Spouses who enter into a business partnership may elect out of partnership rules when they meet specific criteria set forth by the IRS. 

A husband and wife who file a joint return may elect out of the partnership rules. Thus, when the election is made, a joint venture between them is not treated as a partnership for tax purposes.

All items of income, gain, loss, deduction, and credit are divided between the spouses according to their respective interests in the venture, and each spouse takes into account his or her respective share of these items as if they were attributable to a trade or business conducted by the spouse as a sole proprietor. Accordingly, each electing spouse will report his or her shares on the appropriate form, such as Schedule C.

This rule does not apply to spouses who operate in the name of a state law entity (including a general or limited partnership or a limited liability company). The election can be made only for a business operated by spouses as co-owners that is, or should otherwise be, taxed as a partnership (whether or not there is a formal partnership).

A qualified joint venture means any joint venture involving the conduct of a trade or business if:

Notwithstanding other self-employment rules, each spouse's share of income or loss from a qualified joint venture is taken into account under the above rules in determining the spouse's net earnings from self-employment.

Similarly, each spouse's share of income or loss from a qualified joint venture is taken into account under the above rules in determining the spouse's net earnings from self-employment for purposes of the Social Security benefits rules. Thus, each spouse will receive credit for his or her self-employment tax contributions for purposes of receiving Social Security benefits. However, this rule is not intended to prevent allocations or reallocations, to the extent permitted under pre-2007 law, by courts or by the Social Security Administration of net earnings from self-employment for purposes of determining Social Security benefits of an individual.

Generally to qualify as materially participating in the activity, and therefore avoid loss limitations under IRC Sec 469, 500 hours of participation are required during the year, or if participation is less than 500 hours, the taxpayers must provide substantially all of the participation.

IRC Sec 761(f)(2)(B) says one of the requirements is that both spouses materially participate “within the meaning of IRC Sec 469(h) without regard to paragraph (5) thereof”. Paragraph (5) of 469(h) says “in determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account.” So, for this purpose, the spouse’s participation is NOT considered. You would look at each spouse separately, i.e., as if each was operating a separate activity, and disregard the other spouse’s involvement.

Spouses owning and operating a business as an LLC are not eligible to make this election (Schedule C Instructions Pg 3).