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IRS gives leeway on classification of entities owned by husband and wife as community property

Rev Proc 2002-69

IRS says that where an entity is wholly owned by a husband and wife as community property, it will respect their treatment of the entity as either a disregarded entity or a partnership.

Background.
The classification of an unincorporated business entity depends in part on the number of its members or owners. A business entity with only one owner may be classified for tax purposes as a corporation or its entity status may be disregarded. If the entity is disregarded, the activity is treated as a sole proprietorship. A business entity with two or more owners is classified as either a corporation or a partnership.

RIA observation: If entity status is disregarded, the owner generally reports the income and expenses of the entity on his own return (on Schedule C). Treatment as a corporation means that the entity must file a separate return. And, unless an S corporation election has been made, the entity is taxable on its income. If an entity is classified as a partnership, a return must be filed by the partnership, but the net income or loss passes through to the owners of the entity.

The problem.
According to IRS some taxpayers are unsure of the proper classification for an entity that is owned solely by a husband and wife as community property under the laws of a state, a foreign country, or a U.S. possession.

The solution.
To alleviate taxpayer uncertainty and in the interest of administrative simplicity, IRS will respect a taxpayer's treatment of these entities as either disregarded entities or partnerships.

If a qualified entity and the husband and wife as community property owners, treat the entity as a disregarded entity for tax purposes, IRS will accept the position that the entity is a disregarded entity.

If a qualified entity and the husband and wife as community property owners, treat the entity as a partnership for tax purposes and file the appropriate partnership returns, IRS will accept the position that the entity is a partnership.

For this purpose, a business entity is a qualified entity if:
  • It is wholly owned by a husband and wife as community property under the laws of a state, foreign country, or a U.S. possession;

  • No person other than one or both spouses would be considered an owner for tax purposes; and

  • The business entity is not treated as a corporation under Reg. §

301.7701-2.
A change in reporting position will be treated for tax purposes as a conversion of the entity.

Taxation:

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