If you and your spouse run a profitable unincorporated small business together, you may face some tricky tax rules. Understanding how the IRS classifies your business — and planning ahead — can save you money and headaches.
Why the IRS Sees You as a Partnership
By default, an unincorporated business jointly owned and operated by spouses is treated as a partnership for federal income tax purposes. This means:
- You must file an annual Form 1065 Partnership Return.
- Each spouse receives a separate Schedule K-1, showing their share of income, deductions, and credits.
These requirements increase your tax compliance burden and may trigger higher taxes.
The Self-Employment Tax Problem
Self-employment (SE) tax covers Social Security and Medicare taxes for self-employed individuals. For 2025:
- 12.4% Social Security tax applies on the first $176,100 of net SE income.
- 2.9% Medicare tax applies with no upper limit.
- An additional 0.9% Medicare tax kicks in if your joint SE income exceeds $250,000.
Each spouse must complete a separate Schedule SE with your joint Form 1040 to calculate SE tax on their share of partnership income. This can significantly increase your combined SE tax liability.
Example:
If each spouse earns $150,000 of net SE income from a 50/50 partnership (total $300,000), the combined SE tax is about $45,900 — on top of your regular federal income tax. (You do get a deduction for half of the SE tax.)
Three Proven Strategies to Reduce Taxes
1. Elect Sole Proprietor Treatment in a Community Property State
IRS Revenue Procedure 2002-69 allows spouses in community property states to treat their jointly owned business as a sole proprietorship operated by one spouse.
By allocating all net SE income to one spouse:
- Only the first $176,100 is subject to the 12.4% Social Security tax.
- This can substantially lower your SE tax bill.
2. Convert the Partnership to an S Corporation
If you’re not in a community property state, consider electing S corporation status:
- Only salaries paid to you and your spouse are subject to FICA taxes.
- The rest of the profits can be distributed as FICA-tax-free dividends.
- You’ll still need to pay reasonable salaries and meet S-corp compliance requirements.
This strategy often results in significant payroll tax savings.
3. Disband the Partnership and Hire Your Spouse
Another option is to dissolve the partnership and run the business as a sole proprietorship owned by one spouse, hiring the other spouse as an employee:
- Pay the employee-spouse a modest salary.
- Withhold 7.65% FICA from the salary and pay a matching 7.65% as the employer.
- File only one Schedule SE for the proprietor spouse.
This minimizes SE tax exposure because no more than $176,100 (2025 limit) is subject to the Social Security portion of SE tax.
As a bonus, you may also be able to offer employee benefits such as retirement plan contributions to your spouse.
Bottom Line: Don’t Pay More Than You Have To
Running a profitable unincorporated business with your spouse can trigger big SE tax bills and extra compliance work. With proper planning, you can minimize both.
Our team can help you evaluate which strategy — community property election, S corporation conversion, or spouse-as-employee — best fits your situation. Contact us today to reduce your tax burden and simplify your filing requirements.