Husband-and-Wife LLCs in Texas: Disregarded Entity or Partnership Under Rev. Proc. 2002-69

A Fort Worth couple forms an LLC for their business. Both names are on the certificate of formation. Their preparer files a Schedule C for one of them. Three years later an IRS notice arrives asking where the Form 1065 is, with a late-filing penalty that multiplies by the month and by the partner.

That couple may have done nothing wrong. Or they may have done several things wrong. The difference turns on a 2002 revenue procedure that applies only to couples in community property states, including Texas.

The default rule for a two-owner LLC

Under the entity classification regulations in Treas. Reg. 301.7701-3, an eligible entity with two or more members that does not elect corporate status is a partnership by default. An LLC owned by two spouses has two members. So outside a community property state, a husband-and-wife LLC is a partnership. It files Form 1065 every year and issues a Schedule K-1 to each spouse.

Many couples are surprised by that. They think of the business as one household business, and they expect one Schedule C. In a common law state they generally do not get that choice for an LLC.

What Rev. Proc. 2002-69 allows

Rev. Proc. 2002-69 addresses an entity owned solely by spouses as community property under the laws of a state. If the spouses treat the entity as a disregarded entity for federal tax purposes, the IRS will accept that position. If they treat it as a partnership, the IRS will accept that too.

The conditions matter. The entity must be wholly owned by the spouses as community property. No one else can be treated as an owner for federal tax purposes. And the entity must not be treated as a corporation. If the LLC elected S corporation or C corporation status, Rev. Proc. 2002-69 is not the relevant question.

So a Texas couple whose LLC is community property can file a Schedule C instead of a Form 1065. Or they can file a Form 1065. Both are acceptable. The trouble starts when they do not pick one.

Switching positions is treated as a conversion

Section 4.03 of the revenue procedure says that a change in reporting position is treated for federal tax purposes as a conversion of the entity. Moving from partnership returns to Schedule C is treated like the partnership converting into a disregarded entity. Moving the other way is treated like a disregarded entity becoming a partnership.

Conversions have consequences. A partnership that converts can have a terminated partnership year, final return requirements, and questions about the tax treatment of the deemed distribution of assets to the owners. A disregarded entity that becomes a partnership has a deemed contribution of assets. Most small businesses never trigger tax from those deemed transactions, but they create filing obligations and they confuse the IRS's records.

Practically, the worst pattern is the one I see most: a partnership return filed one year, a Schedule C the next, nothing the year after. Each change is a conversion, and the gaps look like missing partnership returns.

The penalty exposure: IRC 6698

If the IRS treats the LLC as a partnership and no Form 1065 was filed, IRC 6698 imposes a penalty for each month the return is late, up to 12 months, multiplied by the number of partners. The per-partner monthly amount is adjusted for inflation every year. With two spouses as partners and a full year of lateness, the penalty for one missing return can run into thousands of dollars, and it applies even if the partnership owed no tax.

Here is the part most people miss. Rev. Proc. 2002-69 is often the defense. If the couple consistently reported the LLC as a disregarded entity, and the LLC is community property owned only by them, the position is acceptable and there was no partnership return to file. Document both elements: the community property character of the membership interests and the consistent reporting history.

If the reporting was not consistent, the conversation shifts to penalty relief. Reasonable cause under IRC 6698(a) is available, and older relief under Rev. Proc. 84-35 for small partnerships is sometimes raised. My penalty abatement guide explains how reasonable cause arguments are built.

Employment taxes, EINs, and other loose ends

A disregarded LLC is still treated as a separate entity for employment tax purposes under Treas. Reg. 301.7701-2(c)(2)(iv). If the LLC has employees, it reports and pays payroll taxes under its own EIN, even when its income lands on Schedule C. That does not change under Rev. Proc. 2002-69.

Self-employment tax follows its own community property rule. Under IRC 1402(a)(5), if the LLC is treated as a partnership, each spouse's distributive share drives their self-employment tax. If it is disregarded, the net earnings generally belong to the spouse carrying on the business. My guide on self-employment tax and Texas community property covers the details.

Keep the EIN records clean too. An LLC that applied for its EIN as a partnership but files Schedule C will eventually get correspondence asking for a Form 1065. Answer it with the Rev. Proc. 2002-69 position in writing.

Not the same as a qualified joint venture

Couples sometimes confuse this with the qualified joint venture election under IRC 761(f). That election lets spouses who file jointly and both materially participate in an unincorporated business elect out of partnership treatment and each file their own Schedule C. The IRS's guidance on that election says it is not available for a business held in a state law entity like an LLC. Rev. Proc. 2002-69 is the route for LLCs, and only in community property states.

When the couple divorces or the community ends

Rev. Proc. 2002-69 depends on community property ownership. If the spouses divorce and each ends up owning part of the LLC as separate property, the entity has two owners who are not holding as community property. It is a partnership by default from that point. If one spouse ends up with the whole thing, it becomes a single-member disregarded entity. Either way, the reporting changes on a date that should be documented.

The same is true if a third member joins, even a child with a tiny interest. Once anyone besides the spouses is an owner, the revenue procedure no longer applies.

What I recommend

• Decide on a reporting position deliberately, and write it down in your records.
• Confirm the membership interests are community property and that no one else owns any part of the LLC.
• File consistently every year. If you want to change, treat it as the conversion it is, with proper final and initial returns.
• Answer any IRS notice asking for a Form 1065 promptly, citing Rev. Proc. 2002-69 if it applies.
• If you have years of inconsistent filings, fix them together, not one notice at a time.

Texas gives married business owners a choice most of the country does not get. A choice you never make is not much of a benefit. If you are holding partnership penalty notices for a business you thought was a sole proprietorship, the fix is usually paperwork and a well-built letter. The firm's small business IRS problems guide has more background, and my Texas small business guide covers the bigger picture. Let's talk: 813-229-7100.