Many of the nation’s successful small businesses are owned and operated by married couples. When these businesses first start, the goal is simply to try and survive to the next day, the next week, the next month.
Often, very little thought is given to the long-term effect of how self-employment income (abbreviated for our purposes here as SEI) is allocated for future Social Security benefits.
But under the right circumstances, planning in this area can make a big difference!
If you are reading this and are thinking, “I wish I would have known this sooner!” don’t despair. In the right circumstances, there may be an opportunity to retroactively amend the split of SEI for couples in this situation. We’ll cover more on that later.
For now, let’s start by understanding what couples who run a business together need to understand about how their pay structure could impact their future Social Security benefits.
The Potential Problem Married Couples Face with Social Security When Running a Business Together
During the early stages of many businesses, the operation is often a joint effort between spouses. One may take a client- or customer-facing lead role, while the other may work behind the scenes handling payroll, marketing, accounts payable and a host of other tasks.
On a practical, everyday level, the business operates as a partnership – even if the legal structure of the business indicates that it is solely owned by one spouse. And in many cases, that spouse begins the company as a sole proprietor.
For tax purposes, a sole proprietorship is considered a “pass-through” business. The profits or losses of the business are calculated on a Schedule C and then passed through to the owner’s personal tax return.
If the business produces income, that income is subject to federal income taxes. Additionally, it is subject to self-employment taxes which fund Social Security and Medicare.
It’s these self-employment taxes that establish eligibility for Social Security and Medicare. An individual’s eventual Social Security benefit is determined based on the level of income received and taxed for Social Security.
For sole proprietor businesses that are run by a husband/wife team, this is where a potential problem arises. A sole proprietor means just that…sole. Only one person is listed on the Schedule C as the proprietor (owner).
This means that any self-employment taxes paid through income generated by the business will only credit the work record of the individual listed as the owner of the business. The spouse who is not listed as the owner will not receive any credit towards a future benefit.
For example, let’s assume that Jack and Lauren run a heating and air business that’s operating as a sole proprietorship. Jack is listed as the owner of the business. Jack spends his day out in the field doing new installations and repairs, while Lauren spends her day tracking invoices, setting appointments, and marketing.
If the business reports a $75,000 profit, the SEI from that profit will only credit Jack’s Social Security earnings record. This means that Lauren will not receive any credit towards a future benefit.
This might not necessarily be a problem, thanks to the way Social Security benefits are normally calculated and paid to family members. But…there is at least one circumstance where this could present a big problem for married couples.
We’ll get to that below. First, let’s look at how a more strategic approach to the allocation of SEI between spouses can make a measurable difference in eventual Social Security benefits.
How to Strategically Organize Your Self Employment Income to Improve Social Security Benefits
When a higher-earning spouse files for his/her benefit, the lower-earning spouse is eligible for a spousal benefit payment of up to 50% of the higher earning spouse’s benefit.
(For an in-depth read on spousal benefits, see Social Security Spousal Benefits: The Complete Guide.)
Let’s go back to our example couple, and assume that Jack’s full retirement age benefit is $2,000. At Lauren’s full retirement age, she would be eligible for a spousal benefit of up to $1,000. This would give Jack and Lauren a collective household benefit of $3,000.
Is it possible that Jack and Lauren could have split the SEI from their heating and air business to arrive at a household benefit that was higher than $3,000?
To figure this out, we can use another example of a different couple who were each born in 1953 and began working in 1975 at the age of 22. They both retired at 66. Using the National Average Wage Index (NAWI) as an earnings benchmark, we can see the following results:
For a couple whose business earned 100% of the NAWI each year, and all of those earnings were credited to one individual, that individual would receive a full retirement age benefit amount of $1,647.
This means that the other spouse would be eligible for a spousal benefit of $824 ($1,647 x 50%). The total household benefit they would receive together would be $2,471.
If they had made the decision to split the earnings, and credit half to each spouse, they would each end up with a benefit of $1,055. In that scenario they would receive a household benefit of $2,110 ($1,055 x 2).
Because there is no “free” spousal benefit, where earnings are not an issue, splitting up the SEI would actually result in $361 dollars less in total monthly benefits.
Now let’s look at the same couple, but see how things change if they earned twice the national wage average on an annual basis. In this case, the individual who had the earnings credited to their work record would have a full retirement age benefit of $2,400. This means that the spousal benefit for the other person would be $1,200. The total benefit they would receive together would be $3,599.
If this couple had made the decision to split the SEI in half, they would each end up with a benefit of $1,647. In that scenario they would receive a collective benefit of $3,294. Again, because there is no “free” spousal benefit, where earnings are not an issue, splitting up the SEI would result in $305 dollars less in total benefits.
This benefit advantage would also continue if one spouse died. In the case of the couple with 200% the NAWI, the surviving spouse would be left with a benefit of $2,400. If they would have split SEI instead, the surviving spouse would be left with a benefit that was $752 lower!
(For more information on how survivor benefits work, check out my comprehensive article.)
In a scenario where a couple has SEI higher than the maximum amount subject to the Social Security portion of self-employment taxes, the household benefit can often be increased by splitting.
The issue with this is that by splitting the amount of SEI that is over the taxable limit to a spouse, that amount is now exposed to the self-employment taxes. This increase in taxes may often be greater than the potential increase in Social Security benefits.
In most cases, whether it’s a spousal benefit or a survivor benefit, there is a clear advantage to allocating the SEI to only one spouse.
(If you want to take a deeper dive into case studies for splitting SEI, see this article by Michael Kitces: Coordinating Social Security Couples’ Benefits For The Self-Employed: The False Promise Of Salary-Splitting)
A Divorce Changes Everything
The wildcard that changes everything discussed above? Divorce.
If a married couple who previously ran a business together got divorced, there would be no “household” pool of benefits from both the higher-earning spouse and the spousal benefit. The lower-earning spouse can still be eligible for a spousal benefit, but that amount will be half of the benefit being paid to the spouse who had the SEI credited to their Social Security earnings record.
For example, let’s again assume that Jack’s full retirement age benefit is $2,000. At Lauren’s full retirement age, she would be eligible for a spousal benefit of up to $1,000. This would give Jack and Lauren a collective household benefit of $3,000.
But if Jack and Lauren divorce, he would be able to continue collecting his $2,000 monthly benefit and Lauren would collect $1,000. Obviously these are the same amounts as before, but they are now individually received. Because they divorced, there’s no “household income” – just what they receive separately.
For a husband/wife team who labored together in building a business, one person having a benefit that is twice as high as the other doesn’t seem fair. Thankfully, under the correct conditions, this inequity can be remedied.
What to Do If You’re Divorced – and Receive Less in Social Security Because of It
Fixing these earning’s record issues first begins with the determination of whether a true “partnership” existed between the spouses.
Businesses are often operated jointly by husbands and wives, but all earnings for self-employment purposes may have been reported by only one spouse, frequently the husband. Partnership determinations in these instances are complicated because that certain outward signs of the husband and wife relationship are similar to the indications of a partnership. Spouses may have jointly operated a business without considering themselves partners because they did not operate under a written partnership agreement.
In this subsequent section they say that the Social Security Administration must determine whether a partnership existed if:
“A question is raised, by or on behalf of a person who worked in the business, as to whether he or she should receive credit for any part of the earnings reported by another, i.e. husband/wife business operation with all earnings reported to the husband.”
To make the “partnership” determination, they follow the steps found on their website which says:
To be a partnership for Social Security purposes, ALL of the following conditions must be established.
1) An intent on the part of two or more people to join together in good faith to carry on a trade or business; and
2) Contributions of capital or services by each; and
3) Each having the right to participate in the management and control of the business; and
4) Each sharing in profits or losses; and
5) Neither was an employee of the other.
Once “partnership” is proven, the Administration is directed to take the necessary action to correct the earnings records. To do this, the Administration would simply equally divide the SEI between the partners (absent an unlikely formal partnership agreement).
Once the SEI was divided between the spouses, this would likely trigger a recalculation of benefits for both individuals. This would mean that the individual who was receiving a lower benefit would have a benefit increase due to the increase of earnings on their record and the spouse being paid the higher benefit would have their benefit reduced.
So this leaves the question of, how far back will the SSA go? They plainly state that there is no time limitation to correct the allocation of SEI. Furthermore, this correction would not require a corrective tax return!
Here’s what the language on their website tells us:
After the time limitation SSA may revise its records, without a correctional tax return, to correct errors made by employers in reporting wages for the wrong period or for the wrong individual or to transfer incorrect entries of SEI to the proper individual or proper period, if the total amount already entered on its records is not changed.
You should be aware that a division of SEI could be a lengthy process. Once the SSA determines that the SEI should be split, the individual who is having their earnings removed will be given notice of the decision and the opportunity to appeal the decision.
How to Plan Your Social Security Benefit for a Likely Divorce
If you think a divorce is certain in the years ahead, and the process to have the SEI redistributed sounds like a lot is being left to chance, there are some steps you can take today.
Since the passage of the Small Business and Work Opportunity Tax Act of 2007, the IRS now permits husband/wife owned businesses to elect a “qualified joint venture” for their unincorporated business.
The election permits certain married co-owners to avoid filing partnership returns, provided that each spouse separately reports a share of all of the businesses’ items of income, gain, loss, deduction, and credit. Under the election, both spouses will file a Schedule C and receive credit for Social Security and Medicare coverage purposes.
Just be cautious when using this election. If there is no eventual divorce, the household Social Security benefit is usually more favorable for allocating the SEI to only one spouse.
Special thanks to Jim Blankenship for his review of this article!