Schedule C vs. 1065

[George]

I have a married couple in a community property state which started 2 businesses in 2005. One business is run by the husband and one is run jointly. They went to the lawyer to set up the LLC's and now came in to file their taxes.

I'm wondering if I should just file them on a schedule C or should I file a 1065 for each business. They never elected to be taxed as a corporation so I believe I can still treat them as a disregarded entity for Federal tax purposes. Please correct me if I'm wrong.

What advantages/disadvantages do you see with one form vs the other?

Any and all opinions appreciated.

[Bees Knees]

You ought to read this exchange I had with Armando, where I taught him a thing or two about tax law.

http://www.thetaxbook.com/forums/showthread.php?postid=97#poststop

[OldJack]

Sch-C for both entities?

If you have LLC's you have no choice but to treat them as disregarded entities according to ownership. Default being Sch-C for the single owner and 1065 for the joint LLC ownership, except for a community property state you can file the default or separate Sch-C’s (2) for either or both entities. However, I don't do community property states so I am no expert on the subject.

As far as Bees Knees comment about the exchange between he and Armando. I read the posts and agree with Armando. Bees Knees understanding of the code resulted in a figment of his imagination. :-)

Husband-wife business. If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C or C-EZ. Instead, file Form 1065. See Pub. 541 for more details. Exception. If you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession, you can treat the business either as a sole proprietorship or a partnership. The only states with community property laws are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. A change in your reporting position will be treated as a conversion of the entity.

[Bees Knees]

OldJack

Originally Posted by IRS website as quoted on another forum
Husband-wife business. If you and your spouse jointly own and operate a business and share in the profits and losses, you are partners in a partnership, whether or not you have a formal partnership agreement. Do not use Schedule C or C-EZ. Instead, file Form 1065. See Pub. 541 for more details. Exception. If you and your spouse wholly own an unincorporated business as community property under the community property laws of a state, foreign country, or U.S. possession, you can treat the business either as a sole proprietorship or a partnership. The only states with community property laws are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. A change in your reporting position will be treated as a conversion of the entity.

What a suprise. That quote is word for word taken from the Schedule C, page 1 instructions.

Yawn.....

Oh...say....I know....Um.....Can you tell me what the penalty is for ignoring those instructions???

[Armando Beaujolais]

Another Rudolf

If you have LLC's you have no choice but to treat them as disregarded entities according to ownership. Default being Sch-C for the single owner and 1065 for the joint LLC ownership, except for a community property state you can file the default or separate Sch-C’s (2) for either or both entities. However, I don't do community property states so I am no expert on the subject.

As far as Bees Knees comment about the exchange between he and Armando. I read the posts and agree with Armando. Bees Knees understanding of the code resulted in a figment of his imagination. :-)

Old Jack is wise and Bees would do well to pay heed to his reasoned perspective.

The different treatment for community property states is the logical result of treating a husband/wife partnership as a husband/wife partnership. In a community property state, for purposes of income, spouses are treated as equal owners of income. No need to go through complicated efforts when the end result will be identical because of community property laws.

A husband/wife partnership is a husband/wife partnership, and the husband is a partner and the wife is a partner, and a partnership return should be filed. Sure, there are lots of things you can get away with in filing, and it's more work to file Form 1065, and maybe nothing will every go wrong, and the blissful couple will live happily ever after. I don't live in a world where it's safe to assume that every ending will be a happy ending.

If it's a partnership, it's a partnership. You can pretend it's something else, but that doesn't make it so.

I put antlers on Charlie the Dog on Christmas and called him Rudolf. It didn't turn him into a reindeer. And I don't think he fooled anyone either. At least no one who was paying attention.

[Bees Knees]

The different treatment for community property states is the logical result of treating a husband/wife partnership as a husband/wife partnership. In a community property state, for purposes of income, spouses are treated as equal owners of income. No need to go through complicated efforts when the end result will be identical because of community property laws.

That doesn't make any sense. 50/50 partners on a Form 1065 are treated as equal owners of income also. Why do community property state husband and wife partnerships get a pass and other husband and wife partnerships in non-community property states do not? They both are 50/50 partners by nature of the existence of the partnership. Using your argument, that should mean community property husband and wife partnerships should file as partnerships, since they are treated just like 50/50 partnerships in non-community property states, which you keep insisting need to file a 1065.

[Bees Knees]

Your acceptance behind the theory that community property state husband and wife businesses do not need to file as a partnership also does not hold water with the Section 179 issue.

One of the big arguments for filing as a partnership on a 1065 is that if the partnership has a loss, the partnership cannot take the Section 179 deduction. But for a Schedule C business with a loss, you can use the W-2 income of the taxpayer and/or spouse to take Section 179 on the Schedule C.

How does that change in a community property state? Isn’t it the same result? A husband and wife partnership in a community property state could use their W-2 income to take the Section 179 deduction even though their Schedule C shows a loss. However, if that same coupled filed as a partnership using 1065, they could not use their W-2 income to take the Section 179 deduction at the partnership level.

There is absolutely no logical reason to suggest community property state husband and wife partnership can by-pass partnership filing requirements while non-community property state husband and wife partnerships cannot.

[Armando Beaujolais]

That doesn't make any sense. 50/50 partners on a Form 1065 are treated as equal owners of income also.

That's silly. I didn't say partnership rules were the same as community property rules. I said that community ownership of property is why the IRS treats partnerships in community property states differently.

You have a good point about the special break spouses in community property states get with the business income limitation. That doesn't mean all taxpayers are treated exactly alike. You say that spouses living in a community property state should be treated no differently from spouses in another state for purposes of partnership filing requirements. Why not extend that line of thought to all tax issues?

I'm not willing to accept the theory that community property laws have no effect on taxation and reporting requirements for married people.

[OldJack]

Penalty?

If I understand Bees Knees correct, he thinks that if there are less than 10 partners in a partnership they do not have to file a federal partnership tax form 1065 (not considering H/W in community property state)? I expect that would be considered a unrealistic preparer position (or willful reckless conduct) that could get him barred from practice before the IRS and subject to a $250 penalty under Reg §1.6694.

[Bees Knees]

Try again

If I understand Bees Knees correct, he thinks that if there are less than 10 partners in a partnership they do not have to file a federal partnership tax form 1065 (not considering H/W in community property state)? I expect that would be considered a unrealistic preparer position (or willful reckless conduct) that could get him barred from practice before the IRS and subject to a $250 penalty under Reg §1.6694.

Reg. Sec. 1.6694-1(a), "Section 6694(a) and section 6694(b) impose penalties on income tax return preparers for certain understatements of liability on a return or claim for refund..."

If you file a Schedule C and split the SE tax and don't abuse other special allocations and Section 179, you will calculate the correct tax. I never said anything about changing the correct tax liability.

Care to try for another penalty?

[OldJack]

Nope the real penalty is not being able to practice before the IRS. Good luck and I hope you don't get caught.

[Bird Legs]

Bees-Sect. 179

Bees Knees, I thought a partnership Sect. 179 deduction flowed through to the partners on the Sched. K-1 regardless of whether there was a Profit or Loss at the partnership level, and deducted on the form 1040 if there is other income.
Or did I misread, misinterpret, your statement?

[Bees Knees]

Bees Knees, I thought a partnership Sect. 179 deduction flowed through to the partners on the Sched. K-1 regardless of whether there was a Profit or Loss at the partnership level, and deducted on the form 1040 if there is other income.
Or did I misread, misinterpret, your statement?

No, the Section 179 deduction is first limited at the partnership level before it can even make it to the K-1.

If you fill out a 4562 for a 1065, you will see it won't let a Section 179 deduction on the return unless the 1065 shows a profit.

[Bees Knees]

Nope the real penalty is not being able to practice before the IRS. Good luck and I hope you don't get caught.

I’ll take that as a you don’t have a citation of any violation. To be disbarred, they first have to make the claim you violated a rule. What rule has been violated?

Section 6231(a)(1)(B) says a partnership with 10 or fewer partners is not a partnership, unless they elect to be treated as a partnership.

Do you know what context Section 6231 applies?

It falls under Subchapter C – Tax Treatment of Partnership Items. The IRS can only audit a partnership under the consolidated audit procedures if a partnership has more than 10 partners, or the 10 or fewer partners in a partnership elect to fall under the consolidated audit procedures.

In essence, without such an election, the auditor can only look at the 1040 of each individual partner to see whether or not partnership items were properly reported. Failure to file a 1065 is not an issue in such an audit IF the partnership items of income, expense, credits, etc. are all properly reported on the 1040.

Again, what rule has been violated if the partners do not make the election to be treated as a partnership for purposes of the consolidated audit rules?