Everything You Need to Know About Disregarded Entities
Disregarded Entities: Individuals, Businesses, and Other Separate Entities for Tax Purposes3 min read
A disregarded entity is an individual, a business, or another type of entity that’s treated as separate from its owner for income tax purposes. It’s often established for asset protection or liability avoidance purposes. The IRS will “disregard” the entity in certain situations, meaning the entity won’t be liable for any taxes or subjected to certain other requirements associated with entities. If you’re based in Los Angeles and seeking counsel that understands local regulation, UpCounsel has a network of experienced lawyers with business law expertise that can provide high quality, cost-effective legal services.
Understanding Disregarded Entities
A disregarded entity is an entity that’s separate from its owner or parent company, or the corporation that started it, but is treated as part of the entity’s owner or parent company for tax purposes. This means it’s not subject to the same tax rules as other entities. It may also be exempt from certain requirements associated with entities—such as employment tax requirements, certain corporate filing requirements, and even governance requirements—depending on the type of entity.
The sole exception is single-member LLCs, which are considered “pass-through” entities and are liable for federal and state income taxes. The LLC pays taxes from its earnings but keeps the entity separate from its owner, meaning the profits are not susceptible to personal liabilities. Disregarded entities may also be exempt from sales and excise taxes, or other taxes or fees.
Types of Disregarded Entities
Disregarded entities are most commonly set up in the form of LLCs or single-member LLCs, since these entities benefit from the liability protection as well as pass-through taxation. This means that profits are taxed at the individual level, and the LLC’s expenses cannot be deducted from the corporation’s profits.
A disregarded entity can also be set up as a C-corporation or an S-Corporation. S-corporations are considered “S” corporations and may have an ownership structure, meaning that the profits are subject to taxation at the individual level if the corporation has two or more owners, and at the corporate level if the corporation has one or more owners.
Benefits of Disregarded Entities
The primary benefit of a disregarded entity is the liability protection it provides. By treating the entity as separate from the owner, the owner is not personally liable for any debts incurred by the entity. Furthermore, the owner is not responsible for any taxes or fees associated with the entity unless they elect to be treated as a “pass-through” entity, such as an LLC or a Subchapter S corporation.
Additionally, disregarded entities provide asset protection because the entity, by definition, is separate from the assets that are owned by the business or person who is the entity’s owner. This can be especially beneficial in instances such as divorce proceedings, business purchases, or debt collection.
Finally, setting up a disregarded entity can save you in taxes. Depending on the type of entity, your profits may be subject to taxation only once, at the individual level, rather than twice, as would be the case with other entities.
Risks of Disregarded Entities
Though disregarded entities can provide significant benefits, it’s important to be aware of the risks associated with them.
For example, disregarded entities do not provide a certain degree of protection from creditors. In other words, if an LLC engages in business activities that put it in debt and the LLC subsequently defaults on its payments, the creditors may pursue and potentially obtain the owner’s assets, including the owner’s personal assets.
Furthermore, disregarded entities may not be recognized in some jurisdictions, so the owner may need to register the entity in certain states or countries in order to conduct business and gain the protections offered by forming a LLC or an S-corporation.
Finally, when utilizing a disregarded entity, it is important to make sure that the corporate formalities—such as filing annual reports and paying taxes—are followed in order to make sure the entity remains as a separate entity and not be disregarded by the Internal Revenue Service.
A disregarded entity is an entity that is separate from its owner or parent company, but is treated as part of that entity for tax purposes. This can provide numerous benefits, such as liability protection and savings on taxes. However, it is important to be aware of the risks associated with disregarded entities, such as their lack of creditor protection and the need to file necessary corporate formalities. If you’re based in Los Angeles and wondering what the regulations and laws are around setting up a disregarded entity or learning more about the financial implications, UpCounsel’s network of experienced lawyers can help you out.