From The Wall Street Journal.com:
Some husband/wife teams commit to more than just loving each other forever. They also choose to become business partners — taking the whole "for richer or poorer" thing to a whole new level. Luckily, a little tax savvy could definitely help tip that scale toward "richer."
But before I titillate you with the gritty details, let me say upfront that this tip only applies to couples living in the nine community property states (Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington or Wisconsin), who run their small business as a husband-wife partnership. If that's the case, then you've probably been filing Form 1065 (U.S. Return of Partnership Income) with the IRS each year to report your business income and expenses. These business tax items are then split between you and your spouse and shown on separate Schedules K-1 from the partnership (one for you and one for your spouse). Eventually, all the numbers from both of your Schedules K-1s are recombined and included on your joint Form 1040. (Anyone who's done this previously will tell you it's about as much fun as a root canal.)
But here's the good news: The IRS says you can treat your husband-wife business as a sole proprietorship for federal-tax-filing purposes. This is thanks to little-known IRS Revenue Procedure 2002-69. The upshot is you can choose to report all your business income and expenses on simple-and-easy sole proprietorship Schedule C (Profit or Loss From Business) which you then include with your Form 1040. Then you can (mercifully) forget about that ultracomplicated Form 1065 and those nightmarish Schedules K-1.
And wait — there's more! Treating your husband-wife business as a sole proprietorship instead of a partnership could potentially save you thousands in self-employment (SE) taxes every year. Here's why.
With a husband-wife partnership, both you and your spouse must each file separate Schedules SE for your respective shares of partnership income. Then you must each pay 15.3% SE tax on the first $102,000 of your share of 2008 partnership SE income. If your share of SE income exceeds $102,000, the SE tax rate drops to 2.9%. So if you have a profitable husband-wife partnership, both you and your spouse can each get hit with the maximum 15.3% SE tax rate on up to $102,000 of SE income (total of $204,000). Remember: This is on top of your federal and state income taxes. Ouch.
In contrast, if you treat your husband-wife business as a sole proprietorship, you only have to file one Schedule SE — for the spouse considered to be the proprietor — with your joint return. That means no more than $102,000 of SE income gets hit with the maximum 15.3% rate (any remaining SE income gets taxed at the much-easier-to-swallow rate of only 2.9%).
So which would you prefer: up to $204,000 taxed at 15.3% or no more than $102,000 taxed at 15.3%? Assuming you prefer the latter, simply treat your husband-wife business as a sole proprietorship instead of a partnership — starting with your 2008 return. Do this by filing Schedule C with your 2008 Form 1040 and by ceasing to file a separate partnership tax return on Form 1065. This simple drill could save you thousands in SE tax for 2008 and similar amounts each year in the future.