Husband-wife LLC taxation - disregarded entity or a partnership?

[golish]

My wife is planning to start a business in which I will be helping out a bit (say, 80-20 work split between her and me, with my participation potentially increasing in the future). We are thinking about forming this as a LLC we both will co-own. For federal tax purposes, will this be treated as a SMLLC or will it be a passive activity for me due to not meeting the material participation tests? At tax time, do we file one Schedule C, two or a Form 1065 + two Schedule K-1s?

We live in WA so we’re in a community property state.

Thanks.

[ZTaxPro · Accepted solution]

The default tax classification for a multi member LLC is a partnership. The exception to split the activity on two Sch C or Sch E is only available for unincorporated entities. An LLC does not qualify for this treatment. I think you should file Form 1065 to report the activity. The passive versus active participation rules are more complex.

[HydroSci]

I have a related question.  Husband wife LLC.  We file 1065 and CA 568.  TT wants the disregarded entity box checked.  Googling I see that CA is a community property state.  So do I check the disregarded entity box? My CPAs in the past did not (but I now think that is incorrect because they also told me that I am a disregarded entity).

Also, can I change profit percentages between years (e.g., 50/50 to 80/20 to 30/70 etc.)?

Next, I find that CA 568 M-1 is out of balance by $800 (the amount of the LLC tax).   I suspect that this stems from the state tax being deductible on the 1065 and not on the 568, and the inclusion of the LLC tax on line 4b of the 568 M-1.  Thoughts on how to fix this? 

[dmertz]

In a community property state a married couple owning an LLC has the option to be treated as a qualified joint venture and disregarded entities, or as a partnership.  If your LLC files Form 1065, you've chosen to treat the LLC as a partnership, for federal purposes it's not a disregarded entity and is not reported on Schedule C.

Where is TurboTax asking you to indicate a disregarded entity?  Is it in the California module?  I thought whether or not the entity was disregarded that was implicit in whether you reported the LLC's income by entering a Schedule K-1 or by reporting income on Schedule C.

[HydroSci]

In the CA 568 it wants that disregarded entity checked.  So you are saying that if I file a 1065 I am not a disregarded entity?

The other questions were:

Also, I can change profit percentages between years (e.g., 50/50 to 80/20 to 30/70 etc.)?  Are there any issues with doing that?  (I want to) CPAs in the past just allocated profits differently than the stated 50/50 percent, and included a statement that it was proportional share of aggregate.

Next, I find that CA 568 M-1 is out of balance by $800 (the amount of the LLC tax).   I suspect that this stems from the state tax being deductible on the 1065 and not on the 568, and the inclusion of the LLC tax on line 4b of the 568 M-1.  Thoughts on how to fix this? 

[BMcCalpin]

The IRS says that to be a husband and wife owners of an LLC to be considered a disregarded entity, they have to satisfy the following:

1. The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or possession of the United States;
2. No person other than one or both spouses would be considered an owner for federal tax purposes; and
3. The business entity is not treated as a corporation under IRC §310.7701-2.

(See https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-compan...)

If the conditions above are satisfied, the husband and wife can choose to be treated as a disregarded entity (in which case, they file two Schedule Cs, allocating income and expenses to each according to their contribution of work) or as a partnership (in which case they do NOT file Schedule Cs but file a 1065 and report K-1s on their 1040 return). Among other things, the use of two Schedule Cs means that there are two Schedule SEs (one under each SS number), so each taxpayer is credited with their proper amount of self-employment tax paid (for when they start drawing Social Security).

It's a binary decision: either you are a disregarded entity or you are a partnership. (of course, the LLC could choose to be treated as a corporation for federal purposes, but that's not being discussed here)