Escape from partnership tax treatment
for spousal businesses limited in scope

An unincorporated business jointly owned by a married couple is generally classified as a part­nership for Federal tax purposes. Under a recent law change made by the Small Business and Work Opportunity Act of 2007 (Small Business Act), if an indi­vidual and his spouse materially participate as the only members of a jointly owned and operated business, and they file a joint return for the tax year, they can make a joint election to be taxed as a qualified joint venture instead of as a partnership. While IRS has yet to issue formal guidance on this change, information on its web site reveals IRS's position that the change is limited in scope-it does not apply to spouses who operate in the name of a state law entity.

Background. The Small Business Act provision gen­erally permits a qualified joint venture whose only members are a husband and wife filing a joint return not to be treated as a partnership for Federal tax purposes. (Code Sec. 761(f)) A qualified joint venture is a joint venture involving the conduct of a trade or business, if:

(1) the only members of the joint venture are a husband and wife,
(2) both spouses materially participate in the trade or business, and
(3) both spouses elect to have the provision apply. (Code Sec. 761(f)(2))

The meaning of material participation is the same as under the passive activity loss rules in Code Sec. 469(h) and its regulations.

Where the election is made, all items of income, gain, loss, deduction, and credit are divided between the spouses according to their respective interests in the venture, and each spouse takes into account his or her respective share of these items as if they were attributable to a trade or business conducted by the spouse as a sole proprietor.

To determine net earnings from self-employ­ment, each spouse's share of income or loss from a qual­ified joint venture is taken into account just as it is for Federal income tax purposes under the provision (i.e., in accordance with their respective interests in the venture).

Reasons for making the election.  Because a business jointly owned and operated by a married couple is gen­erally treated as a partnership for Federal tax purposes, the spouses must comply with filing and recordkeeping requirements imposed on partnerships and their part­ners. Married co-owners failing to file properly as a partnership may have been reporting on a Schedule C in the name of one spouse, so that only one spouse received credit for social security and Medicare cover­age purposes. The election permits eligible married co­owners to avoid filing partnership returns, if each spouse separately reports a share of all of the business­es' items of income, gain, loss, deduction, and credit. Under the election, both spouses will receive credit for social security and Medicare coverage purposes.

Scope of provision limited. The qualified joint ven­ture provision would appear to allow any business jointly owned by spouses to avoid partnership treatment. However, although there has been no formal pro­nouncement, IRS has stated on its website that a qual­ified joint venture "includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity.

IRS also says that mere joint ownership of property that is not a trade or business does not qualify for the election.

How to make the election.  Spouses make the election on a jointly filed Form 1040 by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse's respective interest in the joint venture, and each spouse filing with the Form 1040 a separate Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship) or Schedule F (Form 1040), Profit of Loss From Farming, and, if oth­erwise required, a separate Schedule SE (Form 1040), Self-Employment Tax. For example, to make the elec­tion for 2007, a married couple should jointly file their 2007 Form 1040, with the required schedules. The part­nership terminates at the end of the tax year immediate­ly preceding the year the election takes effect.

Reporting issues. In general, spouses do not need an Employer Identification Number (EIN) for the qualified joint venture. That's because an FIN is not required for a sole proprietorship unless the sole proprietorship is required to file excise, employment, alcohol, tobacco, or firearms returns. If an EIN is required, the filing spouse should complete a Form SS-4 and request an EIN as a sole proprietor.

If the spouses already have an EIN for the partnership, one spouse cannot continue to use that EIN for the quali­fied joint venture. The FIN must remain with the partner­ship (and be used by the partnership for any year in which the requirements of a qualified joint venture are not met).

If the business has employees, either of the sole pro­prietor spouses may report and pay the employment taxes due on wages paid to the employees, using the EIN of that spouse's sole proprietorship. If the business already filed Forms 941 or deposited or paid taxes for part of the year under the partnership's EIN, the spouse may be considered the "successor employer" of the employee for purposes of determining whether the wages have reached the social security and Federal unemployment wage base limits.

Making the election for a rental real estate business. IRS Publication 553, Highlights of 2007 Tax Law Changes, states that if a taxpayer and his or her spouse make the election for their rental real estate business, they must each report their share of the income and deductions on Schedule C or C-EZ instead of Schedule E. Rental real estate income generally is not included in net earnings from self-employment subject to self­employment tax and generally is subject to the passive loss limitation rules. Electing qualified joint venture status and using the Schedule C or C-EZ does not alter the application of the self-employment tax or the pas­sive loss limitation rules. For a rental real estate busi­ness not subject to self-employment tax, the spouses should enter "Exempt-QJV" on Form 1040, line 58, and not file Schedule SE, unless they had other income subject to self-employment tax. If a spouse had net earnings from self-employment of $400 or more, the spouse should enter "Exempt-QJV" and the amount of the spouse's net profit from the rental real estate busi­ness from Schedule C or C-EZ on the dotted line to the left of Schedule SE, line 3. The spouse should subtract that amount from the total of lines l and 2 and enter the result on line 3. The spouse should use the amount on line 3 to calculate the spouse's self-employment tax that will be reported on Form 1040, line 58. The spouse should not enter "Exempt-QJV" on Form 1040, line 58.

Duration of election. Once the election is made, it can only be revoked with IRS permission. However, the election technically remains in effect only for as long as the spouses filing as a qualified joint venture continue to meet applicable requirements. If the spouses fail to meet the requirements for a year, a new election will be nec­essary for any future year in which the spouses meet the requirements to be treated as a qualified joint venture.