Self Employment in Community Property States
Charlene M. Ives, CPA, PC
For income tax purposes, community property rules generally require an equal allocation of income earned by spouses regardless of who actually earned it.
However, for self-employment (SE) tax purposes, the IRS maintains that the spouse conducting the trade or business is solely liable for SE tax on 100% of the trade or business net income.
IRC Sec. 1402(a)(5)(A) states that if any income derived from a trade or business is community income (under the community property laws applicable to that state), all of the gross income and deductions attributable to such trade or business shall be treated as gross income and deductions of the husband (Landsberg). This is the rule unless the wife exercises substantially all of the management and control of the trade or business, in which case all of the gross income and deductions are allocated to her for SE tax purposes (Charlton).
Note: In Rev. Rul. 82-39, the IRS stated that despite IRC Sec. 1402(a)(5), it will follow the noncommunity property rule in community property states, holding that, absent a partnership, only the spouse carrying on the trade or business activity will be subject to the SE tax. The Schedule SE instructions provide similar guidance. As a practical matter, however, a spouse in a community property state who carries on a trade or business probably exercises sufficient management and control over the business to be subject to SE tax under IRC Sec. 1402(a)(5)(A), which makes the IRS stance less contradictory.
The rules for reporting trade or business income derived from community property income do not apply if one spouse is an employee of the other spouse's sole proprietorship (Ltr. Rul. 8742007). In this case, wages paid by the proprietor to the employee-spouse are subject to W-2 and FICA reporting, as discussed in Key Issue 8C.
"Executive Summary":
- The Internal Revenue Code states that SE income will be allocated to the husband, when spouses both work the business.
- However, the IRS allows one or the other spouse to report the income, based on who is actually conducting the business.
- For Federal income tax, both spouses are liable even in community property states. (Recourse: Innocent Spouse)
- But for SE tax, the spouse who operates the business is solely liable.
- If you want to better delineate the relationships, one way is to let the managing spouse report on Schedule C, and put the other spouse on the payroll. Or, select another form of business.
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