Disregarded Entity: Everything You Need to Know
Disregarded entity refers to a business entity that's a separate entity from its owner but that is considered to be one in same as owner for federal tax purposes.4 min read
2. What the IRS Says About Disregarded Entities
3. Disregarded Entities and Employment Tax
4. Foreign Disregarded Entities
5. Disregarded Entities and Business Types
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.
- 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.
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.
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.
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.
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.
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