How to cut self-employment tax on husband/wife partnerships

If you run your business as a husband/wife partnership, you’re forced to fill out a complicated Form 1065 (U.S. Return of Partnership Income) every year. But if you live in one of the nine "community property" states (see list at left), we have good news for you:

Under a little-known IRS ruling, you can now treat your husband/wife business as a sole proprietorship for federal tax purposes. (IRS revenue procedure 2002-69) That means you can stop filing Form 1065 and instead report your 2003 business income and expenses on simple and easy Schedule C, which you then include with your personal 1040 form.

More importantly, treating your business as a sole proprietorship could save you thousands in self-employment (SE) taxes.

Reason: With a husband/wife partnership, both you and your spouse must each file a separate Schedule SE and separately pay 15.3 percent SE tax on the first $87,000 of your 2003 SE income. So you’d be slapped with the horrendous 15.3 percent rate on up to $174,000 of SE income ($87,000 for each spouse). (Note: For income above $87,000, the SE tax rate drops to 2.9 percent.)

In contrast, if you file as a sole proprietorship, only one Schedule SE is required, for the spouse who is considered the proprietor. That means no more than $87,000 is subject to the full 15.3 percent SE tax rate.

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This change could reduce your 2003 SE tax bill by as much as $10,788 ($87,000 of SE income taxed at 2.9 percent instead of 15.3 percent). Plus, your tax filings would be greatly simplified. What a deal!

Note: Before switching, consult your tax adviser about other tax implications, including the impact on your state income tax situation. In most cases, converting won’t have any adverse or unexpected tax side effects.