The expenses allowable in computing the credit are limited to earned income. Generally, only taxable compensation is included in earned income. A taxpayer can elect to include non-taxable combat pay in earned income for dependent care credit purposes even if it is not included in earned income for purposes of the earned income credit or the exclusion for dependent care benefits. For taxpayers who file joint returns, the expense is limited to the EARNED INCOME of the lower paid spouse. Self-employed taxpayers use NET EARNINGS on Schedule C as earned income, even if the net is less than $400. Self-employed individuals who choose the optional method to figure self-employment tax may use the imputed income figured for the optional method as the amount of earned income. 

Split Schedule C Strategy - When both spouses in a married couple are involved in the operation of an unincorporated business, it is fairly common – but incorrect – for all of that business’s income to be reported on one spouse’s Schedule C. In which case, the spouse not filing a Schedule C loses out on the chance to accumulate his or her own eligibility for Social Security benefits and the ability to fund a SEP account.

In addition, to claim a childcare credit - Both spouses on a joint return must have earned income (or imputed income if one of the spouses is a full-time student or is disabled), so unless the non-Schedule C spouse has another source of earned income, the couple will not be allowed a child care credit. There are 2 ways to remedy this situation, either; (1) by filing as a partnership or (2) a joint venture.

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

(1) The only members of the joint venture are husband and wife

(2) Both spouses materially participate in the trade or business, and

(3) Both spouses elect to apply this rule.

Generally, to meet the material participation requirement, each spouse will have to participate in the activity for 500 hours or more during the tax year (Code Section 761(f)(2)(B)).

Observation - If the net income from the business exceeds the annual cap on income subject to the Social Security tax, the combined self-employment tax for the spouses with split Schedule Cs will exceed what a single spouse would have paid if he or she had filed a single Schedule C. In addition, when filing split Schedule Cs, be aware of the different allocation of income for purposes of retirement plans and the opportunity for both spouses to participate in IRAs and SE Retirement Plans.