Husband & Wife Ownership of LLCs in Community Property States

I am frequently asked about the impact of a husband and wife owning the membership interest in an LLC in a community property state.  It is and interesting issue that is unresolved in many respects.

The LLC makes a lot of sense as the entity of choice for couples who are involved in real estate transactions or other investments due to the fact that it protects the individuals from liability so well.  When used in financed real estate transactions, lenders who are packaging and selling their loan porfolios are starting to require that the involved properties are placed in bankruptcy remote entities such as the LLC.

Until a few years ago, the uncertainty that of the husband and wife as owners of an LLC pertained to the issue of  the tax treatment of property transferred in and out of the entity.  Since an LLC with more than one member is usually taxed as a partnership, when the husband and wife sell property held in their individual names and acquire the replacement property in the name of their LLC, the arrangement is clearly a taxable exchange.  (See IRC § 1031(a)(2)(D))

In October of 2002, the IRS issued Revenue Procedure 2002-62  which provides that an LLC that is owned by husband and wife as community property will be treated by the IRS as a disregarded entity for tax purposes.  So, the husband and wife can acquire property through an LLC as replacement property even if they owned the relinquished property in their individual names – without having to file an income tax return on the transaction because the LLC is ignored for tax purposes.

So, in essense, the IRS procedure established a precedent for and LLC owned by a husband and wife in a community property state to be considered a “single member” LLC, which is a disregarded tax entity.  While that is good news from one perspective, it is bad news from another.

The bad news has to do with the question of whether or not charging order protection will apply to one spouse if the other spouse is subject to the judgment of a creditor.  The charging order protection usually gives the “innocent” member/partner the protection that a creditor cannot foreclose on the ownership interest of a debtor member/partner.  This is important because a minority member/partner can suffer extreme economic damages if a majority interest in an LLC/partnership is foreclosed or liquidated by a creditor.

However, the charging order does not ultimately stand up to scrutiny unless the law recognizes that more than one member/partner exists:  If there is no “innocent” member/partner to protect, don’t expect the court to grant charging order protection.

What about married couples in community property states, then?  Does the LLC they own qualify as a single-member – which is the way the IRS treats is – or not?  And if not, then the innocent spouse is not protected by charging order protection!

This is a matter debated by legal minds who practice in the area of asset protection.  Right now, I think the general consensus is that there are no hard and fast rules in this area, and won’t be unless and until a case comes before a court of proper jurisdiction to establish a clear precedent in this area.

Planners and attorneys like to be able to give their clients a clear expectation that by following a certain strategy they can know that the law is clearly on their side and they can expect to prevail in certain circumstances.  For now, however, that assurance cannot be provided for married couples in community property states.

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