Avoiding a Disabling Mistake

A tax law enables husband-and-wife ventures to protect both workers in the event of incapacitation.

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And now for something completely different: a tax code change that actually makes life easier for people, in this case husbands and wives who run small businesses together and want financial protection if they become disabled.

Of course, everyone faces this risk. It gets higher the older we get as brittle bones, heart disease, and all the rest make unwelcome inroads into our otherwise able-bodied, never-miss-a-day-of-work selves. A 20-year-old worker has a 30 percent chance of becoming disabled before retirement, according to the Social Security Administration. "To the extent that husbands and wives go into business together, and if they stay in business together, there's a very good chance someone will become disabled," says Andrew Imparato, president and CEO of the American Association for People with Disabilities.

The choices married business owners make when they file their taxes can affect their eligibility for disability benefits down the road. Typically, married couples file a joint income tax return. If their business is unincorporated, they're generally also supposed to file partnership tax forms that spell out whether the business income should be split fifty-fifty or otherwise. But for simplicity's sake, many couples instead file the forms designed for sole proprietors, putting one person's name down as the owner. This has generally been accepted by the IRS and is really no big deal—unless someone becomes disabled.

If that happens, the person whose name is on the Schedule C (business profit or loss) and SE (self-employment) tax forms is the only one who may be able to qualify for disability benefits. That's because recipients of those benefits are required to have accumulated a certain number of "credits" based on their earnings, their length of employment, and their age at the time they apply. Whoever files the SE form, which is used to calculate Social Security tax, generally earns all the credits. (If you work for a company, your employer deducts this tax from your paycheck.)

This can be a trap for the unwary. Earlier this year, in a story about the pitfalls of individual insurance, I wrote about a couple who own a small business that markets the husband's instrumental music. When the wife, Katherine Styler, got breast cancer several years ago, their health insurance premiums skyrocketed. They have continued to climb; their insurer recently notified the Stylers that it planned to increase their premium to nearly $1,600 a month for a policy with a $6,000 deductible for each of them. Now the couple is trying to qualify Katherine for disability benefits, which would pay her a fixed amount each month, based on her lifetime earnings. But there's a hitch: Because Marshall Styler's name is on their Schedule C and SE forms, Katherine hasn't earned any work credits during the roughly 11 years the couple has been operating the business together. She does get credit for her work before they started the business, but she has to have worked for five of the 10 years immediately before she became disabled to qualify for benefits. So, as far as disability benefits go, she's in some ways starting from scratch.

A recent law addresses this problem. Starting in the 2007 tax year, couples who run a business together can consider themselves a qualified joint venture (instead of a partnership). Each can file Schedule C and SE forms, splitting the income, deductions, etc., equally or whatever's appropriate based on how much each participates in the business. Then, if one of them becomes disabled down the road, each will have been accumulating the necessary work credits for disability purposes.

If you and your spouse run a business together, consider the following to protect yourselves:

• Amend your 2007 tax returns, filing separate Schedule C and SE forms that reflect your proportional participation in the business.

• Check with your local Social Security Administration office. It may be able to revisit previous years and credit your earnings based on how much each spouse participated, says Dorothy Clark, a spokesperson.

• Consider buying a private disability insurance policy. "Generally, with a private plan you don't have to be as disabled as you do for Social Security disability benefits," says Avram Sacks, an attorney and Social Security analyst for CCH, a tax and legal information company. Instead of being unable to engage in any substantial work activity, the standard for Social Security disability, a private plan may require only that you be unable to do the work that you were trained for. That is often an easier standard to meet.