Unresolved Issues Regarding Passthrough Entities, Community Property, and Federal Tax Law Create Headaches for Spouses in Louisiana

Author:Susan Kalinka
Position:Harriet S. Daggett-Frances Leggio Landry Professor of Law, Louisiana State University
Pages:861-926
SUMMARY

I. Classification Of Interests In And Income Of A Disregarded Entity, Partnership, S Corporation, Or Llc As Community Property Or Separate Property And The Federal Tax Treatment Of Such Income. A. Undistributed Income of a Partnership. B. Undistributed Income of an S Corporation. C. Undistributed Income of a Disregarded Entity. D. Should the Undistributed Income of a Passthrough Entity Be Treated ... (see full summary)

 
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Harriet S. Daggett-Frances Leggio Landry Professor of Law, Louisiana State University, Paul M. Hebert Law Center. The author would like to thank Professor Glenn G. Morris for his comments on an earlier draft of this Article.

Page 861

Disregarded entities, partnerships, S corporations, and LLCs that are taxed as disregarded entities, partnerships, or S corporations are sometimes referred to as passthrough entities. The term "passthrough entity" describes the federal and state tax treatment of the entity's income and transactions between the owner and the entity. A disregarded entity is an entity owned by one person whose separate existence from its owner is disregarded for tax purposes.1 Thus, the income of a disregarded entity "passes through" to the owner of the entity, and the owner is liable for the tax on the disregarded entity's income.2 Because a disregarded entity is disregarded as a separate entity from its owner, transactions between the disregarded entity and its owner are not taken into account and have no tax consequences. Thus, distributions from a disregarded entity to its owner are not subject to income tax. In general, a disregarded entity is an unincorporated entity, like an LLC, organized under federal law or the laws of one of the states and is classified as a disregarded entity for federal tax purposes, if the entity has not made an election to be classified as a corporation.3

Under federal tax law, the income of a partnership or S corporation, like the income of a disregarded entity, "passes through" the entity and is taxed to the partners or shareholders. The partners and shareholder must report their shares of the entity's income in the year the income is earned, regardless of whether that income is distributed to them.4 Later, when the previously taxed Page 862 income of the passthrough entity is distributed to the owner(s), the distribution is tax free to the distributee.5 For convenience, this Article often will focus on the treatment of the income of disregarded entities, partnerships, and S corporations under both federal income tax and community property law, with the reader's understanding that the treatment of an LLC's income is likely to be the same if the LLC is taxed as a disregarded entity, partnership, or S corporation. This Article will also sometimes refer collectively to disregarded entities, partnerships, S corporations, and LLCs taxed as such entities as "passthrough entities."

To the extent that a disregarded entity, partnership, or S corporation generally does not pay tax on its own income, the entity is treated as an aggregate of its owners. Louisiana business organization law, however, treats LLCs, partnerships, C corporations, and S corporations as entities separate from their owners.6 It is uncertain whether Louisiana community property law treats a passthrough entity as an entity separate from its owners. The courts all agree that distributions of income earned by a passthrough entity during the existence of the community are community property, even if the interest is the separate property of one of the spouses, unless that spouse has reserved distributions as separate property in accordance with the procedures prescribed by Louisiana community property law.7

The Louisiana First Circuit Court of Appeal has held that the undistributed income of a partnership or S corporation is separate property if the partnership interest or stock in the S corporation is the separate property of a spouse.8 Similarly, Louisiana courts have held that, as a general rule, the undistributed income of a Page 863 partnership is not community property if the interest is the separate property of one of the spouses.9 Nevertheless, the Louisiana Third Circuit Court of Appeal has held that a spouse's share of a partnership's undistributed income is community property even though the spouse owns the partnership interest as separate property, if and to the extent that the spouse may withdraw it at any time and for any purpose.10 The third circuit's distinction between undistributed income of a partnership in general and partnership income that is available to a partner makes sense. Nevertheless, the rule may result in inequity when the community terminates.

On termination and partition of the community, each spouse is entitled to receive one-half of the community property.11 If the undistributed income of a partnership is treated as community property even though a spouse owns the interest in the partnership as separate property, the undistributed income is likely to be treated as having been distributed and then reinvested in the partnership.12 In that case, the non-owning spouse may receive reimbursement for one-half of the income that is treated as reinvested in the partnership. On termination of the community, a spouse is entitled to reimbursement of the amount or value of one- half of the amount or value of community property used for the acquisition, use, improvement, or benefit of the separate property of the other spouse.13 Thus, the spouse who does not own an interest in a partnership would be entitled to the same income twice: first when it is treated as distributed and therefore, community property, and second when the same income is treated as reinvested in the partnership. As of this writing, the Louisiana Supreme Court has not decided whether the undistributed income of a passthrough entity is community or separate property. Thus, it is uncertain how the undistributed income of a passthrough entity that is owned as separate property is classified under Louisiana community property law. Page 864

Regardless of whether the undistributed income of a passthrough entity is treated as community or separate property, the spouse who does not own an interest in the entity will be liable for the tax on that income if the couple files a joint income tax return. As explained above, the owner of an interest in a passthrough entity is liable for the tax on the owner's share of the entity's undistributed income. If the spouses file a joint federal or state income tax return, the income attributable to a spouse's share of a passthrough entity's undistributed income must be reported on the return. Each spouse's liability for the tax required to be reported on a joint income tax return is joint and several, in the case of a federal joint tax return, or joint and in solido in the case of a state joint income tax return.14 Because each spouse is liable for the entire amount of the tax due on the couple's aggregate income for the year in which the return is filed, the tax liability on the undistributed income of a passthrough entity is a community obligation.15 If community property is used to pay the tax on the entity's undistributed income, the spouse who does not own an interest in the entity should not be entitled to reimbursement of any of the community property used to pay the tax. Thus, on partition of the community, the non-owning spouse should not receive any portion of the undistributed income or the amount of community property used to satisfy the tax liability on that income if the couple filed a joint return for the year in which the entity earned the income.16

Nevertheless, on partition of the community, a spouse is entitled to receive one-half of the amount by which a separately owned interest in a partnership, S corporation, or LLC increased in value to the extent that the increase in the value of the interest is attributable to the uncompensated or undercompensated labor of Page 865 either or both of the spouses.17 It may be difficult, however, for the non-owning spouse to prove that the increase in value of an interest in an entity that constitutes the separate property of the other spouse is attributable to the uncompensated or undercompensated labor of one or both spouses, especially if the spouse or spouses have been compensated for services provided to the entity. If the assets of the entity consist of income-producing property, the increase in value of a spouse's interest in that entity is likely to be attributable to the increase in value of the underlying assets, and not attributable to any effort or labor of either spouse.

Inequities may result if any of a spouse's share of the undistributed income of a passthrough entity is omitted from the joint return and the interest in the entity is the separate property of that spouse. In such a case, the IRS may seize the non-owning spouse's share of community property or the non-owning spouse's separate property in satisfaction of the tax deficiency, interest, and/or penalties attributable to the unreported or under-reported income unless the non-owning spouse qualifies as an "innocent spouse" under section 6015 of the Internal Revenue Code or section 47:101(B)(7) of the Louisiana Revised Statutes. However, it is not always easy for a spouse to qualify for innocent spouse status.

If the spouses file separate income tax returns, it is not certain whether a spouse is liable for the tax on one-half of a passthrough entity's...

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