Key Takeaways

  • A disregarded entity is ignored for federal tax purposes, meaning the IRS taxes the owner directly instead of the business.
  • An S corporation is not a disregarded entity; it is a separate tax election that allows pass-through taxation but still requires a corporate return (Form 1120-S).
  • A single-member LLC is the most common disregarded entity, but it can elect to be taxed as an S corp if it meets IRS requirements.
  • Disregarded entities may still owe state-level taxes (sales, property, or franchise fees) even if they avoid federal entity-level taxation.
  • Choosing between a disregarded entity and an S corp affects liability protection, self-employment taxes, payroll requirements, and compliance costs.
  • Businesses must weigh the advantages (simplicity, pass-through taxation) against the drawbacks (limited growth, compliance burdens) when considering structure.

A disregarded entity S corp is just one of several disregarded entities you could establish. With a disregarded business entity, a business's income and assets are not considered for the purpose of federal taxation. Instead, these items get taxed on the personal return of the business owner.

What Are Disregarded Entities?

When it comes to federal taxation, the Internal Revenue Service (IRS) ignores disregarded entities. Any income earned by a disregarded entity will get taxed, but will be treated as the business owner's personal income. You should be very careful when planning your taxes while operating a disregarded entity.

There are three primary types of disregarded entities:

  • Single-member LLCs: These limited liability companies form at the state level and have only one member.
  • S Corporations: These corporations have made a special tax election with the IRS. With an S corporation, business income passes to company members and gets only taxed once, on their personal returns.
  • Check the Box: These entities can decide whether to get taxed as a corporation or treated as a disregarded entity. Generally, check-the-box entities are businesses in the United States that receive income from foreign entities.

Limiting personal liability while controlling taxes is the main purpose of a disregarded entity. In the past, it was considered a rule that liability protections required an addition tax burden. Today, limiting a business owner's personal liability does not require additional taxation for most entities.

Is an S Corp a Disregarded Entity?

While S corporations share some similarities with disregarded entities, they are not classified as such under federal tax law. A disregarded entity, such as a single-member LLC, has its income reported entirely on the owner’s tax return without filing a separate federal business return. By contrast, an S corporation must file Form 1120-S and issue Schedule K-1s to its shareholders. Although the income ultimately passes through to the owners, the entity itself is not “disregarded” in the eyes of the IRS.

Businesses sometimes confuse the two because both structures offer pass-through taxation, but the compliance requirements differ. An LLC can start as a disregarded entity and later elect to be taxed as an S corp if it wants to reduce self-employment tax liability and meet IRS eligibility rules.

State Taxes and Disregarded Entities

In some states, a business's disregarded entity status will be ignored, and the business will get taxed as a corporation. While these states may not tax disregarded entities, they will charge fees that would apply to corporations, which can be very expensive.

A mistake that many make related to disregarded entities is assuming that these businesses are not required to pay any taxes. While it's true that disregarded entities are ignored for federal taxation, there are numerous state taxes that disregarded entities must pay:

  • Property tax
  • Sales tax
  • Use tax

Disregarded entities must also comply with state-level reporting requirements and fee payments. So, if the owners of a disregarded entity make a sale, this sale would not be subject to federal taxation but would be subject to sales taxes.

Differences Between Disregarded Entities and S Corps

When comparing disregarded entities to S corporations, several distinctions stand out:

  • Formation: A disregarded entity is typically a single-member LLC. An S corp is a corporation (or an LLC that elects S corp taxation).
  • Tax Reporting: Disregarded entities file no separate business return at the federal level, while S corps must file an annual corporate return.
  • Self-Employment Taxes: Disregarded entity owners pay self-employment taxes on all net income. S corp owners may pay themselves a salary (subject to payroll tax) and take additional distributions that avoid self-employment tax.
  • Ownership Rules: Disregarded entities are limited to one owner. S corps allow up to 100 shareholders but restrict ownership to U.S. citizens and certain trusts.
  • Compliance Burden: Disregarded entities are simpler, while S corps must maintain corporate formalities, payroll systems, and additional filings.

Understanding these differences helps business owners choose the structure that balances liability protection, tax savings, and administrative ease.

Drawbacks of Disregarded Entities

If your disregarding entity has employees, you will need to comply with the same withholding rules as normal entities. Disregarded entities can be easily mishandled, especially when it comes to taxes. If you're not careful, you could end up facing a larger tax bill than you expect.

You must be very careful if you're performing international transactions with your disregarded entity. For instance, while your business will be considered a disregarded entity in the United States, you may not be treated as a disregarded entity in other countries.

While operating your disregarded entity, you should also make sure that you are paying any required state-level taxes. All business transactions, including corporate acquisitions, are subject to sales and use taxes. If you fail to pay these taxes, you will likely face hefty penalties.

Advantages of Electing S Corp Taxation

While disregarded entities are simple, some business owners outgrow their benefits. Electing S corp status may provide advantages such as:

  • Potential Tax Savings: By designating a portion of income as salary and the rest as distributions, owners may reduce overall self-employment tax liability.
  • Expanded Ownership: S corps permit multiple shareholders (up to 100), which may facilitate raising capital.
  • Perception and Credibility: Some clients, lenders, and investors view corporations as more established than disregarded entities.
  • Retirement Contributions: S corp owners can often contribute more to retirement accounts through payroll-based plans.

However, these advantages come at the cost of more complex compliance requirements, such as running payroll, filing separate returns, and adhering to corporate governance standards.

Paying Disregarded Entity Taxes

When paying taxes for your disregarded entity, you will use a W9 form. To make sure you pay your taxes correctly, you must be certain that your W9 form includes the correct information. For instance, you will need to include the same legal name that you will use on your federal tax return. You should link any tax ID number that you use on this form to your legal name.

If your disregarded entity is a single-member LLC, the name you include on your W9 form should be your company owner's name. Do not use the name of the LLC.

The tax identification and classification that you use for your disregarded entity single-member LLC can fall into one of three categories:

  • If the owner of the LLC is an individual, you should choose the sole proprietor classification and use your Social Security Number.
  • Single-member LLCs owned by a partnership or corporation should use these classifications and include the Employer Identification Number (EIN).
  • Single-member LLCs owned by another LLC should choose the LLC classification and include the EIN.

Make sure you are choosing the correct classification and identification before you submit your W9 form.

Compliance Considerations for Disregarded Entities and S Corps

Whether operating as a disregarded entity or as an S corp, compliance remains critical:

  • Federal Filings: Disregarded entities report income on the owner’s Schedule C, E, or F, while S corps must file Form 1120-S annually.
  • Payroll Obligations: Disregarded entities with employees must withhold payroll taxes, and S corps must ensure reasonable salaries are paid to shareholder-employees.
  • State Requirements: Some states impose franchise taxes or minimum annual fees regardless of disregarded entity status. S corps often face similar obligations at the state level.
  • Record-Keeping: Even disregarded entities must maintain proper books for liability protection. S corps face stricter requirements, such as holding annual meetings and maintaining bylaws.

Failing to meet compliance obligations can eliminate liability protection and lead to significant penalties.

Frequently Asked Questions

  1. Is an S corp a disregarded entity?
    No. An S corporation is not a disregarded entity. It must file its own tax return, though its profits pass through to shareholders.
  2. Can a disregarded entity elect S corp status?
    Yes. A single-member LLC (a disregarded entity) can elect S corp taxation if it meets IRS requirements for shareholders and filing deadlines.
  3. Why would someone switch from a disregarded entity to an S corp?
    Often for tax savings on self-employment taxes, expanded ownership opportunities, or increased credibility with investors and lenders.
  4. Do disregarded entities pay state taxes?
    Yes. Even if they are ignored for federal tax purposes, disregarded entities may owe sales, property, franchise, or use taxes at the state level.
  5. Which is simpler to manage, a disregarded entity or an S corp?
    A disregarded entity is simpler, with fewer filings and lower compliance costs. S corps require more paperwork and payroll but may offer tax advantages.

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