You have a tremendous number of ways you can structure, control, and manage your retirement account. The Solo 401k is at the center of that flexibility. You and/or your spouse can have 401ks with another employer and still contribute to a Solo 401k. Or you can exclusively hold all of your retirement funds in a Solo 401k. Or your spouse can do one and you do the other. But most of all, your Solo 401k greatly increases the types of investments that you can make, including co-investing with your spouse when he or she has a Solo 401k.
There are many ways your spouse can be involved with your Solo 401k. One is that your spouse can be an employee of your sole proprietorship and a participant in your Solo 401k. This allows the two of you to double your annual contributions to the plan. But one variation seldom considered allows your spouse to be an active owner in the same sole proprietorship you own. This can be the right answer when your spouse has more control of the business than as an employee.
Spouses Can Own a Sole Proprietorship Together
A basic business requirement for a Solo 401k is owning a business. That’s because a Solo 401k is an employer-sponsored retirement plan. For a Solo 401k, a simple sole proprietorship can be the perfect answer for running your small business.
You may not have thought this is possible based on the definition of a sole proprietorship being a business with only one owner. However, the IRS has a unique classification when married couples are both active participants in a sole proprietorship. The IRS term for this is a Qualified Joint Venture (aka “spousal” joint venture). This became available as a result of the Small Business and Work Opportunity Act of 2007.
However, unless you elect to file as a qualified joint venture, the IRS automatically classifies it as a partnership (even if there is no formal partnership agreement). A partnership can create tax complexity because it requires issuing a Schedule K-1s to each of you, rather than reporting the business income and expenses on a Schedule C. There are also additional record-keeping requirements imposed on the partnership as well as the partners.
Because this is federal law, all states allow a jointly owned and managed business to be classified as a “qualified joint venture”. Then, the IRS treats both owners as sole proprietors for tax purposes.
IRS Requirements of a Married Sole Proprietorship
The requirements to qualify as co-sole proprietors are relatively simple:
- The married couple must be the only owners of the business.
- The spouses must file a joint income tax return.
- Both must “materially participate” in the business. That means each spouse works in the business’s day-to-day operations on a regular, continuous, and substantial basis.
- The IRS has multiple definitions of material participation but a general rule of thumb is working 100 hours in the business annually with a safer number being 500 hours. The type of work should be directly related to business operations rather than as an investor. (Also, see IRS Publication 925 for passive activities.)
- Both spouses must share the items of income, gain, loss, deduction, and credit based on each spouse’s interest in the business.
- Both spouses must elect qualified joint venture status.
Joint Venture Potential Pitfalls
The election to be a qualified joint venture is made by simply preparing and attaching separate Schedules C, or Schedules F, and Schedules SE (self-employment tax) for each spouse with a joint individual income tax return. Once made, the election is only revocable with the consent of the IRS. However, if the qualifications are no longer met it would no longer apply. Afterward the business resumes filing tax returns as a partnership or sole proprietorship.
Unfortunately, some existing business entities do not qualify to switch to qualified joint venture status. These include corporations (S-corp or C-corp). Limited liability entities are a state designation (recognized by the IRS). These can become a qualified joint venture. However, they must first elect a new status at the state level (sole proprietor or partnership).
Community property states allow a spouse LLC to become a qualified joint venture. Community property is a type of joint ownership of assets. Nine states provide for this type of ownership between spouses. Business earnings can be included as jointly owed in these states if the earnings meet other criteria. This principle of joint ownership allows the IRS to treat joint ownership of an LLC by two spouses the same as it would for a partnership owned by two spouses. (The nine states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.)
Advantages and Disadvantages of a Co-Sole Proprietorship
Your circumstances may have other reasons that make a qualified joint venture preferred. However, the three most universal reasons are:
- It’s less expensive and easier to file two Schedule C business tax forms than to file a complicated partnership income tax return for your business. There are three tax returns involved with a partnership. A partnership must file its own business tax return (an information return). The partnership return divides the income between the partners for tax purposes. Income passes down to the partners to be taxed on each of their personal returns.
- It alleviates the couple from having to maintain the records required of a partnership.
- Both spouses receive Social Security/Medicare credits for business profits. Although spouses must pay self-employment taxes on their share of the profits, these taxes add to each spouse’s Social Security/Medicare eligibility and benefits. When only one spouse reports self-employment income as a sole proprietor to avoid the paperwork that comes with a partnership, this means that only one spouse receives the credit for the taxes paid. The other spouse will be short-changed concerning their future social security benefits.
Other Considerations for a Co-Sole Proprietorship
Another possible advantage is not needing to create and file a partnership, LLC, or corporation registration if you haven’t done so already. Nor pay the registration fees.
Something else to consider is that sole proprietorships also qualify for the pass-through tax deduction established in 2017. That allows you to deduct up to 20% of your net business income on your income taxes — a nice big deduction.
You can also change the business structure at a future date if that becomes the right thing to do. Whatever you decide, your Solo 401k still has the same features and services that come with all accounts. A time when a spouse may need a separate Solo 401k plan is if he or she has their own sole proprietorship (or LLC, C or S Corporation).
Still, the qualified joint venture remains a sole proprietorship. It doesn’t offer the same asset and liability protections that a separate entity (corporation or LLC) can offer. As always, consult with a tax professional or attorney about what is best for your specific situation.