Disregarded Entity LLC: Everything You Need to Know
Disregarded Entity LLC are unique structures with specific advantages.
Taxation is quite simple, since the business’ income and deductions can be reported on personal income tax returns. However, there is a separation between the owner and the business entity so that the owner is not personally responsible for any liabilities from the business. Thus, it combines the best parts of a sole proprietorship and a limited liability company.
What is a Disregarded Entity?
A disregarded entity is a business unit that is separate from its owner except when it comes to taxes. An example of a disregarded entity is a single member LLC as it absorbs the liabilities. However, profits from it are reported on the owner’s personal tax returns.
The benefit from this arrangement is that the owner is not personally responsible for any debts or liabilities that emerge from the LLC’s operation. Like single member LLCs, corporations are separate entities created by their owners for a specific purpose. Unlike single member LLCs, corporations are taxed separately for the most part. Sole proprietorship is not a disregarded entity, because it isn’t a separate entity.
For disregarded entities, the business’ income is reported on the owner’s personal tax return rather than filing a separate return. Therefore, most corporations are not disregarded entities because their income is taxed at the corporate level.
Which Business Type is a Disregarded Entity?
Single member LLCs are disregarded entities, since owners report business income on their tax returns while their liabilities are protected. In sole proprietorships, business income is reported on owner’s personal tax returns, but there is no separate entity due to a lack of protection from the business’ debt and liabilities. Most single member LLCs are considered to be disregarded entities for federal tax purposes. However, an LLC can be taxed as a corporation if it files Form 8832.
Disregarded Entity on Business Tax Forms
The term “disregarded entity”:
- Comes up on many different tax forms such as during the application for a tax ID number
- Comes up during the registration of a single member LLC
- Is the IRS’ preferred nomenclature to signal that business profits will be reported on personal income tax returns while the business entity is its own separate unit
Some background on the Disregarded Entity
The Internal Revenue Code is clear that any business entity is a corporation by default. Therefore, if the owner wants his entity to be a disregarded entity, he must file the proper forms so that taxes will be paid on an individual level rather than at the corporate level. Ultimately, businesses can choose their own classification for federal tax purposes.
LLC Not Electing to be a Corporation
LLCs which choose not to be taxed and treated as corporations become disregarded entities by default, since they are taxed like sole proprietorships but are separate entities from their owner. However, LLCs can also choose to be taxed on the corporate level.
The key difference between a single member LLC and a sole proprietorship is that the single member LLC is a separate entity. This comes with protection for the owner against the business’ debt and liabilities. In sole proprietorships, the owner can be held personally responsible for any debts, liabilities or damages that result from the business’ operations.
Both single member LLCs and sole proprietorships file a Schedule C which reports their business’ income and deductions. These figures are included with the owner’s individual income tax return. Thus, the tax treatment is the same for sole proprietorships and single member LLCs. Basically a single member LLC is considered to be a disregarded entity by default unless it files Form 8832 which signals its intention to be taxed like a corporation.
Liability Issues for a Disregarded Entity
Disregarded entities can lead to confusion at times, because for tax purposes, they are treated as a single entity with the owner. However, for liability purposes, they are separate entities. Single member LLCs can clarify that they are not sole proprietorships when it files its Application for Employer Identification Number (EIN) on Form SS-4.
Disregarded Entity and Employment Tax
Disregarded entities have responsibility for paying employment taxes. They can report and pay employment taxes with the name and Employer ID number assigned to the LLC or use the name and Employer ID number of the owner. If the disregarded entity does not have employees, then there is no need to report or pay taxes.
According to the IRS:
- LLCs with a single member are classified as sole proprietorships by default.
- LLCs with multiples members are classified as partnerships.
- Most LLCs are considered to be disregarded entities unless they choose to be taxed as corporations. In which case, it ceases to be a disregarded entity.
- S Corporations are disregarded entities due to income being reported on owners’ personal tax returns.
As of 2009, the IRS has mandated that LLCs are responsible for reporting and paying employment taxes as well as excise taxes. This means that single member LLCs need to obtain an Employment Identification Number and have a bank account in its own name.
Single member LLCs which earn more than $400 from business operations are responsible for paying self-employment taxes. This can be reported on Form 1040.
Why Choose Disregarded Entity Status?
Some of the advantages of being recognized as a disregarded entity are:
- A less complicated tax structure when compared to corporations.
- There is no double taxation as business income is taxed at the corporate level.
- Distributions are taxed as personal income.
Filing of taxes is simpler for disregarded entities, since all business income is reported on Schedule C and included with personal income. Corporations must file corporate tax returns. It can be advantageous to file as a corporation if the business income is quite large. All business income from disregarded entities is subject to a self-employment tax. For corporations, you only pay self-employment taxes on the amount that is withdrawn as a salary.
Therefore, disregarded entity status is particularly tax advantageous for new businesses due to its simplicity. If the business thrives and grows, it is worth consulting with a tax professional to change its classification.
What Is an LLC Disregarded Entity?
LLC disregarded entities only apply to single-member LLCs. Sole proprietorships are not separate entities from the owner. LLCs with multiple members are not considered to be disregarded entities because business incomes cannot be simply reported on personal tax returns.
The concept of a limited liability company came about in the early 1980s at the state level. Due to its popularity and embrace from entrepreneurs, the IRS incorporated them into their tax code.
Disregarded by IRS
Single member LLCs are classified as disregarded entities due to liabilities being separate from the owner and business income paid and reported on the owner’s personal tax returns. Essentially, when it comes to taxes, the IRS is disregarding that the company is separate from its owner.
For single member LLCs, any business income is subject to self-employment taxes. The rate differs depending on the amount. Additionally, the self-employment tax is in addition to income taxes. However, half of the self-employment tax is deductible.
LLCs With Employees
Single member LLCs with employees are subject to employment and excise taxes. They continue to be treated as separate entities. As of 2009, LLCs must use their own name and Employer identification number when reporting and filing employment taxes.
If the LLC does not have employees, then it's not necessary for it to have a unique employer identification number. However, certain states do require a unique Employer Identification Number, and it is necessary to open a bank account. LLCs can obtain its Employer Identification Number online through the IRS website.
Taxpayer Identification Number
If a single member LLC does not have any employees, then it can file using its owner’s Social Security number or its Employer Identification Number. If it has employees, then it must use its Employer Identification Number.
Liability Protection Unaffected
Even though taxes of the disregarded entity are treated in the same way as sole proprietorships, there is no impact on its limited liability status. The LLC will protect the owner’s personal assets from any debts, liabilities, or damages that may accrue from business operations.
Changing Tax Status
Single member LLCs can choose to change its tax designation to a corporation at any time. This step can be appropriate if the business has grown larger. However, it comes with additional tax complications. Single member LLCs can also become partnerships if another partner joins the company. In both cases, the LLC is no longer a disregarded entity.
Filing of Tax Returns
Single member LLCs which are owned by an individual will report business income and deductions on Form 1040. If the single member LLC is owned by a corporation, then the business’ income and deductions are reported on corporation's tax return, Form 1120.
While most disregarded entities are single member LLCs, S Corporations and REITs also qualify as disregarded entities as business’ incomes are reported on personal income tax returns. Additionally, these structures are separate entities with owners protected from the business’ liabilities.
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