Limited liability companies (LLC’s) are often a preferred entity choice for small businesses, farm operations, and rentals because they offer some liability protection for owners. Generally, LLC’s are treated as partnerships for tax purposes, and a Form 1065 partnership income tax return is required to be filed.
In community property states, when a husband and wife are the sole members in an LLC, the activity of the LLC can be reported on the married couple’s Form 1040 federal individual income tax return. In this case, the LLC is considered a disregarded entity, and no partnership return is required to be filed.
A potential problem may arise when a couple has reported the farming, business, or rental income from a disregarded LLC on their individual income tax return and then one spouse dies. When the spouse’s estate or a trust is a member in the LLC, a partnership return may be required.
For example, Frank and Mabel have two LLC’s that are owned 50% by each spouse. One LLC holds farmland and the other one is where the farming operations are done. While both spouses were alive, the farmland rental was reported on Schedule E, and the farm income was reported on Schedule F of their Form 1040 individual income tax return. But, when Mabel died, both LLC’s are no longer disregarded entities. Rather than husband and wife, the members of the LLC at the date of death are now Frank and Mabel’s estate.
To make matters worse, often in the year of death, individual income tax returns need to be extended while the estate is settled or the surviving spouse takes over the recordkeeping. You must be careful to recognize when you are in this situation, or you may not make a timely extension of the partnership returns which are now due. In Frank and Mabel’s case, they would likely be exposed to a penalty to the tune of $195 per-month after the April 15th due date, per partner. Frank, Mabel, and Mabel’s estate would each receive K-1’s from each LLC, so if they didn’t realize their filing requirement until August, they would be exposed to $4,680 ($195 x 3 partners during the year x 4 months x 2 late returns) of penalties!
If you and your spouse have a disregarded LLC, this would be a very good item to talk to your tax advisor about and to add to your survivor’s checklist as part of your estate plan!