Divorcing the Husband and Wife Business: an Analysis and Critique of I.r.c. § 761(f)

• Citation: Vol. 25 No. 4
• Publication year: 2010

Georgia State University Law Review

Volume 25 , „ ,

Article 15

Issue 4 Summer 2009

3-21-2012

Divorcing the Husband and Wife Business: An Analysis and Critique of I.R.C. § 761(f)

Adam S. Winger

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Winger, Adam S. (2008) "D ivorcing the Husband and Wife Business: An Analysis and Critique of I.R.C. § 761(f)," Georgia State

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Winger: Divorcing the Husband and Wife Business: An Analysis and Critiqu

DIVORCING THE HUSBAND AND WIFE BUSINESS: AN ANALYSIS AND CRITIQUE OF I.R.C. § 761(f)

Adam S. Winger*

Introduction

Congress extended a unique benefit to husband-and-wife businesses in its 2007 modification of I.R.C. § 761(f).¹ The subsection now allows a spousal venture to elect out of federal partnership status in favor of a newly created hybrid entity, the "qualified joint venture." By splitting the existing partnership into two distinct sole proprietorships, the qualified joint venture relieves couples of complex compliance burdens associated with partnership taxation.³ Additionally, I.R.C. § 761(f) calls for a proportionate division of income between the spouses, thus each will be correctly awarded Social Security and Medicare credit for their efforts.⁴ Although the subsection's benefits are clear, Congress' failure to resolve several related issues may unfortunately limit the legislature's benevolent intent.⁵

This article provides an analysis of I.R.C. § 761(f), highlighting some of its benefits and shortcomings and also provides a few recommendations for improvement.⁶ Part I investigates several benefits I.R.C. § 761(f) seeks to extend.⁷ Part II offers both an

* Adam S. Winger is a CPA and graduated from Georgia State University College of Law in 2010. He is obtaining his LL.M. in taxation from New York University, and will join the Birmingham, AL firm of Baker, Donelson, Bearman, Caldwell & Berkowitz, PC. in June, 2010.

1. U.S. Troop Readiness, Veterans' Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007, Pub. L. No. 110-28, § 8215,121 Stat. 112, 193 (codified as amended at I.R.C. § 761(f) (West 2007)).

2. I.R.C.§ 761(f) (West 2007).

3. I.R.C. § 761(f)(1); see also I.R.S. 2002 Report to Congress, Nat'l taxpayer Advoc. 181 (2002) [hereinafter I.R.S. Report].

4. I.R.C.§ 761(f)(1).

5. See discussion infra Part I.

6. See discussion infra Parts I—III.

7. See discussion infra Part U.

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analysis and critique of the subsection's provisions.⁸ Finally, Part III provides functional recommendations for improvement.⁹

I. I.R.C. §761(f) Benefits

I.R.C. § 761(f) achieves three core objectives, and does so without detrimentally impacting national revenue:¹⁰ First, it relieves husband-and-wife businesses of unnecessary compliance burdens; second, it ensures the integrity of the Internal Revenue Service (IRS); third, it corrects an existing problem with family Social Security and Medicare crediting.¹¹

A. Reduces the Compliance Burden

Whether they know it or not, a couple working together is most likely operating a partnership for federal tax purposes.¹² As a result, the spouses are expected to understand and comply with Subchapter K of the Internal Revenue Code.¹³ Subchapter K's provisions, however, are "distressingly complex and confusing" and present immense challenges even to "one who is sophisticated in tax matters with many years of experience in the tax field."¹⁴ By enabling a couple to elect out of partnership status, I.R.C. § 761(f) relieves couples of the majority of these hardships.¹⁵

To illustrate the compliance burdens, the following is an example of the potential annual filing requirements. The partnership is recognized as an entity apart from its owners.¹⁶ Consequently, the

8. See discussion infra Part III.

9. See discussion infra Part IV.

10. See I.R.S. Report, supra note 3, at 181.

11. Id.

12. See S.S.R. 84-11, 42 (1984), available at http://www.ssa.gov/OP_Home/rulings/oasi/47/SSR84-1 l-oasi-47.html (indicating the couple may not know of their partnership status).

13. U.S. Income Portfolios: Partnerships, Portfolio 710-2nd (BNA Tax and Acer. center.) § I.

14. Foxman v. Comm'r, 41 T.c. 535, 551 n.9 (1964) [hereinafter U.S. Income Portfolios 710]; accord Susan Kalinka, Louisiana Civil Law Treatise Limited Liability Companies and Partnerships, § 3.7 (3d ed. 2007).

15. See I.R.S. Report, supra note 3, at 181.

16. Treas. Reg. § 301.7701-2(c)(2Xiii) (2006).

couple must file a Form 1065 on the entity's behalf reporting all income, deductions, gains, and losses from operations.¹⁷ Next, two Schedule K-ls must be completed that reflect each spouse's allocable share of the income or loss.¹⁸ The couple must then transcribe the Schedule K-l information onto individual Schedule Es, reporting the partnership income as their own.¹⁹ Next, because partners are not considered employees for federal tax purposes, both must complete Schedule SEs, characterizing their distributive share of income as earned from self-employment.²⁰ Finally, all personal schedules merge onto the couple's joint Form 1040, which ultimately determines the net tax liability on partnership earnings. The IRS estimates the partnership forms alone—Form 1065 and Schedule K-ls—take approximately 165-200 hours to prepare and file.²² Translated into economic terms, a family business has the option to either sacrifice more than a month of productive labor or pay lofty fees to a tax practitioner just to comply with Subchapter K.

By allowing married couples qualified joint venture status, Congress removes nearly all federal compliance burdens.²⁴ In contrast to the partnership, the qualified joint venture's two sole proprietorships are not separate legal entities for federal income tax

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purposes. Consequently, no entity-level filings are required. Instead, the spouses simply divide net income in accordance with their respective ownership interests and report this information on

17. See I.R.S., Instructions to Form 1040 (2008), at C-2, available at http://www.irs.gov/pub/irs-pdfZii040.pdf [hereinafter 1040 Instructions].

18. I.R.S. Report, supra note 3, at 175.

19. See I.R.S., Instructions to Schedule E (Form 1040), at E-l, E-5 (2006), available at http://www.unclefed.com/IRS-Forms/2006/il040se.pdf. Schedule E relates to "Supplemental Income and Loss" from a partnership.

20. See id. at SE-2.

21. See generally id.

22. I.R.S. Report, supra note 3, at 172.

23. See generally charles rangel, taxpayer protection ACT of 2007, H.R. rep. No. 110-84, at 8 (2007) (indicating husband-and-wife business owners "may be subject to unnecessary complexity under present law") [hereinafter rangel Act].

24. Andrew R. Biebl, Tax Bill du Jour, top producer, Summer 2007, at 34.

25. U.S. Income Portfolios: Partnerships, Portfolio 700-3d: Choice of Entity (BNA Tax and Acer. Center.) § n-B [hereinafter U.S. Income Portfolios 700].

26. Id.

two Schedule Cs. Unlike the partnership, "[t]he IRS estimates that it takes the average taxpayer about [eleven] hours to complete a Schedule C." Although each spouse will remain responsible for reporting self-employment income, the qualified joint venture relieves couples of the most oppressive burdens associated with Subchapter K.²⁹

B. Assisting in Maintaining the Integrity of the IRS

Due to either a lack of awareness or the substantial cost of compliance, family businesses have traditionally shirked the responsibilities connected to their partnership status.³⁰ This continuing neglect triggered the IRS's issuance of Revenue Procedure 81-11.³¹ Instead of punishing the couples, however, the procedure exacerbated the problem by waiving penalties for small businesses that "historically had not filed partnership returns."³² Interestingly, the waiver did not "eliminate the filing requirement for partnerships ...; it merely providefd] that a penalty for failure to file will not be assessed." The National Tax Advocate took issue with this leniency, stating:

Respect for the integrity of the tax system suffers when rules are imposed that place an unnecessarily heavy compliance burden on taxpayers, that many taxpayers ignore .. ., that the IRS . .. does not enforce, and that have no impact on tax liability. It is

27. Id. § II-B, -A-4 n.28; see 1040 instructions, supra note 17, at C-2. The Schedule C is used to report "Profit and Loss from Business" operations. Note also that Schedule F is used for similar items in farming contexts.

28. I.R.S. Report, supra note 3, at 172.

29. Id. at 181. Note also that in Chief Counsel Advice 200816030, guidance was issued to confirm that rental real estate income, which would otherwise be exempt from Self Employment tax, will retain its exempt status in the hands of a qualified joint venture. Qualified Joint Ventures and Rental Business Income, I.R.S. Chief Counsel Advisory 200816030 (Apr. 18. 2008).

30. See Revenue Procedure. 81-11, 1981-1 C.B.651 (superseded by Rev. Proc. 84-35).

31. Id.

32. Id. (listing additional requirements); accord Royer v. Apfel, No. IP-99-1387-CH/G, 2000 WL 1707955, at *3 (S.D. Ind. Oct. 16, 2000) (indicating many small family partnerships do not comply with business formalities).

33. Social Security Ruling 84-11, at *3 (1984).

confusing and pointless for the Internal Revenue Code to require all partnerships to file a partnership tax return, while the IRS .. . does not enforce the requirement----³⁴

Congress effectively mitigated the risk of compromising its integrity via modification of I.R.C. § 761(f).³⁵ By splitting the husband-and-wife business into two...