Tuesday, February 6, 2018
Some spousal business ventures can elect out of the partnership rules for federal tax purposes as a qualified joint venture (QJV). I.R.C. §761(f). While the election will ease the tax reporting requirements for husband-wife joint ventures that can take advantage of the election, the Act also makes an important change to I.R.C. §1402 as applied to rental real estate activities that can lay a trap for the unwary.
When is making a QJV election a good planning move? When should it be avoided? Are their implications for spousal farming operations with respect to farm program payment limitation planning? Is there any impact on self-employment tax? This week I am taking a look at the QJV. Today’s post looks at the basics of the election. On Thursday, I will look at its implications for farm program payment limitation planning as well as its impact on self-employment tax.
The QJV election is the topic of today’s post.
Joint Ventures and Partnership Returns
A joint venture is simply an undertaking of a business activity by two or more persons where the parties involved agree to share in the profits and loss of the activity. That is similar to the Uniform Partnership Act’s definition of a partnership. UPA §101(6). The Internal Revenue Code defines a partnership in a negative manner by describing what is not a partnership (I.R.C. §§761(a) and 7701(a)(2)), and the IRS follows the UPA definition of a partnership by specifying that a business activity conducted in a form jointly owned by spouses (including a husband-wife limited liability company (LLC)) creates a partnership that requires the filing of an IRS Form 1065 and the issuance to each spouse of separate Schedules K-1 and SE, followed by the aggregation of the K-1s on the 1040 Schedule E, page 2. The Act does not change the historic IRS position.
Note: Thus, for a spousal general partnership, each spouse’s share of partnership income is subject to self-employment tax. See, e.g., Norwood v. Comr., T.C. Memo. 2000-84.
While the IRS position creates a tax compliance hardship, in reality, a partnership return does not have to be filed for every husband-wife operation. For example, if the enterprise does not meet the basic requirements to be a partnership under the Code (such as not carrying on a business, financial operation or venture, as required by I.R.C. §7701(a)(2)), no partnership return is required. Also, a spousal joint venture can elect out of partnership treatment if it is formed for “investment purposes only” and not for the active conduct of business if the income of the couple can be determined without the need for a partnership calculation. I.R.C. §761(a).
A spousal business activity (in which both spouses are materially participating in accordance with I.R.C. §469(f)) can elect to be treated as a QJV which will not be treated for tax purposes as a partnership. In essence, the provision equates the treatment of spousal LLCs in common-law property states with that of community property states. In Rev. Proc. 2002-69, 2002-2 C.B. 831, IRS specified that husband-wife LLCs in community property states can disregard the entity.
Note: The IRS claims on its website that a qualified joint venture, includes only those businesses that are owned and operated by spouses as co-owners, and not those that are in the name of a state law entity (including a general or limited partnership or limited liability company). So, according to the IRS website, spousal LLCs, for example, would not be eligible for the election. However, this assertion is not made in Rev. Proc. 2002-69. There doesn’t appear to be any authority that bars a spousal LLC from making the QJV election.
With a QJV election in place, each spouse is to file as a sole proprietor to report that spouse’s proportionate share of the income and deduction items of the business activity. To elect QJV status, five criteria must be satisfied: (1) the activity must involve the conduct of a trade or business; (2) the only members of the joint venture are spouses; (3) both spouses elect the application of the QJV rule; (4) both spouses materially participate in the business; and (5) the spouses file a joint tax return for the year I.R.C. §761(f)(1).
Note: “Material participation” is defined in accordance with the passive activity loss rules of I.R.C. §469(h), except I.R.C. §469(h)(5). Thus, whether a spouse is materially participating in the business is to be determined independently of the other spouse.
The IRS instructions to Form 1065 (the form, of course, is not filed by reason of the election) provide guidance on the election. Those instructions specify that the election is made simply by not filing a Form 1065 and dividing all income, gain, loss, deduction and credit between the spouses in accordance with each spouse’s interest in the venture. Each spouse must file a separate Schedule C, C-EZ or F reporting that spouse’s share of income, deduction or loss. Each spouse also must file a separate Schedule SE to report their respective shares of self-employment income from the activity with each spouse then receiving credit for their share of the net self-employment income for Social Security benefit eligibility purposes. For spousal rental activities where income is reported on Schedule E, a QJV election may not be possible. That’s because the reporting of the income on Schedule E constitutes an election out of Subchapter K, and a taxpayer can only come back within Subchapter K (and, therefore, I.R.C. §761(f)) with IRS permission that is requested within the first 30 days of the tax year.
In general, electing QJV status won’t change a married couple’s total federal income tax liability or total self-employment tax liability, but it will eliminate the need to file Form 1065 and the related Schedules K-1. In that regard, the QJV election can provide a simplified filing method for spousal businesses. It can also remove a potential penalty for failure to file a partnership return from applying. That penalty is presently $200 per partner for each month (or fraction thereof) the partnership return is late, capped at 12 months.