Understanding Community Property States: LLCs & Taxes

Understanding Community Property States: LLCs & Taxes

Though divorce can be a complex and costly process no matter where you live, getting divorced can look very different if you reside in what’s known as a “community property state.” Different states have different laws for how a couple’s assets get divided in the event of a divorce, and this is especially important for business owners to understand. When it comes dividing marital assets during a divorce, knowing what type of state you live in is essential for understanding your legal options and protecting your financial interests.

What Are Community Property States?

There are nine states that use the legal term “community property” to represent the ownership and division of married people’s assets in the event of a divorce. Community property states are:

  • Arizona
  • California
  • Idaho
  • Louisiana
  • Nevada
  • New Mexico
  • Texas
  • Washington
  • Wisconsin

How Do Community Property States Work?

In community property states, the law treats any marital property acquired by the couple during their marriage as “community property” that is equally owned by both members of the couple. Community property states assign a simple 50-50 split to the division of property acquired during the marriage, including any businesses owned by the couple.

This is a very different model than that of non-community property states, which are sometimes referred to as “common law property states.” Instead of a simple 50-50 division of marital property, the other 41 states use a legal principle called “equitable distribution” to assign assets to each spouse in a divorce.

How Do Community Property States Affect Business Owners?

If you own a business such as an LLC in a community property state and you get divorced, your ex-spouse could be granted a 50 percent ownership of your business if it was started or acquired during your marriage. Unless you want to keep your ex-spouse as a business partner, you’ll need to create a plan for maintaining (or regaining) full ownership of your business.

You might need to sell your business and pay your spouse a 50 percent portion of the proceeds in order to “buy out” their share. If you want to keep the business yourself, you might need to give your ex-spouse a similar amount of money from your other marital assets to buy out their ownership portion.

How Do Community Property States Affect Your Taxes?

Most of the time, living in a community property state does not affect your tax liabilities. However, there are a couple situations where community property should be a tax consideration: if you’re going through a divorce, or if you and your spouse reside in separate locations and file separate tax returns (for more details, refer to IRS Publication 555).

In community property states, if a married couple files separate tax returns and each partner earns income, their income can still be treated as “community income” — meaning they each have to report 50 percent of joint income as “their” income. Talk to a tax professional if you have questions about whether your location will affect your tax status and how you and your spouse choose to file.

What Is the Tax Treatment of Your LLC in Community Property States?

Many small business owners choose to incorporate their legal business entity as an LLC. For tax purposes, LLCs have the great advantage of passing through income directly to the owners; the IRS calls this being a “disregarded entity.” In community property states, however, this can create some complexity if a husband and wife are both considered “owners” of the LLC. (Note that this can occur even for a single-member LLC where only one partner is actually running the business!)

Fortunately, the IRS has a special rule in place just for this situation. Even in community property states where a single-member LLC is technically owned by a married couple, the LLC can still be treated as a disregarded entity for tax purposes. This means the owners can still pass income through to their own tax returns, as opposed to a partnership model where they would face additional taxes and compliance obligations.

In community property states, your LLC must meet all these requirements to be treated as a single-member LLC and disregarded entity:

  • The LLC must be wholly owned by the husband and wife as community property under state law
  • No one else can be considered an owner of the LLC for federal tax purposes
  • The business is not otherwise treated as a corporation under federal law

For more details, refer to the IRS website on Rev. Proc. 2002-69.

Community property states have some specific legal rules and procedures for handling your marital assets, as well as a few other considerations related to taxes. If you live and own a business in a community property state, you need to be prepared for these obligations and possible challenges regarding the ownership of your business. Incfile offers a suite of services to help you manage these challenges, and we can also help file your business and personal taxes.

Becca Christman

Rebecca has been freelancing as a work-at-home professional for over six years. She has written more than 1,000 blogs.