@Taxathrone
See this IRS page
https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-compan...
A two-member LLC where the spouses are the only two members and in a community property state has 2 clear options.
1. File as a partnership on form 1065.
2. File as 2 disregarded entities on schedule C under revenue procedure 2002-69.
https://www.irs.gov/pub/irs-drop/rp-02-69.pdf
The third option you mention is more complicated. Publication 541 and the revenue procedure both say that the IRS will accept the taxpayer‘s designation as either a disregarded entity or a partnership. The question then is, who owns the business and how is ownership treated under state law. (Because LLCs are created under state law but federal law does not recognize their existence, both unincorporated partnerships and partnerships structured as LLCs are treated the same at the federal level.)
Let’s consider a sole proprietorship in a non-community property state that is clearly owned by spouse A. However, spouse B participates in the business and should be entitled to a share of the income and the Social Security retirement and disability credits that go along with it. If spouse A makes spouse B a partner in the business, they must file a form 1065 partnership return. However, spouse A can also employ spouse B as an employee or as a subcontractor. Some of the income of the business would be paid to spouse B which would be deducted as a business expense by spouse A and reported as taxable income by spouse B.
Publication 541 and the revenue procedure apply to both unincorporated partnerships and LLC‘s. The IRS position is that a business owned by two spouses in a community property state has a third option in addition to the two I listed above:
3. Report the entire business under one of the spouses.
Similar to the situation in a non-community property state, the participation of spouse B could be recognized by making spouse B an employee or subcontractor.
However, if the business has been organized as an LLC, then state law comes into consideration. It may be illegal under state law for the entire business to be reported under spouse A if both spouses are members of the LLC, even though it might be acceptable under to the IRS under federal law. (In other words, a business owned by two spouses in a community property state that is not organized as an LLC under state law may have more tax flexibility than a business that is organized as an LLC under state law.)
For a truly definitive answer, you should seek out professional representation in your own state.
