax?
The equivalent social security and Medicare tax rate on self-employment income is 15.3% on up to $90,000 of net earnings (for the year 2005). If net earnings are more than $90,000, only the Medicare tax portion (2.9%) applies on the excess.
Your net earnings from self-employment are reduced by half your social security tax. This reduction is incorporated into Schedule SE in that your net earnings from self-employment are multiplied by 92.35% (100% minus half of 15.3%). This corresponds to the way employees are treated for social security tax purposes – the employer pays an amount of tax equivalent to the employee’s tax, and this amount is not included in the employee’s taxable salary or wages for income tax purposes.
You can also deduct half your self-employment tax in determining your adjusted gross income on Form 1040. This deduction is calculated on Schedule SE and then transferred to Form 1040.
If you work for an employer and have a salary or wages in addition to your earnings from self-employment, the $90,000 limit on income subject to social security tax still applies. The social security tax on your salary or wages is paid first. Your employer will deduct 7.65%. Then, if your net earnings from self-employment, when added to your salary or wages, are still less than the $90,000 limit, you will pay the self-employment tax on all your net earnings. But, if your salary or wages plus your net earnings from self-employment exceed the $90,000 limit, you will only be subject to the social security portion of the self-employment tax on the part of your net earnings up to the limit. You would still be liable for the 2.9% Medicare tax on all your earnings, with no limit. If this is the case, you will need to complete Long Schedule SE in Section B of the schedule. The calculations are built into the individual line instructions.
Allocation of Net Earnings
For social security purposes, each spouse that participates in a family-owned, or spousal business, is treated as having his or her own self-employment income, even if a joint return is filed for federal income tax purposes. If both spouses participate equally in the business, they will generally be treated as partners and will each be subject to social security tax on their individual shares of net earnings up to the maximum limit. The IRS can deem that a spousal business is a partnership for tax purposes, even though it has not been formally set up as a partnership. In this case, the spouses could be considered equal partners, with each subject to self-employment tax on half the net earnings from the business.
An allocation of net earnings other than an equal allocation between the spouses must be within reasonable limits based on each spouse’s participation in the business and on their respective contributions to the business.
If one spouse exercises substantially all the management control, the business could be treated as a sole proprietorship and all the earnings from the business would be allocable to the spouse who manages the business. If the other spouse participates in the business in an employer/employee relationship and is paid a salary, he or she would be subject to self-employment tax on that salary, again up to the limit. In order to maintain this characterization of the business as a sole proprietorship, with one of the spouses working in an employee role, the business should be structured with one spouse as the business owner, with an employment contract or agreement for the other spouse, actually paying the salary and filing the necessary payroll tax returns (Form 941, Employer’s Quarterly Federal Tax Return).
In addition to affecting the social security and Medicare tax obligations of the spouses, the allocation of net earnings from a husband and wife business can have an effect on each spouse’s eventual retirement benefits. Social security retirement benefits are based on the average indexed monthly earnings of an individual over his or her working life. And, working spouses have the option of receiving social security retirement benefits based on their own work history, or based on a specified percentage of their spouse’s social security benefits. Therefore, the allocation of net earnings from self-employment in the husband and wife business will have an effect on these benefits.