Donald and Brenda Fitch learned the hard way that married entrepreneurs have a third partner in their businesses—Uncle Sam. The couple recently lost a tax court battle with the IRS over how much money they owed in self-employment taxes for their respective businesses. Their hard-earned experience provides an important lesson for couples when both spouses are small-business owners.
Self-employment taxes are the equivalent of payroll taxes for employed people, with the business owner responsible for both the employer and the employee portions. If your small business turns a profit, you almost certainly owe self-employment taxes.
For 2014, self-employment taxes consist of 12.4 percent of the profits of a business's first $117,000 in net income and 2.9 percent on all net income. Many small businesses may owe nothing in income taxes but are still liable for a self-employment tax.
A Tale of Taxes Owed
During the years 2005 through 2007, the Fitches both owned their own, separate businesses. Donald is a CPA who runs his own practice while Brenda is a licensed real estate agent who owned a realty business at the time. In each of these years, the realty business turned a profit while the accounting practice lost significant amounts of money.
When the couple filed their tax returns for each of these three years on Form 1040, they attached a single Schedule SE, which computes how much self-employment tax they owed. Since the accounting practice lost more money than the realty business made, they jointly presented a net loss each year, which meant they didn’t owe any self-employment taxes, since those taxes are tied to profits.
When the IRS audited the couple's returns, the agency disagreed with how they had calculated their self-employment tax liability. The Fitches tried to argue that Donald technically owned both businesses and that it was therefore acceptable to present a single Schedule SE. The IRS, however, had evidence to the contrary.
The argument the agency presented was that each spouse owned and managed a separate business: Brenda was the real estate agent and performed all the duties associated with being an agent (finding clients, running ads, showing houses, etc.), while Donald focused on his accounting business. The couple had filed a separate Schedule C for each business as well. Although Donald managed Brenda's accounting and would occasionally provide advice to her on her business, this didn’t outweigh all the other evidence proving that the businesses were separately owned and operated companies. The Fitches tried to argue that Donald did a great deal more for the realty business than provide accounting services and occasional advice, but they had no evidence to back it up.
As the owners of separate businesses, each spouse should have filed a separate Schedule SE for their particular business attached to their joint Form 1040. Under that scenario, Donald would owe zero self-employment taxes, but Brenda would have a tax liability because her business was profitable. As a CPA, Donald disagreed with the IRS on this, but the tax court ultimately sided with the IRS, and the couple had to pay more than $5,000 in self-employment taxes plus interest.
How could the Fitches have avoided this problem? By providing better evidence that Donald was the actual owner of both businesses, as they claimed. They lost the tax court case mainly because they couldn't prove that Donald was the owner of both the CPA business and the realty business and that he materially participated in both. Had the Fitches been able to show evidence that Donald was the owner of both businesses, then the self-employment income from both businesses could have been attributed to him, saving the couple more than $5,000.
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