401k Contributions Guidance for Two-Member LLC in a Community Property State

Question

We established an LLC at the beginning of this year, with just two members – my spouse and myself. We reside in a community property state and file our taxes jointly as a married couple.

Throughout this year, we've utilized our LLC to carry out business activities. My spouse has been working on a separate project, having earned about $1k, while I undertook contract work in the IT field, earning roughly $200k.

Both of us were actively involved in the LLC's operations, each contributing more than 500 hours of work (met material participation test). However, we've encountered conflicting information regarding the tax filing status for our LLC and contributions to our 401k plans. Despite consulting with tax advisor, and CPA, we still don't have a definitive answers.

Essentially, we have the following questions:

1. Can we file as a Qualified Joint Venture (QJV)? Here is the IRS's definition of a QJV (https://www.irs.gov/businesses/small-businesses-self-employed/election-for-married-couples-unincorporated-businesses):

A qualified joint venture is a joint venture that conducts a trade or business where (1) the only members of the joint venture are a married couple who file a joint return, (2) both spouses materially participate in the trade or business, and (3) both spouses elect not to be treated as a partnership. A qualified joint venture, for purposes of this provision, includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company) (See below). Note also that mere joint ownership of property that is not a trade or business does not qualify for the election. The spouses must share the items of income, gain, loss, deduction, and credit in accordance with each spouse's interest in the business. The meaning of “material participation” is the same as under the passive activity loss rules in section 469(h) and the corresponding regulations (see Publication 925, Passive Activity and At-Risk Rules). Note that, except as provided in section 469(c)(7), rental real estate income or loss generally is passive under section 469, even if the material participation rules are satisfied, and filing as a qualified joint venture will not alter the character of passive income or loss.

Does the IRS assume that a QJV can only consist of one business? If my spouse and I have separate activities considered as two businesses, does this mean that we can't be treated as a QJV and should instead file as a partnership?

2. Should we split our taxes equally (50/50 as per Schedule SE) or should it be proportional to our profit margins (my spouse pays taxes on $1k while I pay taxes on $200k)?

3. Can we both contribute to the maximum allowable amount for our 401k plans, which is $66k each, or is my spouse only allowed to contribute $1k, reflecting their earned income?

Answer 1

Both of us were actively involved in the LLC's operations, each contributing more than 500 hours of work (met material participation test).

This is confusing. How come you earned 200K and your spouse only earned 1K while you both have contributed >500 hours to the LLC?

Does the IRS assume that a QJV can only consist of one business?

Yes, absolutely. You can have multiple QJV businesses, but each business needs to qualify.

If my spouse and I have separate activities considered as two businesses, does this mean that we can't be treated as a QJV and should instead file as a partnership?

Yes, if you work each on their own business then you do not have a QJV or partnership, you have two Schedule C businesses.

Should we split our taxes equally (50/50 as per Schedule SE) or should it be proportional to our profit margins (my spouse pays taxes on $1k while I pay taxes on $200k)?

This depends on the State law and your agreements (community property States may dictate how earnings for married couples are attributed, prenups/postnups may also affect that). Talk to a family law attorney, this is not a tax question. Once you figure out who owns the income, the tax question will resolve itself.

Can we both contribute to the maximum allowable amount for our 401k plans, which is $66k each, or is my spouse only allowed to contribute $1k, reflecting their earned income?

For 401k your spouse can only use their own earned income. For IRAs communal income is used (i.e.: non-working spouse can contribute to the IRA based on the earnings of the working spouse).