Article: Strategies for Reducing Self-Employment Taxes


	Jeff Bither

June 2007

Strategies for reducing self-employment taxes

The IRS allows husband-wife business owners, in community property states such as Arizona, to structure their businesses in ways that can lower their Social Security and Medicare tax liability

If you and your spouse are the sole members of a traditional or single-member limited liability company and you are residents of Arizona or one of the eight other community property states,1 you should know about certain IRS-approved maneuvers that may reduce your self-employment (SE) tax and simplify your federal income tax filing obligations. The strategies can be a little complicated, but the potential benefits warrant your attention and patience.

Background. For 2007, the maximum 15.3% SE tax rate applies to the first $97,500 of SE income. (The 15.3% consists of 12.4% for Social Security tax and 2.9% for Medicare tax.) The portion of your SE income that exceeds $97,500 continues to be subject to the 2.9% Medicare tax, but it is exempt from the 12.4% Social Security tax.

If both you and your spouse have SE income, each of you must separately compute your SE tax (on a separate Schedule SE), even if you file jointly, and each of you must pay the maximum 15.3% SE tax until each of your respective SE incomes exceeds the Social Security tax ceiling for the year. Therefore, in the absence of planning strategies that reduce your liability, if both you and your spouse report SE income of $97,500 or more, your aggregate SE tax for the year would probably be more than $25,000.

Fortunately, the IRS allows you to implement certain strategies that can significantly reduce your SE tax liability.

Opportunities. Revenue Procedure 2002-69 defines a business entity, including a sole proprietorship, as a “qualified entity” – i.e., eligible for the flexible treatment of either a sole proprietorship or partnership as provided in Revenue Procedure 2002-69 – provided that:

the entity is wholly owned by a husband and wife as community property,
no person other than one or both spouses would be considered an owner of the entity for federal tax purposes, and
the entity is not treated as a corporation.

Revenue Procedure 2002-69 goes on to say that the IRS will respect your treatment of a qualified entity as either (a) a sole proprietorship (including a single-member LLC that is treated as a sole proprietorship for federal tax purposes), or (b) a partnership (including a multimember LLC that is treated as a partnership for federal tax purposes).

In other words, if you and your spouse treat your qualified entity as a sole proprietorship for federal tax purposes, that’s acceptable to the IRS. And if you treat your qualified entity as a partnership for federal tax purposes and you file partnership returns, that’s okay, too.

It is important to note that Revenue Procedure 2002-69 provides that a “change in reporting position will be treated for federal tax purposes as a conversion of the entity.” This is an important provision, as the following examples illustrate.

Example 1: You own a qualified entity that, for federal tax purposes, has been treated as a husband-wife partnership or LLC. You can convert the qualified entity into a sole proprietorship or a single-member LLC for federal tax purposes simply by filing a Schedule C for the conversion year.

Example 2: Conversely, you own a qualified entity that, for federal tax purposes, has been treated as a sole proprietorship or single-member LLC. You can convert the qualified entity into a husband-wife partnership or LLC simply by filing an initial Form 1065 for the conversion year.

SE Tax Implications. Revenue Procedure 2002-69 specifically says that the rules explained above apply “for federal tax purposes,” which means for both federal income tax and SE tax. To summarize the SE tax rules for residents of Arizona and other community property states:

Trade or business income (including trade or business income from a partnership) is generally considered to be community income under state community property laws.
Community income must be split 50/50 between the spouses for federal income tax purposes (achieved automatically on a joint return).
However, the 50/50 rule doesn’t apply for SE tax purposes. Instead, when any of the income derived from a trade or business other than a partnership is considered community income, 100% of the gross income and deductions from such trade or business must be allocated for SE tax purposes to the spouse who carries on the business.
In the case of partnership trade or business income, the spouse who is the partner reports his or her distributive share of the partnership’s income and deductions items for SE tax purposes, while the non-partner spouse reports none.
However, in the case of a jointly operated husband-wife partnership, the partnership’s income and deduction items are allocated between the spouses for SE tax purposes according to their distributive shares.

Converting from a Partnership or LLC. If you own a qualified entity that, for federal tax purposes, is treated as a husband-wife partnership or LLC, you should consider converting it into a sole proprietorship for federal tax purposes (or single-member LLC treated as such for federal tax purposes), if doing so would result in significant SE tax savings.

Example 3: Converting an existing 50/50 husband-wife partnership that generates $200,000 of SE income into a sole proprietorship that is treated as belonging to one spouse would reduce your SE tax bill by roughly $11,000. Of course, the exact SE tax results would depend on whether either or both of you have any salary income or SE income from other sources that is subject to the Social Security tax. The conversion is accomplished by liquidating the assets (if any) of your existing husband-wife partnership or LLC into a new sole proprietorship or single-member LLC considered to be owned by either you or your spouse. In most cases, the only actual federal income tax impact of the conversion will be ceasing to file Form 1065 and instead filing Schedule C for the new sole proprietorship or single-member LLC. However, as was mentioned above, the SE tax savings from such a conversion could be substantial.

Converting from a Sole Proprietorship or SMLLC. If you own a qualified entity that is treated, for federal tax purposes, as a sole proprietorship or single-member LLC, you should consider “converting” it into a husband-wife partnership or LLC for federal tax purposes, if doing so would result in significant SE tax savings.

Example 4: Your existing sole proprietorship generates $90,000 of SE income, and your spouse earns a $100,000 salary from his or her job at a third-party employer. If you convert your sole proprietorship (pursuant to Revenue Procedure 2002-69) into a 50/50 husband-wife partnership, almost $49,000 of SE income is shifted from you to your spouse. That would reduce your combined SE tax bill by about $6,000, since the $49,000 of SE income that you shifted to your spouse’s Schedule SE is taxed at only 2.9% instead of being taxed at 15.3% on your Schedule SE. The conversion is accomplished by contributing for federal tax purposes the assets (if any) of the sole proprietorship (or single-member LLC) to the new husband-wife partnership (or husband-wife LLC).

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.