A partnership automatically comes into existence whenever two or more people enter into business together to earn a profit and don’t incorporate or form a limited liability company. You can elect to be excluded from the partnership provision if you are in a business arrangement that is for investment purposes only and not for the active conduct of business (think rental property). The election is made the first year the participants are in business together. Prior to the passage of the Small Business & Work Opportunity Tax Act of 2007 it was unclear how to classify a single member LLC owned by one spouse but operated by both spouses. For years after 12/31/06 a husband & wife can elect to be treated as a joint venture. Let’s take a look at an example.
Wife opens up a restaurant and husband helps out. In fact they both spend all their waking time running the restaurant. They have not formally formed a partnership and they fill out all legal paperwork with the wife as the owner, but they both actively participate in running the restaurant. My inclination would be to report the income and expenses on their joint tax return as one Schedule C. But the IRS will classify them as a partnership and require a Partnership Form 1065 be filed for the income & expenses of the business. They can elect out of the provision to file a partnership return and split the income & expenses 50/50 with a Schedule C being filed for the wife and one for the husband. Why does it matter? Because self employed income tax is due on the net income from the business. If the business has net income of $140,000 and only 1 owner SE tax is only due on $106,800 but if the IRS can classify the net income as 50/50 then it receives SE income tax on the full $140,000 because the wife reports $70,000 and so does the husband!
What if the husband and wife own rental property? The same theory applies. They can elect out of filing a Partnership Form 1065, but the instructions say that a qualified joint venture must be reported on 2 Schedule Cs. Rental Income is normally reported on a Schedule E and self employed income tax is not due. Therefore the rental income is moved from 1 Schedule E to 2 Schedule Cs splitting the income & expenses 50/50 AND “Exempt- QJV” printed where SE tax normally appears on the Form 1040. That all seems just too confusing to me so I continue to report it on the Schedule E. My basis for this is found in the instructions to the Form 1065. It states that “mere co-ownership of property that is maintained and leased or rented is not a partnership. However, if the co-owners provide services to the tenants, a partnership exists” Thus, husband-wife co-owned or jointly owned real estate, leased to a third party with minimal services on their part, does not normally give rise to a partnership and may continue to be reported on a Schedule E.
So the answer to the question ” Are Spouses Automatically Partners in a Business Setting?” is yes if they are both involved in the business, but there are some provisions set in place to avoid filing a partnership tax return.
