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Small Business Tax Tip for Married Couples: The Partnership Loophole

By George Khoury, Esq. on March 09, 2017 | Last updated on March 21, 2019

It's getting to be that time of year when the country struggles with tax forms, tax returns, tax software, tax laws, tax people, tax bills, and everything else to do with taxes. For business owners, tax season is even more hectic as not only are individual returns due for owners, but they must get all their employee, and contractor, tax forms out, or face serious penalties.

Apart from having someone to lean on during the troubling, and taxing, times between New Years and mid-April, there are a quite a few benefits to spouses running a business together. The partnership loophole (a.k.a. electing out of partnership status) is one of the benefits and is likely the most regularly used avenue for married business partners to avoid filing the dreaded 1065.

The Husband and Wife Partnership Loophole

If a business is unincorporated, it is likely to be characterized as a sole proprietorship, unless a person is or gets married. Then, a business owner that wants to be a sole prop actually needs to be careful to ensure that they maintain that status rather than becoming a husband/wife partnership. Generally, if a married couple is operating a business together, then the sole prop designation is inaccurate, as a sole prop, literally, requires that there be only one business owner. Most frequently, husband and wife teams operate as partnerships, which, for the uninitiated, entails a rather nightmarish tax filing headache.

Fortunately, many husband and wife business partnerships can qualify for a special exemption from having to file partnership taxes. The exemption is called 'electing out of partnership status.' To qualify, the couple must file their taxes jointly, be the only owners of the business, and both spouses must significantly participate in running the business. There's still some more paperwork than filing for a sole prop (such as each spouse must have a separate K-1), but it's generally much less paperwork (and frustration) than for filing for a partnership.

When it comes to complex business, and even individual, taxes, if you are unsure about anything, it is highly advisable to seek out assistance from a qualified tax professional, accountant, or attorney. Additionally, it is important to note that the above information generally only applies to federal taxes. Individual state tax laws will likely vary.

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