Tax Questions and 401k Contributions Guidance for Two-Member LLC in a Community Property State

[illuminato]

We established an LLC at the beginning of this year, with just two members – my spouse and myself. We reside in a community property state and file our taxes jointly as a married couple.

Throughout this year, we've utilized our LLC to carry out business activities. My spouse has been working on a separate project, having earned about $1k, while I undertook contract work in the IT field, earning roughly $200k.

Both of us were actively involved in the LLC's operations, each contributing more than 500 hours of work (met material participation test). However, we've encountered conflicting information regarding the tax filing status for our LLC and contributions to our 401k plans. Despite consulting with tax advisor, and CPA, we still don't have a definitive answers.

Essentially, we have the following questions:

1) Can we file as a Qualified Joint Venture (QJV)?
Here is the IRS's definition of a QJV (https://www.irs.gov/businesses/small-businesses-self-employed/election-for-married-couples-unincorporated-businesses):
A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a married couple who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company) (See below). Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse's interest in the business. The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules). Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.

Does the IRS assume that a QJV can only consist of one business? If my spouse and I have separate activities considered as two businesses, does this mean that we can't be treated as a QJV and should instead file as a partnership?

2) Should we split our taxes equally (50/50 as per Schedule SE) or should it be proportional to our profit margins (my spouse pays taxes on $1k while I pay taxes on $200k)?

3) Can we both contribute to the maximum allowable amount for our 401k plans, which is $66k each, or is my spouse only allowed to contribute $1k, reflecting their earned income?

 

[LdiJ]

We established an LLC at the beginning of this year, with just two members – my spouse and myself. We reside in a community property state and file our taxes jointly as a married couple.

Throughout this year, we've utilized our LLC to carry out business activities. My spouse has been working on a separate project, having earned about $1k, while I undertook contract work in the IT field, earning roughly $200k.

Both of us were actively involved in the LLC's operations, each contributing more than 500 hours of work (met material participation test). However, we've encountered conflicting information regarding the tax filing status for our LLC and contributions to our 401k plans. Despite consulting with tax advisor, and CPA, we still don't have a definitive answers.

Essentially, we have the following questions:

1) Can we file as a Qualified Joint Venture (QJV)?
Here is the IRS's definition of a QJV (https://www.irs.gov/businesses/small-businesses-self-employed/election-for-married-couples-unincorporated-businesses):
A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a married couple who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company) (See below). Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse's interest in the business. The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules). Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.

Does the IRS assume that a QJV can only consist of one business? If my spouse and I have separate activities considered as two businesses, does this mean that we can't be treated as a QJV and should instead file as a partnership?

2) Should we split our taxes equally (50/50 as per Schedule SE) or should it be proportional to our profit margins (my spouse pays taxes on $1k while I pay taxes on $200k)?

3) Can we both contribute to the maximum allowable amount for our 401k plans, which is $66k each, or is my spouse only allowed to contribute $1k, reflecting their earned income?

If you have one LLC you have one business. The business might have more than one project, but it is still one business. The business profits would be divided based on the percentage ownership of the business, UNLESS you file as a partnership and you have guaranteed payments to partners based on the work performed. In that case the guaranteed payments would be allocated to the partner doing the work and the balance of the profit's divided based on ownership percentages.

You really need to sit down with a tax professional to figure all of this out. You have to treat things consistently going forward. However, if your wife officially only has income of $1000.00 then of course she cannot contribute the maximum to a 401k.

 

[Taxing Matters]

We established an LLC at the beginning of this year, with just two members – my spouse and myself. We reside in a community property state and file our taxes jointly as a married couple.

Throughout this year, we've utilized our LLC to carry out business activities. My spouse has been working on a separate project, having earned about $1k, while I undertook contract work in the IT field, earning roughly $200k.

Both of us were actively involved in the LLC's operations, each contributing more than 500 hours of work (met material participation test). However, we've encountered conflicting information regarding the tax filing status for our LLC and contributions to our 401k plans. Despite consulting with tax advisor, and CPA, we still don't have a definitive answers.

Essentially, we have the following questions:

1) Can we file as a Qualified Joint Venture (QJV)?

You operate the business as a LLC. That disqualifies you for the QJV election. The page you linked specifically tells you that, including the paragraph you quoted below:

Here is the IRS's definition of a QJV (https://www.irs.gov/businesses/small-businesses-self-employed/election-for-married-couples-unincorporated-businesses):

A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a married couple who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company) (See below). Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse's interest in the business. The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules). Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.​

​

(Bolding added.) In short, you have to operate the business much like a general partnership, not a limited liability entity like a LLC, corporation, LLP, LLLP, etc.

There are a lot of good reasons for forming a LLC, especially the limited liability protection for the owners. That might well be worth losing the benefit of the QJV status. That's something you might want to discuss with a tax lawyer.

If you did operate as a QJV, it could conduct several lines of business, just like any general partnership would.

Does the IRS assume that a QJV can only consist of one business? If my spouse and I have separate activities considered as two businesses, does this mean that we can't be treated as a QJV and should instead file as a partnership?

The IRS won't assume anything. But it does look at the facts of how the business is run. And if it is run as two separate businesses then that is the way the IRS will treat it. So if all she does is just the stuff for the business she does and does not do anything for the joint venture (like administrative work, etc) or any work on your project the IRS may see them as two separate enterprises. Also, all the income and expenses of the both activities must be treated as a single business, meaning that all the income, expenses, and credits of each enterprise are combined into a single set of books — income statements, balance sheets, etc, and it helps if both operate with the same trade name. Also both spouses must be liable for the debts of the JV.

But before I go any further, there is an important fact that will affect your choices on how to organize this: in what state do you reside and conduct the business activity?

 

[illuminato]

But before I go any further, there is an important fact that will affect your choices on how to organize this: in what state do you reside and conduct the business activity?

We reside and conduct the business activity in TX.

 

[davew9128]

You operate the business as a LLC. That disqualifies you for the QJV election. The page you linked specifically tells you that, including the paragraph you quoted below:

Disagree. An LLC in a community property state is an explicit exception to that rule.

 

[Litigator22]

Disagree. An LLC in a community property state is an explicit exception to that rule.

Just curious, but would this blurb be addressing the same IRS exception that you above make reference to?

The IRS has issued a" special rule applicable to LLCs owned by married couples who live in community property states. Under this rule, a married couple can treat their jointly owned business as a disregarded entity for federal tax purposes if: the LLC is wholly owned by the husband and wife as community property under state law no one else would be considered an owner for federal tax purposes, and the business is not otherwise treated as a corporation under federal law."

 

[Taxing Matters]

Just curious, but would this blurb be addressing the same IRS exception that you above make reference to?

It is indeed the case that in a community property state a LLC owned only by a married couple may elect for the LLC to be treated as a disregarded entity for federal income tax purposes. The rule was made to allow business owners in community property states to have the same options for how their LLC can be treated as owners in non community property states do. A rule that I admit did not come to my mind when I wrote the earlier post, and it was a good catch by you. As I don't practice in a community property state this rule very rarely ever comes into play. The effects of making that election go further than most small business owners realize and if they don't want an ugly tax surprise later they ought to see a tax professional in their state. The election is great in some circumstances but awful in others.

 

[Litigator22]

It is indeed the case that in a community property state a LLC owned only by a married couple may elect for the LLC to be treated as a disregarded entity for federal income tax purposes. The rule was made to allow business owners in community property states to have the same options for how their LLC can be treated as owners in non community property states do. A rule that I admit did not come to my mind when I wrote the earlier post, and it was a good catch by you. As I don't practice in a community property state this rule very rarely ever comes into play. The effects of making that election go further than most small business owners realize and if they don't want an ugly tax surprise later they ought to see a tax professional in their state. The election is great in some circumstances but awful in others.

I don't recall who said it. Someone must have. But such earnest frankness displays fine character. Our frequently besieged profession needs more of your kind.
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Good catch? No credit due here. I assumed from the OP's intelligent rhetoric that he knew something of what he was talking about. And being aware of some of the eccentricities of community property law I did a quick look in the old www and this bit of blog popped up.
Ciao