Running a business requires navigating a unique legal framework at both the state and federal levels. As such, the continuously evolving tax regulations and legal must-dos impose an additional burden to the business owners. This complexity is further compounded when it comes to disregarded entities.

Disregarded entities represent such businesses, such as limited liability companies in which the ownership is separated from the management. Here is a comprehensive overview of frequently asked questions on disregarded entities in Chicago.

What Is a Disregarded Entity?

A disregarded entity is a type of business entity that is similar to a limited liability company (LLC). It has a similar structure of ownership and management, but differs in classification for tax purposes.

Instead of being classified as a separate taxpayer, a disregarded entity is viewed as an extension of the LLC owner or partners known as the ‘Disregarded Entity Owner’ (DEO). It follows that the entirety of the disregarded entity’s income, expenses, losses, deductions, and taxes flow through and are reported on the DEO’s personal income tax returns.

What Are the Benefits of a Disregarded Entity?

When running a business in Chicago, the favorable legal regulations of a disregarded entity offer a number of tax-saving and risk-mitigating opportunities.

For starters, disregarded entities can save time on tedious paperwork. Since they are not considered separate legal entities, disregarded entities do not need to file a separate tax return. All the income, losses, or deductions associated with a disregarded entity are included in the entity’s owner (DEO) tax return.

Additionally, disregarded entities offer liability protection. This means, in case the disregarded entity is sued, the assets of the owner are not at risk and it is the entity’s assets—not the owner’s—which would draw a plaintiff’s claims. This is beneficial for those who form the entity as a way to protect their personal assets from creditors.

Are Disregarded Entities Required to Pay Taxes?

The answer may vary depending on the location and nature of a business. Generally, disregarded entities are treated as ‘pass-through entities’ in the eyes of the law and the associated taxes are ‘passed-by’ to the DEO disregarding the existence of the entity.

Note that self-employment tax may need to be paid by the owner, depending on their business activities. The Internal Revenue Service (IRS) requires the payment of self-employment tax in certain cases where the owner is engaged in an active business.

Are Disregarded Entities Common in Chicago?

The legal status of disregarded entities in Chicago is based on the definition set forth in the state’s LLC Act and regulations. LLCs are regulated by the state and are therefore required to file documents with the Secretary of State.

In the State of Illinois, LLCs are a standard type of business entity while disregarded entities are not very common. Since disregarded entities are not distinct legal entities, they are generally viewed in the same light as LLCs for administrative and taxation purposes.

Are there Any Cases Where a Disregarded Entity Becomes a Separate Taxpayer?

There are certain cases where a disregarded entity may become a separate taxpayer. Generally, these are cases where the entity is engaged in more complex activities or deals with non-residents’ parties.

For instance, the IRS may decide to treat a disregarded entity as a separate taxpayer if it carries more than 50% of its business outside the US. The same applies if the entity engages in certain categories of taxable activities such as trading financial instruments or transferring intangible property. Additionally, a disregarded entity may also become a separate taxpayer if the DEO does not meet the IRS's tests of an actively engaged owner.

When Should You Form a Disregarded Entity?

While disregarded entities offer certain advantages, their selectiveness in terms of the business activities they cover requires a case-by-case approach. Ultimately, the decision to form a disregarded entity should be made after careful deliberation and should only be capitalized on when the tax benefits are significant.

Forming a disregarded entity is particularly beneficial for business owners looking to save on the paperwork and the associated costs. Additionally, a disregarded entity is best suited for companies with an asset-light structure, a small customer base, and few employees.

When forming a disregarded entity in Chicago, it is important to inquire about the compliance needed for a specific business activity, especially if the company is engaged in cross-border operations.

How to Make the Most of a Disregarded Entity?

Setting up a disregarded entity is a risky undertaking as it is largely burdened with tax liabilities and foreign exchange loss. To minimize the associated risks, it is essential to draft an agreement between the entity owner (DEO) and the entity itself. Such a contract should clearly spell out the parties’ respective liabilities and responsibilities.

Additionally, business owners should seek help from experienced tax lawyers familiar with all aspects of the disregarded entity regulations in Chicago. An experienced attorney will be able to help optimize the structure and the tax advantages of the entity.

At UpCounsel we have established a wide network of experienced attorneys who specialize in tax & business law, and are able to take up challenging cases in a cost-effective manner. Using UpCounsel, you can find individual tax attorneys and business legal counsels that are up to the task of forming and managing a disregarded entity compliant with Chicago’s local regulations.


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