Test Form

An LLC is an entity created by state statute. The IRS did not create a new tax classification for the LLC when it was created by the states; instead IRS uses the tax entity classifications it has always had for business taxpayers: corporation, partnership, or disregarded as an entity separate from its owner, referred to as a “disregarded entity.”

The IRS always classifies LLCs as one of these types of taxable entities. By default, a multi-owner LLC is taxed as a partnership and a single-owner LLC is a disregarded entity. If a “disregarded entity” is owned by an individual, it is treated as a sole proprietor. If the “disregarded entity” is owned by any other entity, it is treated as a branch or division of its owner. The LLC can change the tax classification by electing to be taxed as a corporation (usually an S corporation to avoid double taxation).

See How to Choose a Tax Classification for an LLC for more information on choosing a tax classification for an LLC. In most cases, accepting the default classification with the option to make an S corporation election will provide the most flexibility.

Because the new business will be owned by a married couple that resides in a community property state, you can choose which default tax classification to apply.

• Disregarded Entity—Does not require the LLC to file a separate tax return. Instead, income and loss is reported on the spouses' joint tax return. Many people prefer disregarded entity classification due to its simplicity.
• Partnership—Requires the LLC to file a separate partnership tax return (IRS Form 1065) and issue informational returns (Schedule K-1) to each spouse.

This decision affects the tax classification only and does not affect the actual ownership of the LLC. The selection you make here will include language that is consistent with the choice you made on the prior screen.

This section allows you to choose whether to restrict a owner from transferring that owner's equity to someone else. Restricting transferability of equity is a popular planning technique. It has two benefits:

• Preventing Unintended Business Partnerships. If the company has or could have more than one owner, restrictions on transferability protect the owners from being forced into a business partnership with anyone other than the current owner.


• Enhanced Creditor Protection. If a owner has creditors, restricting transferability can help defeat a creditor's claim to have an interest in the business under the rationale that the owner lacked authority to transfer equity to the creditor.

The selections below allow you to choose whether to restrict transferability and, if you elect to do so, specify the conditions under which equity may be transferred.

Phantom income is income that is taxable to a owner even if the owner has not received cash to pay the tax. Phantom income is a common problem for LLCs and S corporations. You can read more about phantom income at How to Avoid Phantom Income.

In community property states, a owner's spouse generally has a community property interest in any equity that the owner acquires during the marriage. A spouse's community property interest can give a owner's spouse the ability to manage, control, or dispose of equity unless the spouses provide otherwise.

Community property rights can result in unintended consequences to the company and—if the company is or could be owned by multiple owners—to the other owners. A Spousal Consent attempts to avoid these consequences by having a owner's spouse consent to various terms of the Keep the default tax classification, but provide the ability to elect to be taxed as an S corporation in the future.

The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. Even if no owner lives in a community property state now, though, people are migratory. There is always the chance that a owner will move to a community property state.