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Welcome and thank you for your question. I'll do my best to provide an informative answer. Please let me know if you need any clarification.
I agree with you that it should not present any problem due to the netting of the Schedule C's on 1040. The only pro/con I see is that this transaction shifts social security earnings from the husband to the wife. Over time this would result in a higher earnings record for the wife and thus she would receive more in retirement and her husband would receive less. As long as the rent amount is about what fair market value would be, I can't see it causing problems.
That said, I don't believe the transaction is technically correct. For one, the building is owned by the trust, yet rent is paid to the wife. It seems that rent should be paid to the trust. And how is depreciation expense on the building claimed? Is it taken as a deduction on the trust? It seems there is a possible deduction out there that is not being taken. Also, the wife should not be reporting rental income on Schedule C. I understand that she runs a property management company, but the money this company receives should be fees for managing the properties (not rent). Any rents she receives for buildings she owns would be reported on Schedule E.
If it were my client, I would need to examine all of the facts and all of the tax returns before making a complete recommendation. Upon doing so, my recommendation would probably lean in this direction: The husband should form an S corporation for his business to better manage self-employment earnings. The wife could consider the same. If the wife's business owns buildings and receives rents, the rental activities should be reported on Schedule E, not C, and the property management side could be handled in a separate entity (possible an S corp). I would also want to be certain the depreciation on the building is being deducted somewhere. Again, a full review of all tax returns and analysis of the entire situation would be needed for a proper tax recommendation, but this is the direction I would look to begin.
I hope this helps and please let me know if you have any questions.
You mentioned that the rent from husband's sch. c should be paid to the trust. If it's a revocable family trust, does it change your answer? I thought the grantor trust is taxed at grantor's income tax (form 1040).
I am sure the wife's Sch.c is taking depreciation for the building.
Can you explain about husband's payment to trust? again, husband and wife are trustees' of the revocable family trust. Can you do transaction between husband's Sch. C business and the trust? Do you have any opinion about how the treatment is viewed by the IRS?
How is S corp helpful to husband's tax planning?
Agreed, the activity of the trust would be reported as if it happened in the hands of the grantor, so although it would flow through the trust, the end result is the same and it's a mute point. When looking at the two Schedule C's combined, it is as if the building was owned by the "combined" Schedule C and the mortgage interest, taxes, etc. were deducted on the C. The rental income and expense cancel out, as you noted. The combined botXXXXX XXXXXne is the same and the only difference is you've moved some SE income from one spouse to another.
Potential tax savings under an S corporation is as follows:
As of now, the entire botXXXXX XXXXXne of both Schedule C's is subject to self-employment tax. In the S corporation, the owner(s) would take a "reasonable" salary. Any remaining profits in the business would be reported on the K-1 as ordinary income, but Not subject to SE tax. The savings could be huge if the schedule C businesses are highly profitable. It's actually helpful to both of their planning, not just the husband's.
If separate entities are created, and the husband continues to rent the building, the rent would be subject to self-rental rules, meaning basically that it cannot be used to create passive income (in order to deduct other passive losses). Same would apply if rental activity was reported on the Schedule E instead of C. Just something to keep in mind.
Thank you for your reply. But I don't understand what you are saying:
If separate entities are created, and the husband continues to rent the building, the rent would be subject to self-rental rules, meaning basically that it cannot be used to create passive income (in order to deduct other passive losses). Same would apply if rental activity was reported on the Schedule E instead of C.
What is self-rental rule? Are you saying the rental business (so far wife's sch. c) can't create passive income? what is passive income? Is Gains from investment of stocks qualified as passive income? Can disallowed rental loss (due to passive loss) offset any gains from investment income from stock sales? If passive rental loss only allowed up to $25,000.00 per taxpayer? Per return? per property?
You said something very interesting about creating S corp. How is it done? do you need a lawyer to do that? or can you just fill out a form yourself? Can a CPA help with this? Is there a deadline when you can create S corp for 2012?
If the husband's business has 6 employees, can it still be a S corp?
Can husband still contribute to SEP IRA if he does business as S corp?
If wife's business (property management) was reported on Sch. C, and you said it should be reported on Sch. E. What are the differences if it has gain (pay SE tax) and if it has loss (offset other ordinary income), other than the obvious mentioned?
Thank you for your help.
Rentals are typically considered passive and thus subject to passive loss limitations. Rental income is generally not reported on Sch. C. In your situation the husband/wife schedule C's are offsetting so it is as if there is no rental income/expense.
To set-up an S corp I typically recommend using a lawyer to do the incorporation paperwork, but a site like www.legalzoom.com could also walk you through it. A corp or an LLC would work. Once the entity is created, a Form 2553 would need to be filed to "elect" to be taxed as an S corporation.
Yes, S corps can (and usually always) have employees. Owners of an S corp are actually required to take a reasonable salary.
Yes, the husband could still contribute to the SEP IRA but there may be more favorable retirement options. I typically work with a trusted pension expert on the set-up of the retirement plan because the rules are complex.
The property management should be reported on Sch. C but the rental activity is what seems to me should be reported on Sch. E. Keep in mind I am an outsider to the whole situation and this is a general response. But generally, rental income and expenses go on Sch. E not C. The result is lower SE tax if there is income, but potential limited losses if there are losses (due to the passive loss limitations).
For a full detailed review of the situation it is advisable to have all of the tax returns reviewed by a CPA and have a lengthy discussion before making any drastic changes. I'm not trying to sound like I'm backing out of an answer, but this forum is more for general tax questions as opposed to an assessment of a tax situation.
I hope I have helped and thank you again for using this service.