When Should You Set up an LLC With a Spouse?

When married couples start a business, they often think about forming a limited liability company, or LLC. An LLC is a business type that is set up to protect members from personal liability for business debts and other legal liabilities. In some circumstances, the benefits of limited liability may diminish when a spouse regularly participates in a business because the spouse may incur personal liability for their actions.

Deciding to set up a single-member LLC or a multi-member LLC with your spouse depends on several factors. These include how you want to pay taxes, protect your personal assets, and follow state laws. We'll explore when it's smart for married entrepreneurs to form an LLC and how it affects things like income tax, Social Security, and Medicare.

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Personal Liability of a Participating Spouse

If a spouse regularly helps in the business, not having an LLC can be risky. Without an LLC, the business is likely to be a sole proprietorship. This means if the business owes money or gets sued, the couple's personal assets could be at risk. An LLC can help protect these assets. In community property states, it may be automatic for both spouses to be considered owners. In other states, the non-participating spouse might not be liable. It's important to know your state's laws.

If a spouse regularly works in an LLC, they may incur personal liability for their actions if they fall under the following categories:

• Independent Contractor: If the law considers the spouse an independent contractor, the spouse may be subject to personal liability. Determining whether the spouse is an independent contractor depends on several factors. These include whether the person or company receiving the services has a right to control the result of the work and the method by which it is accomplished. Because independent contractors are not employees, they are personally liable for their acts.
• Employee: The law may hold an employer liable for the injury caused by its employees. While the members of the LLC receive protection from personal liability for the actions of employees when the employee's acts are independent or not related to the functions of the job, the employee may incur personal liability. If a spouse is considered an employee, personal liability may result if the actions are outside the scope of employment.
• General Partner: Under a general partnership, partners are personally liable for the debts of the business. This means that if the law considers a spouse a general partner of the business, personal liability may be attached.

The personal liability of a spouse defeats the purpose of an LLC set-up because property owned by the spouse alone and property owned jointly by the spouses may be subject to a legal judgment.

Tax Complications of a Participating Spouse

Other complications may arise when a spouse regularly works in an LLC. If a spouse receives payment for their services from the LLC, the Internal Revenue Service (IRS) may consider the spouse an employee. Consequently, the failure to pay payroll taxes and withhold other taxes may result in IRS penalties. 

Having an employee also requires paying other expenses like unemployment insurance and workers' compensation insurance. If, on the other hand, a spouse is not paid for working on an occasional basis, the IRS will probably not consider the spouse an employee.

If one spouse is the only member, the IRS sees it as a disregarded entity for federal tax purposes. This means business income is reported on Schedule C of your personal tax return. If both spouses are members, it's considered a multi-member LLC, which is like a partnership. This can change how you file taxes. States have different rules, too. Some allow a qualified joint venture, letting couples avoid complex partnership tax returns.

When a Spouse Regularly Takes Part in the Business

If a spouse contributes to the business in minor ways and on an infrequent basis, in most cases, this will be unproblematic. If both spouses actively run the business, making the non-member spouse a member of the LLC might make sense. This changes the business structure to a multi-member LLC. In some circumstances, it may be best to make the spouse a member of the LLC when any of the following occurs:

• The spouse receives payment for their contribution
• The spouse regularly participates in and is involved with the business
• The spouse conducts business or interacts with the public on behalf of the LLC

It's important to update the LLC operating agreement and inform the secretary of state's office. This change can impact how you pay taxes and report income. It's not just about income tax. Self-employment tax for Social Security and Medicare also come into play.

Make a Spouse a Member of the LLC

When a spouse frequently works in an LLC, one of the best ways to avoid personal liability is to make the spouse a member. An LLC can add new members by following the terms of the operating agreement. The operating agreement, a document created when the LLC was set up, defines important terms about the management of the company.

In general, operating agreements require all members to agree to the addition of a new member. After the addition of a member, an LLC must amend the operating agreement to reflect the changes to the members' interests in voting, profits, and losses. To avoid complications with the IRS, the spouse's voting rights and the rights to profits should reflect more than a 0% interest.

Update the operating agreement to include both spouses. Remember, each state has different rules. In community property states, it might be automatic for spouses to own the business together. In other states, you may need to follow additional steps to make it official. Speak with a legal professional for help.

Get Legal Help Setting up Your LLC

Before deciding to make your spouse a member of an LLC, your first step should be to consult a lawyer to understand the legal implications. An experienced small business attorney will be able to explain the tax implications and help you avoid problems before they arise.

Get started today by contacting a small business attorney near you.