LLC Taxation: Community Property & Disregarded Entities

A limited liability company, or LLC, is a flexible, unincorporated limited liability entity organized pursuant to state law that is often used to structure both small and large businesses alike. One key characteristic of an LLC is flexibility as to how the LLC is taxed pursuant to federal law.

An LLC can elect taxation, under the Internal Revenue Code, as either: (1) a traditional corporation taxed pursuant to Subchapter C, (2) a small business corporation taxed pursuant to Subchapter S, (3) a partnership taxed pursuant to Subchapter K (if applicable), or (4) a disregarded entity (if applicable). This post focuses on the last two regimes: taxation as a partnership and taxation as a disregarded entity.

Normally, an LLC that is owned by one person, often called a single-member LLC, is taxed as a disregarded entity by default for federal income tax purposes while an LLC that is owned by more than one person, often called a multiple-member LLC, is taxed as a partnership by default for federal income tax purposes. In some states, however, there is even flexibility as to this default classification.

Revenue Procedure 2002-69 permits a business entity that is wholly-owned by a legally married couple as community property to treat that entity, which has not elected federal taxation pursuant to either Subchapters C or S, as either: (1) a disregarded entity or as (2) a partnership taxed pursuant to Subchapter K of the Internal Revenue Code. In the United States, a minority of states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin — are called "Community Property" states, meaning that all property not acquired by gift, devise (e.g. via will or living trust), or descent (e.g. via intestacy) is presumed to be community property and jointly owned by the married couple.

Both taxation as a disregarded entity and taxation as a partnership are commonly called "pass-thru" taxation, meaning that there is no tax at the entity-level, e.g. LLC-level, unlike a traditional corporation taxed pursuant to Subchapter C, commonly called a "C-Corp" of the Internal Revenue Code. For example, profits generated by a C-Corp that are subsequently distributed to the owners of the C-Corp as dividends are taxed twice, once at the corporate level and once at the shareholder level. This so-called "double taxation" is not imposed upon pass-thru entities, for which there is only one level of taxation.

If both taxation as a partnership or taxation as a disregarded entity permit pass-thru taxation, what is the difference between the two tax regimes? For many small businesses the answer is convenience.

If an LLC is a disregarded entity, its owner(s) need not file a separate tax return for the entity; rather, the owner(s) simply file Schedule C along with Form 1040. In contrast, the owners of an LLC taxed as a partnership must file another return (Form 1065) in addition to any individual Form 1040.

This brief overview of some important considerations associated with LLC taxation is by no means comprehensive. Always seek the advice of a competent professional when making important legal decisions.

Steve Cook is an LLC attorney at Cook & Cook. Although his office is located in Mesa, Arizona, he represents clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.

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