Question – My husband and I started a business recently and formed an LLC. We are confused about whether we should be filing a Schedule C as a Sole Proprietor or Partnership Form 1065. Are a husband and wife considered one member or partners in an LLC?
Our Answer – While on the surface, it would seem this would be pretty easy to answer, there are several considerations for a married couple to consider when forming an LLC.
Since an LLC (Limited Liability Company) is an entity created by state statute, there isn’t a one size fits all answer as every state has different laws. Depending on the state the LLC was formed and the elections made by the LLC, there can be long-term ramifications on this selection. One major complexity is that there are differences on how living in a community property state (AZ, CA, ID, LA, NV, NM, TX, WA, & WI). Community property states have laws any property acquired by a married individual while married is owned in common and those assets are evenly split in the event of a divorce.
One of the great benefits of an LLC is the flexibility of how the entity is taxed. Owners can elect to have a Limited Liability Company elect to be taxed as either as a corporation, partnership, or as part of the owner’s tax return (a “disregarded entity”) by the Internal Revenue Service (IRS). A disregarded entity just means an entity that is not recognized by the IRS for tax purposes. The profits of the business are passed to each of the owners based on their ownership, also known as pass-through taxation.
The information below largely refers to the ways an LLC can choose to be taxed.
A multi-member LLC, this includes an LLC that is jointly-owned by a married couple, is generally classified as a partnership by default for Federal tax purposes. Keep in mind that many accountants have been cautious in applying the election of a disregarded entity to an LLC in a non-community property state.
Because a business jointly owned and operated by a married couple is generally treated as a partnership for Federal tax purposes, the spouses still must follow with tax filing and record keeping requirements.
Qualified Joint Venture Election
Another option for married couples is the Qualified Joint Venture Election. If both spouses take part in the business and are the only members of an LLC, and a joint tax return is personally filed, a qualified joint venture can be elected instead of a partnership.
This election treats each spouse as a sole proprietor instead of a partnership. This is something to consider over the partnership as it will give each spouse credit towards their social security earnings and Medicare coverage. Since income and deductions are divided between the two Schedule Cs, both spouses receive their individual Social Security quarters since FICA (Federal Contributions Act) and Medicare goes to each spouse and not the married couple as a couple.
How to file for the Qualified Joint Venture Election
Spouses make the election on a jointly filed Form 1040 by dividing the LLC’s income, deductions, gain, loss, and credit between each spouse’s respective interest in the joint venture. Each spouse will file the Form 1040, a separate Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship)
Single-Member LLC Election
In most cases, an LLC jointly owned by husband and wife in most cases can elect to be treated as a Single-Member LLC (SMLLC) in community property states (AZ, CA, ID, LA, NV, NM, TX, WA, & WI). The IRS provided this designation under IRC Section 7701 –
“Taxpayers’ treatment of business entity owned solely by a married couple as community property under applicable local laws, where no other person would be considered owner for tax purposes and where the entity isn’t treated as corp., as either disregarded entity or as a partnership, will be respected for federal tax purposes.“
At tax time, spouses will file a joint tax return, which typically provides income tax savings. To make the election, income, deductions, asset gain or loss must be divided between each spouse based on the percentage of their ownership in the LLC. Then each spouse must file a separate Schedule C or C-EZ and will also file a Schedule SE to pay any self-employment tax.
The single-member LLC election may not require an EIN (Employer Identification Number) since both spouses are filing as sole proprietors, but one would be needed if the LLC had employees.
One Spouse is the Owner
Another solution if the single-member status is desired, is to have one spouse to be the sole owner of the LLC and be a “disregarded” entity. A disregarded entity is an entity that is separate from the owner legally but is not recognized as being separate for tax purposes. In this case, a single-member LLC files with the IRS as a sole proprietorship. When the LLC is set up where only one spouse is the owner, often the other spouse works in the business as an employee.
This may not be an acceptable solution for some couples, especially if both spouses are significantly involved in the operations of the business. They may feel more comfortable in having the ownership of the business more formalized.
The last election to consider is having the LLC classified as a corporation. While the primary reason for forming an LLC is asset protection, there may be tax benefits too.
One way the LLC can be taxed is as a C corporation. An LLC that elects to be taxed as a C corporation is first taxed on profits. Any remaining profits can be distributed to the members as dividends. The big downside for most people is that the C corporation has double taxation since both the profits (which are subject to income tax) and then the dividends are taxed. There are situations where this provides advantages for large business. To elect C corporation status, IRS Form 8832, Entity Classification Election will need to be filed.
The other election for a Limited Liability Company is to elect S corporation status. The S corp is an IRS designation for smaller businesses. There are some restrictions, like only having up to 100 members and some limits on who can own one along with a few other restrictions. As an S corporation, the LLC isn’t taxed on profits, much like the single-member LLC and partnership election. The individual members are taxed on the profits. Why the S corporation election is especially interesting is because instead of taking all profits as income for the owners (which are subject to self-employment income taxes), some of that income can be distributed as dividends, which are usually taxed lower than taxes on income.
To have an LLC to be taxed as an S corporation, IRS Form 2553, Election by a Small Business Corporation.
Regardless of how you choose to have your LLC taxed, it is recommended to get professional advice to best protect yourself. This advice may also be especially important if you live in a community property state.