Key Takeaways

  • A disregarded entity is a business entity separate from its owner for legal purposes but treated as one and the same for federal tax purposes.
  • Single-member LLCs are the most common example of disregarded entities.
  • Disregarded entities offer liability protection while allowing pass-through taxation.
  • The IRS still requires employment and excise taxes to be filed under the entity’s EIN, not the owner's SSN.
  • Foreign entities can also qualify as disregarded entities for U.S. tax purposes.
  • There are pros (simplified tax filing) and cons (limited flexibility, potential state-level issues) to disregarded entity status.
  • Electing corporate taxation or adding a second member can change disregarded status.

What Is a Disregarded Entity?

The term disregarded entity refers to a business entity that's a separate entity from its owner, but that is considered to be one in the same as the owner for federal tax purposes. The business owner essentially wants the IRS to "disregard" the fact that the business is a separate entity when it comes time to file taxes.

Generally, businesses are separate entities from their owners. For liability purposes, the separation is an important aspect for business owners. If the business incurs debt or is the subject of a lawsuit, this is separate from the business owner, who unlike a sole proprietor, would not have his own personal assets on the line. Many of the most common business entities are separate from their owners, including corporations, limited liability companies (LLCs), and partnerships.

The vast majority of businesses are taxed separately from the business owner; the business and its owner use completely different tax forms. This can be a hassle for those small-business owners who would prefer to file business taxes along with their own personal taxes, but who want the liability protection these business forms provide. The disregarded entity helps these business owners file taxes the way that they want to, helping them to save time.

Currently, the only business entity that is a pass-through entity, where the business is not separate from the owner, is the sole proprietorship. Sole proprietors file their Schedule C business tax form as part of their own personal income taxes. However, unlike other business forms, there isn't any liability protection offered to sole proprietors. That means that any legal action taken against the business is directed at the person who founded it. In short, it is a lawsuit against you and your company, which puts your personal assets at risk.

A disregarded entity:

  • Is a pass-through entity only for tax purposes.
  • The business owner can file business taxes with their own taxes.
  • It only impacts the designation during tax time.
  • Does not compromise the liability protection otherwise offered.

This is a major benefit for you as an owner, as it helps keep your personal assets safe from any legal actions taken against the business. An LLC owned by a single person is the only type of business that can opt to be taxed as a disregarded entity. Usually, LLCs are taxed as partnerships.

Benefits and Drawbacks of Disregarded Entity Status

Disregarded entities offer a streamlined tax experience for eligible business owners, but the structure may not fit every situation.

Benefits include:

  • Simplified tax filing: Income and expenses are reported directly on the owner's individual tax return, typically using Schedule C.
  • Pass-through taxation: Profits and losses "pass through" to the owner, avoiding double taxation.
  • Full liability protection (for LLCs): Owners retain protection from personal liability for business debts and lawsuits.
  • Flexibility: Owners can choose to elect corporate tax treatment in the future if business needs evolve.

Drawbacks to consider:

  • Limited to single-owner LLCs: Multi-member LLCs and corporations are not eligible for disregarded status.
  • Potential confusion with banks and vendors: Some institutions prefer to interact with an entity that files its own return.
  • State-level tax rules vary: Some states do not recognize disregarded entity status and may impose separate entity-level taxes.
  • Restrictions on fringe benefits: Owners may have limited access to tax-advantaged employee benefits like health insurance deductions.

What the IRS Says About Disregarded Entities

The Internal Revenue Service's Internal Revenue Code assumes that businesses are, by default, corporations. Businesses that are not corporations are considered eligible entities that can elect their own classifications for filing federal taxes. Businesses, aside from sole proprietorships, can decide what they want to be considered for tax purposes.

When Disregarded Entity Status Begins and Ends

Disregarded entity classification begins automatically upon the formation of a single-member LLC unless the owner elects to be taxed as a corporation. However, this status can change if:

  • The owner adds a partner or transfers part of the ownership, converting the LLC to a multi-member entity.
  • The owner files IRS Form 8832 to elect corporate taxation.

Once disregarded status ends, the entity must begin filing separate tax returns and follow all applicable IRS reporting requirements for its new classification.

Disregarded Entities and Employment Tax

If you decide to file federal taxes as a disregarded entity, this does not change the way that you file employment taxes. You'll still need to file any employment or payroll taxes just as you did before, using your EIN. Deciding to become taxed as a disregarded entity does not have an impact on types of taxes besides federal taxes.

How Disregarded Entities Report and Pay Taxes

Although disregarded for income tax purposes, these entities are treated as separate from their owners for employment tax and certain excise tax purposes. Key points include:

  • EIN usage: Employment and excise tax forms must be filed under the entity’s EIN, not the owner's SSN.
  • Tax forms: Employment taxes are typically filed using Form 941 or 944, while excise taxes use various IRS forms depending on the type.
  • Liability remains with the entity: The disregarded entity—not the owner—is responsible for filing and paying these taxes.

This dual treatment reflects the IRS’s attempt to balance administrative simplicity for income tax with accountability for payroll and industry-specific taxes.

Foreign Disregarded Entities

Other entities besides those in the U.S. are eligible for consideration as a disregarded entity. For corporate tax purposes, a foreign disregarded entity is taxed as a foreign branch of an American-based corporation. The tax process for such a foreign entity would include calculating foreign taxes, which come into play during the U.S. tax process. All the foreign disregarded entity's income is taxed as the owner's income, even if the profits of the company do not go to the owner directly.

For foreign disregarded entities, the IRS does not separate transactions made between the business owner and the foreign disregarded entity. This is because the owner is considered as a single entity with the business, so it wouldn't make sense for these transactions to be taxed as if they were separate. This can make filing taxes in the United States for companies with international presences much simpler than it is currently as a traditional LLC.

Additional Compliance Considerations for Foreign Owners

Foreign-owned disregarded entities (FDEs) face additional filing obligations:

  • Form 5472 Requirement: FDEs with a foreign owner must file IRS Form 5472 annually along with a pro forma Form 1120.
  • Information reporting: These forms report transactions between the U.S. disregarded entity and its foreign owner or related parties.
  • Penalties for noncompliance: Failing to file Form 5472 can result in a penalty of $25,000 or more per year.

These rules aim to ensure transparency and prevent tax avoidance through foreign-controlled structures.

Disregarded Entities and Business Types

The main business types are sole proprietorships, single-member LLCs, multimember LLCs, partnerships, corporations, and S corporations. Sole proprietorships are not considered disregarded entities, because they are not registered as business entities with the state. Usually, all a sole proprietorship needs to function is a "doing business as" title and a local business license.

LLCs may or may not be disregarded entities depending on their structure. Single-member LLCs are viewed as disregarded entities because the LLC is a separate entity from its sole member for liability purposes and is registered with the state or state where it conducts business. The sole member of the LLC, however, does have profits and losses pass through to him, and the LLC itself is not taxed as a business.

Multimember LLCs are not disregarded entities because they do pay business taxes as a partnership does. They still benefit from liability protection, but the company is required to pay income taxes. Likewise, partnerships are not disregarded entities. This goes for limited partnerships and limited liability partnerships as well.

Corporations are required to pay taxes through a Form 1120, U.S. Corporation Income Tax Return, so they are also not considered disregarded entities. Owners of corporations also have liability protection, as do members of S corporations. Subchapter S corporations are required to file Form 1120-S returns, but these are simply informational returns. S corporations determine their own tax attributes like income, credits, and deductions. This ability takes them out of the disregarded entity classification.

Changing Tax Classification of a Disregarded Entity

While the default tax classification for a single-member LLC is disregarded entity status, owners can change how the business is taxed by filing IRS Form 8832. This allows the business to be taxed as:

  • A C corporation
  • An S corporation (by also filing Form 2553)

Reasons for electing corporate taxation might include:

  • Retaining profits in the business for expansion.
  • Accessing different retirement plan options.
  • Offering fringe benefits to the owner-employee.

Once the change is made, the business is no longer considered a disregarded entity.

Frequently Asked Questions

1. What is a disregarded entity for tax purposes? A disregarded entity is a business that is legally separate from its owner but is treated as part of the owner for federal income tax purposes.

2. Can a disregarded entity have employees? Yes, a disregarded entity can have employees, but it must use its own EIN to report employment taxes.

3. How do I elect for my LLC to be a disregarded entity? If you're the sole owner of an LLC, it is automatically treated as a disregarded entity unless you file IRS Form 8832 to change its classification.

4. Does disregarded entity status affect my state taxes? Possibly. Some states treat disregarded entities the same as the IRS, while others impose their own filing and tax obligations.

5. What happens if I add a member to my single-member LLC? The LLC becomes a multi-member LLC and is no longer a disregarded entity; it is treated as a partnership for tax purposes unless another election is made.

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