Don’t Lose S Corporation Status Because of Community Property Laws

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If you live in a state with community property laws, your spouse may be an owner in your corporation, even if he or she doesn’t actually have in stock by name. (IRS Reg. Section 1.1362-6(b)(2)(i); provides that when stock of the corporation is owned by husband and wife as community property (or the income from the stock is community property), each person having a community interest in the stock or income therefrom must consent to the election.) Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Puerto Rico, Texas, Washington, and Wisconsin are community property states. Also, Alaska allows married couples to opt-in to community property.

Community Property

Generally, in Community Property states, property acquired during a marriage belongs to both spouses. Even property that existed before the marriage but was improved by contributions of community property, can then be converted to community property. And that community property would be distributed equally upon dissolution of the marriage. Examples of community property may include: wages earned by either spouse during the marriage; assets purchased/improved during the marriage with marital income; interest income earned by business investments and operations Separate Property, on the other hand, can be classified as follows: any that that was owned prior to the marriage; anything that was inherited or received as a gift during the marriage; and anything either spouse earned after the date of separation.

So, a corporation formed during the marriage–or with marital assets/income–is considered community property. And, as a result, each spouse immediately owns the property. And because of that ownership, they are inherently a shareholder of the business.

S-Corporation as Community Property

Because of that ownership, if the corporation wishes to elect S-Corporation status, needs ALL of its shareholders to meet the requirements and ALL of its shareholders to consent to the S-Corporation status (see page 2 of IRS Form 2553). Even if the entity is intended to be solely owned and managed by only one spouse of the marriage, the other spouse must (1) be a resident alien and (2) must provide their information (name, address, social security number) and signature on the election.

If the spouse fails to do so, the corporation runs the risk of losing its S-Corporation status upon discovery by the IRS. And losing that status could have a detrimental tax effect on the S-Corporation and its individual shareholders. Furthermore, the IRS can go 3-years back to discover and enforce the failure to properly obtain the community property spouse’s consent on the IRS Form 2553.

Rev. Proc. 2004-35 to the Rescue

In the event you are an unsuspecting victim of the above-described IRS “gotcha-moment,” do not despair. There is a process provided under IRS Revenue Procedure 2004-35 that provides automatic relief for certain taxpayers requesting relief for late shareholder consents for S corporation elections in community property states. Provided that the shareholder and his/her spouse had reported all income, gain, loss, deduction, or credit consistent with the S-Corporation election from the election was to be effective onward, and meets the filing requirements, the IRS will grant automatic relief and treat the late election as timely.

Filing the Form 2553 With Consenting Spouse

The recommended process would be to list the consenting spouse (name, address, SSN) as a shareholder on page 2, but next to her name indicate, “consenting spouse.” And in the ownership column then list their individual ownership as 0% or N/A and date acquired as N/A.