Salary/Dividend Split In Texas - Married Filing Separately

[Bryan Hancock]

I am in the process of setting up a new entity in Texas that will replace my old operations entity that I've been using for the last 14 years.  I'm engaged to what will be my 2nd wife after a lengthy and somewhat contentious divorce.  

An attorney is preparing my new operating agreement and for some reasons I would like to keep private we're looking to do a 99/1 split on our income tax returns as married filing separately in Texas.  I visited with my long-time accountant a few weeks ago and he informed me that in Texas for some reason if you file married filing separately you have to report half of your spouse's income on your return.  This is undesirable for our situation so I am trying to understand the mechanics, whether or not this is correct, and if there is a way we can legally avoid doing this.  

To provide more detail here would be the normal scenario for buy/sell (operations) projects going forward:

• Special purpose entity would be formed for each new project that will be developed and sold using my own capital, bank capital, and syndicated capital
• The new development entity we're organizing would specify the 99/1 split of distributions and would act as the manager of each SPE. The entity would be filing a 1120s as a LLC electing to be taxed as an s-corp
• We'd be personally filing as married filing separately

We would like cash to flow like this:

1.  Out of the SPE (tax form would be K1 presumably)

2. In to the LLC's bank account

3. Out of the LLC bank account as a salary/dividend split (tax form would be 1099 presumably)

4.  In to each of our individual bank accounts

5.  Later to a joint bank account (tax form would be 1040 presumably)

What I am seeking is a method that allows 99 parts out of 100 of this income to show on one of the two tax returns.  This would presumably be part salary and part dividend if that part matters for the procedural way it is reported on the returns.  Is there a way to do this?  We could do a private agreement if needed.  

[Michael Plaks]

@Bryan Hancock

Your long-time accountant is correct in principle. Our state is one the community property states, which you should be quite familiar with, having gone thru a divorce.

For tax purposes, with two returns using "married filing separately" status, you have community income and non-community aka separate income. Whatever is considered community income must be split between the two returns 50/50. Whatever is considered separate income goes on one of the returns in its entirety. 

The problem is that it is quite difficult to ensure that something retains its separate character when you are married. "Later to a joint bank account..." as you mentioned? Fuggedaboutit!

Here is the IRS Publication that outlines these rules:  https://www.irs.gov/publicatio...  And here is the IRS internal manual that discusses the application of these rules in a very technical way, making for some tough reading: https://www.irs.gov/irm/part25...  Probably best to leave it to professionals to interpret.

What you're trying to accomplish makes already complex hurdles twice or thrice as hard: you want to own the same entity together with your new wife but treat each other's ownership as separate income under the community property rules. First, I would challenge whether this is the right idea to begin with. There could be alternatives. But if you do have to set it up this way, then you would need top tier legal and tax counsel to accomplish your desired tax treatment. Keep in mind that the Federal tax law in this area partially defers to the state law, which varies from state to state.

I'm almost sure that you would need to set up two separate business entities, one for you and the other for her, and make these two entities 99/1 co-owners of the joint business entity. This is just a start. Details and implementing ironclad business procedures are key.

PS. Have you considered simplifying your life? :)