Understanding Taxes for Small Businesses Owned by Married Couples

Spouses joining forces in a business is a common foundation for entrepreneurial success, but the tax implications of these structures present a cascade of important decisions. The formation of a limited liability company (LLC) rains particularly complex circumstances upon unsuspecting couples. They should seek professional tax advice to avoid confronting unintended tax consequences.

Tax without an LLC

An LLC is created by registering with the state in which the business is organized. A business formed by one person without state registration is a sole proprietorship, and the individual owner is taxed on the business’s profit. Unregistered businesses formed by multiple individuals are automatically treated as partnerships. Profits from a partnership are reported on a separate tax return, but tax is assessed on the individual partners.

Spouses who begin businesses without state registration can escape the step of a partnership tax return. Instead, they may divide the business revenue and expenses on their joint tax return as if the enterprise was two separate sole proprietorships. Formation of an LLC upsets the ability to follow this tax-reporting shortcut, known as a qualified joint venture.

Spouses with an LLC

The IRS automatically treats an LLC formed by more than one person as a partnership. Consequently, spouses establishing an LLC together might discover that having this entity doesn’t deliver the desired federal tax arrangement. A partnership tax return is generally required.

As an exception to this general rule, the IRS will permit spouses operating an LLC in a community property state to enjoy tax reporting as a qualified joint venture. The LLC of spouses in a community property state is simply disregarded for federal income tax purposes.

Worth remembering is what happens upon the death of one spouse in an LLC. The survivor no longer has a spouse as a partner. Rather, the estate of the deceased spouse is the partner of the survivor. In a community property state, the LLC is no longer disregarded as a qualified joint venture. A partnership tax return generally becomes necessary. In most states that lack community property statutes, the surviving spouse simply has a different partner until the decedent’s estate is settled.

LLC Tax Elections

Any LLC may elect federal tax treatment as a corporation by the IRS. A corporation operates as an entity distinct from its owners. The business files a separate tax return and pays corporate income tax. The LLC members effectively become shareholders. They may also be compensated as employees of the corporation. Payments from the corporation to shareholders are dividends. Payments to employees, even if they are also shareholders, are wages. Dividends and wages are taxed differently. Moreover, the corporation receives a tax deduction for wages but not for dividends paid.

In contrast to regular corporations, S-corporations have made an additional election to have their shareholders personally taxed on business profits. Distributions of S-corporation profits to shareholders are not taxed as dividends. This avoids double taxation on payments from the corporation to shareholders. However, shareholders who work for their S-corporations must receive some compensation as wages. Wages incur payroll taxes. Clearly, careful planning is necessary to assure preferred results are secured when an LLC elects tax classification as a corporation.

Consider Current Year When Reporting Last Year’s Taxes

As the deadline passes for payment of income tax on last year’s income, immediate attention should be directed at addressing tax on income that’s being earned this year. The government imposes penalties when income tax is not remitted throughout the year. Although wage-earning employees satisfy this obligation through paycheck withholding, entrepreneurs are confronted with the duty of making their own calculations and sending estimated tax payments. The first of these payments for this year is due on the same date as the deadline for last year’s tax return.

This year’s estimated tax amounts are ideally determined from a projection of business income. This is easily identified if you prepared a current-year business budget. At the very least, projected income for this year can be derived from your taxable business income from last year. Simply identify whether you expect to generate more or less income than last year. A common expectation is that this year will be about the same. Your tax accountant can calculate estimated tax payments for this year based on the expected business income and your other income sources.

Two other methods for determining estimated tax installments are available. One is a complex form with your next tax return that shows your income during different periods throughout the year. Tax accountants can prepare it only if you maintain burdensome records. The other technique entails paying this year an amount of tax equivalent to last year. Even if you make substantially more income this year, you escape an underpayment penalty by making estimated tax payments your accountant identifies based on last year’s taxes.