Setting up a “Mom and Pop Shop”? — Plan Carefully When It Comes to Self-Employment Taxes!
If you live and work in Southern Illinois, you probably rely on several “Mom and Pop Shops” for services and products on a regular basis. Family-owned businesses make the American economy durable and robust. They are reservoirs of assets and incubators of innovation and productivity. Here is an excellent article about the economic impact of family businesses.
Beginning with tax year 2007, joint husband-and-wife businesses with material participation by both spouses could elect Qualified Joint Venture treatment, an option that helps ensure each spouse gets proper Social Security credit for his or her self-employment earnings.
My experience as a Southern Illinois Disability attorney:
Minimizing Self-Employment Taxes Now Can Hurt You Later
Some tax preparers and some people who do their own taxes are tempted to focus on getting the lowest possible tax bill for a couple engaged in a family business.
The logic is simple: If the net taxable income for the business is over $118,500.00, allocating all or most of the income to one spouse will save 12.4% of the excess. This may sound like solid logic, but it is both short-sighted and possibly illegal because it cheats one spouse out of contributions to his or her Social Security earnings record and it misrepresents the nature of his or her contribution to the business.
From my perspective as a Southern Illinois Social Security attorney assisting clients with their Social Security Disability Insurance claims, this approach has serious disadvantages for the spouse who pays little or no self-employment taxes on his or her share of the income.
As I have explained in an earlier blog, you build up your Social Security benefit amount by paying Social Security taxes. If you work for an employer, you pay 6.2% and your employer pays 6.2% for a total of 12.4%. Medicare is an extra 2.9%, split between the employer and the employee.
When you are self-employed, you pay the entire amount—12.4% for Social Security tax and 2.9% for Medicare. At first, this sounds unfair, but there are some adjustments that make it hurt a little less: one half of the Social Security tax is deducted from net earnings for purposes of calculating self-employment taxes AND one half of the Social Security tax is deducted from gross income on IRS form 1040.
How Does This Hurt One Spouse?
This article will focus on two situations—disability and retirement.
For purposes of this article, I will refer to the spouses as MaxSpouse (paying SE taxes on the maximum net income) and ZeroSpouse (paying no SE taxes at all because all income was allocated to MaxSpouse).
If ZeroSpouse can no longer work because of illness and injury, his or her earnings record will show zeros in years when he or she was actually working very hard. This can lead to three different bad outcomes:
1. ZeroSpouse is not insured
If MaxSpouse and ZeroSpouse have used this “tax planning” technique for several years, there is a chance that ZeroSpouse is not insured for Social Security Disability Insurance Benefits. See this blog that explains how that happens.
2. ZeroSpouse’s monthly benefit is low
Even if ZeroSpouse is still insured for Social Security Disability Insurance Benefits, his or her monthly benefit will be much lower than ZeroSpouse’s because the benefit is calculated based on the amount of reported earnings.
The concept is simple–The higher the earnings over a lifetime, the higher the benefit amount when disabled or at retirement.
3. ZeroSpouse is seen as lazy or dishonest by the judge who hears the disability case
If ZeroSpouse’s Social Security Disability Insurance claim goes to a hearing with an Administrative Law Judge (ALJ), the ALJ will review the earnings record and see the years with zero earnings and wonder what was going on.
Some ALJ’s will hear ZeroSpouse testify that they used to work really hard but cannot work now and think that ZeroSpouse is exaggerating or lying.
Some ALJ’s will actually conclude that ZeroSpouse was committing tax fraud for years and that is a sign of dishonesty. ALJ’s can even request a fraud investigation by the IRS.
When ZeroSpouse retires, his or her lifetime earnings, average indexed monthly earnings (AIME), and primary insurance amount (PIA) will be much lower than MaxSpouse’s.
Most people do not realize that you get “less bang for your buck” at higher incomes when it comes to Social Security benefits.
When a worker’s PIA is calculated, he or she gets 90% of the first $856 of his or her AIME per month compared to 32% of his or her AIME between $856 per month and $5,157 per month and 15% of the amount over $5,157 per month. So you see, by shifting all of the income to MaxSpouse, the PIA is reduced by up to 1/6th for the first $10,000.00 per year in income and 1/3rd of the next $50,000.00!
You don’t have to be a math wizard to realize that neither spouse’s earnings record will get the benefit of the excess earnings that were excluded from self-employment taxes. So when this MaxSpouse/ZeroSpouse approach is used year after year, the result is a significant reduction of Social Security disability and retirement income.
The situation can be even more devastating for ZeroSpouse if there is a divorce before they have been married for ten years.
What Should Mom and Pop Shops Do? Advice from a Southern Illinois Social Security Disability attorney
My advice as a Southern Illinois Social Security Disability representative: Retain the services of an experienced tax accountant familiar with family businesses and Southern Illinois disability law before trying to save a few dollars on self-employment taxes by shifting all of the income to MaxSpouse and leaving ZeroSpouse with an earnings record full of zeroes.