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tax time question (long answer)

updated sat 17 jan 98


Olivia T Cavy on fri 16 jan 98

Here are a few thoughts about Kathi's idea of forming a partnership with
one's spouse. In her case this was done with rental property if I
remember correctly.

The point that your audit risk might drop could be true with a
partnership vs proprietorship, but I understand that audit risk 1)
increases with income, and 2) varies across the country and IRS district.
Even though Sch C filers are more likely to be audited than people on
W-2's, you just can't always tell which returns will be selected for

Forming a partnership has a lot more implications than merely allocating
income between 2 people rather than just yourself. The IRS will deny the
business purpose of the partnership if the sole purpose is to avoid
paying self-employment tax on income. Or if the spouse-partner doesn't
actively participate in the business and has
employment income from other sources (and thus some of the partnership
income would not be subject to social security self-employment tax if the

spouse's total income exceeded $65,400 in 1997). If the return is
examined, you could lose some of the gains. Plus, by making some of your
residence business property (regardless of whether you do this as a sole
proprietor or as a partnership) you will have to do a quick dance when
you want to sell the residence, to avoid picking up gain subject to tax
(the 2 of the last 5 years used as a residence rule).

Remember that when you convert part of your residence to business
property (whether attached or a separate building) you will lose the
ability to shelter the gain on sale. It becomes business property and
loses its character as a residence. In some cases real estate taxes could
actually go up (if the assessors found out) and you could be in violation
of land use restrictions. When you sell your house you will recapture
depreciation from the business use, regardless of whether or not you have
taken the depreciation deduction. The operative phrase is "depreciation
allowed or allowable". etc etc.

Also, you need to be sure any rent charged is reasonable, that there is a
lease, and that the rent is paid. You have to run the rental in a
business like manner, or you run the risk of having the IRS treat it as a
sham transaction. It is also possible that if you and your spouse
divorce, you will end up owning a business with someone whom you wish
were out of your life. If the spouse owns half of your business in a
partnership, that person owns half. Period. Your split up may have gotten
more complicated with another legal entity (the partnership), not that
ending a relationship is usually simple.

The bottom line is that you will also have to file a partnership return,
which is more complex than a Schedule C. It's a Form 1065 and it looks
deceptively simple. A partnership is a flow-through entity, meaning that
the partnership doesn't pay taxes. Income flows through to the partners,
which each partner receiving a K-1, which each partner uses to prepare
his/her own tax return. So you've added another layer to the income tax
preparation procedure.

You and your tax advisor would want to consider whether the dollars
involved are significant enough to even consider a partnership, and then
depending on your individual situation, whether it is cost effective.
Then there are the psychological aspects to setting up your own business
as a partnership, namely the self-worth issues. If my spouse works on a
W-2 and doesn't do much in my business, and my only job is as an artist,
do I really want to say that half of what I earn is really earned by my
spouse? I don't think I would, regardless of how much I love my spouse.

In addition there are issues relating to self employement tax. By
aggressively (and legally) minimizing your self employment income you
will pay less self-employement (social security) tax. However you may be
decreasing your benefits when you get to collect social security. You may
or may not care, but you should understand the implications of what you
are doing.

There are also the issues of having a written partnership agreement-
which should be done by a lawyer considering all the possible change of
partner issues, including termination of relationship and death issues.
What if one wants to get out, or the other wants the other to get out? If
there are 2 partners in a partnership and one of them dies, with the
other being the sole beneficiary, the partnership terminates unless
another partner is admitted. Who will that partner be? What is the value
of the partnership interest? These are the usual issues of forming a
partnership and often people form partnerships without considering them.

As I said, you are creating another legal entity when you form a
partnership. Sometimes it's a good idea, sometimes not. But if your only
purpose is to avoid paying taxes, the IRS will consider it to be a sham
and will deny it.

The partnership idea can certainly work in some situations but I would
caution that it's not a panacea. Again there are other implications in
owning a business with someone else, even your spouse. You could clearly
specify that the other partner owns a very small ownership share, but if
the relationship ends, your partnership could become a living hell,
particularly if it is a 50-50% partnership. Although it may not appear to
be true, a partnership as a form of organization is significantly more
complicated than a sole proprietorship times two. Particularly for older
workers, you may actually wish to have income at a level that will
provide for larger social security payments when you actually collect
social security. (I know, it's hard to imagine anyone's wanting to pay
tax on more income.)

I'm not saying to do it or not to do it. Just understand all the possible
remifications of what you are doing when you establish a partnership (or
a limited liability company taxed as a partnership) and make an informed
decision. And always be sure to dot the i's and cross the t's in
following your professionals' advice. ;-}

This wasn't part of Kathi's question, but if your partner is not your
spouse (ie the 2 of you are not married) your legal and tax situations
are different than for a married couple. Setting up a partnership could
make even more sense for you. You certainly will want to consult your
lawyer to give your partner which ever income-sharing, inheritance, power
of attorney benefits fit your needs.

Bonnie D. Hellman, CPA in PA and CO
Pittsburgh, PA
work email:
home email:

On Fri, 9 Jan 1998 11:12:51 EST Linda Blossom
>I was just wondering what Bonnie and other cpa's and accountants had
>to say
>about this idea of a partnership with the spouse?
>Linda Blossom
>2366 Slaterville Rd.
>Ithaca, NY 14850
>-----Original Message-----
>From: KLeSueur
>To: Multiple recipients of list CLAYART
>Date: Wednesday, January 07, 1998 12:41 PM
>Subject: Re: Tax time question
>>In a message dated 1/6/98 5:07:11 PM, you wrote:
>><>>returns with a CPA, but in my opinion, schedule C, the form
>>that folks like potters usually use for their business returns,
>>is as simple and straight forward as a tax form can be.
>>I can do mine in an hour or less.
>>This system works well until that horrible day when a letter comes
>>you that in just two weeks you are to appear at the IRS, records in
>>an audit. I've been through it and I can tell everyone that there's
>>calm the heart more than to say to the auditor, "My tax preparer is
>>to answer all questions." Then just sit there with your mouth shut.
>It is
>>absolutely amazing what items will be disputed by an auditor. "Why do
>>help at a fair?" It is absolutely amazing what the auditors don't
>>can only deduct $.13 per mile." Having a certified tax preparer
>>from the auditor can save lots of money.
>>There are two other bits of advice I can give that may help people
>avoid an
>>audit. First, if at all possible set up a partnership rather than
>>proprietor. If you are married set up a partnership with your spouse.
>>chances of being audited will drop significantly and if you are
>audited the
>>person doing the audit will be accustom to looking at business
>>than individual returns.
>>Second, if at all possible, have the studio pay rent for the space.
>In my
>>the studio is in a separate building. The property is in my name and
>>partnership rents it from me. As a result, the rent is not subject to
>>employment tax. Consider, if the rent is $750 a month, that's $9000
>a year
>>not subject to the 15% self-employment tax. $1350. That $9000 then
>>"investment" income for me and is taxed at a lower rate.
>>Another way to do it is to form a partnership with your spouse to buy
>>property the studio sits on. Then rent the property to yourself as a
>>The main advantage to this is that it eliminates all questions about
>>office deduction. You are renting the property for your business use.
>>It may be complicated, but if you ever have to sit in that IRS
>>be glad you did it.
>>Kathi LeSueur (who has sat in that IRS office)