Key Takeaways

  • A disregarded entity is a business structure where the entity is separate from its owner legally but not for federal tax purposes.
  • Single-member LLCs are the most common type of disregarded entity.
  • Disregarded entities offer pass-through taxation and limited liability protection.
  • Owners must still comply with employment tax rules and self-employment tax obligations.
  • Choosing disregarded entity status simplifies tax reporting but may limit some tax planning strategies.
  • Businesses can change classification by filing Form 8832 with the IRS.

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. A 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.

Advantages and Disadvantages of Disregarded Entities

While disregarded entities offer appealing simplicity, they come with unique trade-offs. Understanding both the pros and cons helps business owners make informed choices.

Advantages:

  • Simplicity in Tax Filing: No separate business tax return; profits and losses flow through to the owner's personal return.
  • Avoidance of Double Taxation: Since income is not taxed at the entity level, there's no corporate tax burden.
  • Limited Liability Protection: Like other LLCs, disregarded entities protect personal assets from business liabilities.
  • Flexible Tax Classification: Owners can choose to elect corporate tax treatment if needed.

Disadvantages:

  • Self-Employment Tax Exposure: Profits are subject to self-employment taxes, which can be significant.
  • Limited Credibility: Some investors or clients may view disregarded entities as less formal than corporations.
  • Fewer Tax Planning Opportunities: Corporate structures may offer more sophisticated tax strategies that are unavailable to disregarded entities.
  • State Law Variance: States may have different rules for how disregarded entities are treated, particularly in regard to taxation and liability.

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. According to the Code, eligible entities that have only one owner can choose:

  • To be considered an association.
  • To be disregarded as a completely separate legal entity than its owner.

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. It's worth noting that the only kind of business that meets all of the qualifications to be classified as a disregarded entity are single-member LLCs, otherwise known as SMLLCs.

Sole proprietorships can't be classified as disregarded entities due to the fact that there is no legal separation from the business and its owner in any way.

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 as 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 as 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 the file their Application for Employer Identification Number (EIN) on Form SS-4.

Compliance and Reporting Requirements

Even though a disregarded entity does not file a separate federal income tax return, it is still subject to important compliance responsibilities:

  • EIN Requirements: A disregarded entity must obtain its own EIN for employment and excise tax purposes.
  • Separate Financial Records: The IRS expects the entity to maintain its own financial records and bank accounts, even if taxes are reported on the owner's return.
  • State Filings: Some states require disregarded entities to file annual reports or pay franchise taxes, regardless of federal tax treatment.

Non-compliance with these requirements can lead to penalties, audits, or even the loss of limited liability protection.

Disregarded Entity and Employment Tax

Disregarded entities have responsibility for paying employment taxes. They can report and pay employment taxes with the name and EIN assigned to the LLC or use the name and EIN of the owner. If the disregarded entity does not have employees, then there is no need to report or pay taxes.

LLC Classification

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.

How to Elect Out of Disregarded Entity Status

If an LLC wants to be taxed as a corporation, it must file IRS Form 8832. This allows the LLC to be treated as either a C corporation or, if eligible, an S corporation.

Steps to Elect Corporate Tax Status:

  1. Complete IRS Form 8832 (Entity Classification Election).
  2. Select the appropriate classification (corporation).
  3. Submit the form within 75 days of the intended effective date or up to 12 months in advance.
  4. Keep records of the election for future reference and IRS verification.

Note: Once elected, the classification must remain in effect for 60 months unless there is a change in ownership or another qualifying event.

Employment Taxes

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.

Self-Employment

Single-member LLCs that 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.

When Disregarded Entity Status May Not Be Ideal

Disregarded entity status is not always the best choice. It may not suit businesses with high profits, investors, or multiple owners. Situations where it may be less appropriate include:

  • Businesses Planning to Raise Capital: Investors often prefer corporations for their familiar governance structures and share-based equity.
  • Large Profit Margins: High self-employment taxes on all profits can outweigh the simplicity of pass-through taxation.
  • Expansion Plans: States may treat disregarded entities differently, complicating multi-state operations.

In these cases, opting for corporate tax status or forming a multi-member LLC or corporation might offer better financial and operational outcomes.

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.

Self-Employment Tax

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 EIN when reporting and filing employment taxes.

If the LLC does not have employees, then it's not necessary for it to have a unique EIN. 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.

Transitioning to a Partnership or Corporation

A disregarded entity can lose that status if it gains a second owner or elects corporate treatment.

  • Becoming a Partnership: If a single-member LLC adds a member, it automatically becomes a multi-member LLC and is taxed as a partnership unless an election is made.
  • Electing Corporate Status: As noted, filing Form 8832 or Form 2553 (for S corp status) changes how the IRS treats the entity for tax purposes.

It's important to consult a tax advisor or attorney before making such changes, as they have long-term implications for taxes, liability, and operations.

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 the corporation's tax return, Form 1120.

Single-Member LLC

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. Note that for tax purposes, the single-member limited liability company doesn't exist. Rather, all of the company's liabilities and assets are considered to be the property of the corporation that has acquired it.

Although the tax status of a disregarded entity is somewhat transparent for the purpose of federal taxes, it's not nearly as transparent from the perspective of local state laws. The owner of a single-member LLC, for example, isn't held personally responsible for the legal and financial obligations of their company. Since the company is a disregarded entity, however, the owner is considered to be the entity's employer in terms of employment taxes.

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 not recognized as separate for federal tax purposes, meaning all income and deductions are reported on the owner's personal return.
  2. Can a disregarded entity have employees?
    Yes, a disregarded entity can have employees. It must obtain an EIN and file employment taxes under its own name.
  3. Is a disregarded entity the same as a sole proprietorship?
    No. While the tax treatment is similar, a disregarded entity like a single-member LLC provides liability protection that sole proprietorships do not.
  4. How do I change my LLC from a disregarded entity to a corporation?
    File IRS Form 8832 to elect corporate tax classification. For S corporation treatment, also file Form 2553.
  5. Do all states treat disregarded entities the same?
    No. State tax treatment and reporting requirements vary. Some states may require additional filings or taxes even for entities disregarded at the federal level.

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