“MARRIED … WITH LLCs” – When One or Both Spouses Are LLC Members
Have you ever tried to research the ways limited liability companies (LLCs) and the owners (called “members”) are treated when one spouse is the sole member or both spouses are members? This is one of many confusing areas of LLC law that lots of people are unfamiliar with (including, presumably, Al Bundy).
In this article, we try to clear the thicket a bit and provide a better idea of the different options. We also include a couple of handy charts to help out.
To start with, it’s necessary to distinguish the two major forms of property ownership in the United States: separate property and community property. This will necessarily be over-generalized, as the laws vary somewhat from state to state. (You may want to stop me right here and ask: “Wait a minute – aren’t we were talking about LLCs, not property?” Well, your interest in an LLC is property, personal property not real property.)
In a separate property (sometimes called ‘equitable distribution’) state, separate property is that property acquired before marriage or by gift or inheritance during marriage. The remaining property, called ‘marital property’ (or occasionally and confusingly, ‘community property’) is all other property acquired during the marriage.
Marital property can be held in the name of either or both spouses, but their respective ownership of that property is not necessarily equal. In a divorce the court can divide up that property in any manner it deems equitable, given the circumstances of the two spouses.
In a community property state, of which there are nine (plus Alaska, which allows couple to opt in to community property ownership), separate property is defined in a manner similar to that of the other states (see above). Everything else is community property, in which the spouses do have equal ownership. Thus, in a divorce, the community property is divided equally between the two spouses, subject to certain modifications for things like child support.
With that introduction, let’s lay out the similarities and differences in how LLCs are treated when one of the members is married or when both spouses are members. We’ll look at several features of LLCs:
- Management right – who has the right to manage the membership interest and the LLC?
- Economic rights – who has the equity ownership interest, the right to distributions, etc.?
- Tax status (federal income tax) – how are the LLC and the membership interests classified?
- Asset protection – which ownership type is better for asset protection purposes?
Note that these charts assume the LLC is set up during marriage.
Separate Property State
| Named Member | ||
| One Spouse (SMLLC) | Both Spouses | |
| Management Right | Named spouse only (with some exceptions) | Each spouse (as modified by operating agreement, otherwise by state LLC statutes) |
| Economic Rights | Named spouse only (subject to power of equitable division by court, in divorce) |
Each spouse (as modified by operating agreement, otherwise by state LLC statutes) (also subject to equitable division) |
| Tax Status (federal) | Disregarded entity* (reported on Form 1040 Schedule C) | Partnership** – no disregarded entity status (but may elect corporation or S corporation tax status) |
| Asset Protection | Less | More |
|
* Means no separate tax return is filed for the LLC; everything is reported on Form 1040 Schedule C. ** Means a separate Form 1065 tax return is required. |
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Community Property State
| Named Member | ||
| One Spouse (SMLLC) | Both Spouses | |
| Management Right | Named spouse only (with some exceptions) | Each spouse (as modified by operating agreement, otherwise by state LLC statutes) |
| Economic Rights | Named spouse (subject to other spouse’s community property interest) | Both spouses equal under community property law (but can ownership be other than 50/50?) |
| Tax Status (federal) | Disregarded entity (reported on Form 1040 Schedule C) | Partnership* by default, but can elect disregarded entity status (or may elect corporation or S corporation tax status) |
| Asset Protection | Less | More (but additional steps needed to override community property presumption) |
|
* Means no separate tax return is filed for the LLC; everything is reported on Form 1040 Schedule C. ** Means a separate Form 1065 tax return is required. |
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Following are a few remarks about each of the four categories in the charts above.
Management rights – Note first that the LLC can be designated as ‘manager-managed.’ If it is, then even if only one spouse is the named member, the other spouse or a third party can be named as a manager. Second, if there is a two-spouse LLC, the management provisions under the LLC statutes may create ambiguous or awkward situations with the spouses. For these and other reasons, it is better to have an operating agreement that designates one spouse as manager or designating both spouses and providing procedures for decision-making and succession.
Economic rights – In a community property state, can ownership of the LLC ever be other than 50/50? That is, can the operating agreement provide for uneven sharing of economic rights, and what would that mean legally? Would this convert the LLC to a partnership for federal tax purposes? Also, in an equal-sharing LLC with two members that are not spouses, it is always advisable for the operating agreement to provide a buy-sell type of mechanism to handle a proposed sale or transfer by one member and to address potential deadlocks. But in a two-spouse LLC, the marital properly laws usually will take precedence over such buy-sell provisions.
Federal (income) tax status – The “check the box” Treasury Regulations don’t specifically contemplate a spousal-owned LLC as a disregarded entity. In a separate property state, a two-spouse LLC would be deemed to be a partnership under the classifications contained in the Regulations. In a community property state, the result would be unclear, because the spouses’ equal interest in the membership make it appear more like a single interest. The IRS dealt with this situation in Revenue Procedure 2002-69, stating that a community property spousal LLC can elect to be a disregarded entity; absent an election, the LLC presumably would be a partnership.
Asset protection – Single member LLCs (SMLLCs) are fundamentally more susceptible to a veil-piercing attack, as compared to a multiple member LLC. Why? Mainly because it is more difficult to maintain the separation between the entity and its owner. (See our article, Business Asset Protection – How Well Does It Work?)
What about protecting the assets of the LLC from a creditor of a member? In most states, the SMLLC is more probably more vulnerable than a multiple member entity, because in the latter, there is a second economic owner who can object to the transfer of the membership interest to the creditor. In a community property state, is a two-spouse LLC a single member or multiple member entity? (We’re referring here to state law, not federal income tax.) It is advisable to have an agreement between the spouses that the interests are separate property to reinforce the intention that the LLC have two distinct members. Having an operating agreement that covers this situation is also a key element of this protection.
