Key Takeaways:

  • Disregarded Entities: Single-member LLCs are automatically considered disregarded entities for tax purposes unless they elect to be taxed as a corporation.
  • S Corporations: S Corps provide tax benefits such as pass-through taxation while allowing owners to pay themselves a reasonable salary to minimize self-employment taxes.
  • LLC vs. S Corp Taxation: LLCs can elect to be taxed as an S Corp to potentially save on self-employment taxes, but they must comply with IRS rules on owner compensation.
  • Owner Compensation: S Corp owners must take a "reasonable salary," which is subject to payroll taxes, with additional profits distributed as dividends, reducing self-employment tax obligations.
  • Eligibility for S Corp Status: Not all businesses can elect S Corp status; they must meet IRS criteria, including limits on shareholders and ownership structure.
  • Administrative Requirements: S Corps face stricter operational requirements, including required payroll management and annual tax filings, whereas disregarded entities have simpler tax reporting.
  • Impact on Business Growth: S Corps can provide tax advantages as a business grows, while disregarded entities are better suited for small businesses with minimal operational complexity.
  • Choosing Between an LLC and S Corp: Businesses should consider liability protection, tax obligations, administrative burden, and long-term growth when deciding between an LLC taxed as a disregarded entity or an S Corp.

LLC disregarded entity vs S corp defines a disregarded entity as a legal unit that is ignored for income taxes, both federal and state. It has a legal existence apart from the owner but elects to be disregarded for the purpose of federal income taxes. In other words, the business doesn't want to have a separate identity from the owner. Another name for a disregarded entity is a pass-through entity.

The most common form of a disregarded entity is a single-member limited liability company (LLC) that chooses to be taxed as a corporation. Tax law allows an entity that would otherwise be disregarded to choose taxation as a traditional corporation or an S corporation. If that is the route the business elects, it is no longer considered a disregarded entity.

Basics of Disregarded Entities

The responsibility for business debts and legal judgments depends on the legal structure of the company and is governed by state law. In order for a business to be considered a disregarded entity, two things must be true:

  • The business structure must be separate from the owner in terms of liability.
  • The business must be taxed through the owner's personal tax return using Schedule C to determine the net income.

You don't have to take any specific action to be classified as a disregarded entity. You only need to file a Single-Member LLC (SMLLC) with Schedule C and add the net income or loss on your personal tax return. For example, partnerships and sole proprietorships are disregarded entities since this is how those companies report business income.

A disregarded entity, apart from the owner, can be responsible for other types of taxes other than income. For example, the entity may have to pay taxes on property owned by the business. Also, a disregarded entity can be held liable for its own actions.

Tax Treatment of Disregarded Entities

A disregarded entity is not separate from its owner for tax purposes, meaning all income, deductions, and credits pass through to the owner's tax return. However, the business itself may still be required to comply with state and local tax obligations, such as sales tax and employer taxes.

  • Employment Taxes: If a disregarded entity has employees, it must withhold and remit payroll taxes, file employment tax returns, and pay unemployment taxes.
  • Excise Taxes: Businesses engaging in specific activities (e.g., fuel sales, environmental fees) may be liable for excise taxes, even if they are disregarded for federal income tax.
  • State Tax Variations: Some states do not follow the IRS's disregarded entity classification and require separate state filings.

A disregarded entity does not issue a separate tax return unless it elects corporate taxation or has employment tax obligations.

Limited Liability Companies (LLCs)

The responsibility for business debts and legal judgments depends on the legal structure of the company and is governed by state law. Federal income tax status is governed by federal law. The Internal Revenue Service (IRS) considers an LLC as one of the following:

  • A sole proprietorship, if it has one member only. The IRS ignores the separate existence of the company and assigns the activities to the owners. Most states impose income taxes in the same manner.
  • A partnership, if it has more than one member.

Because of this default consideration, most LLCs are disregarded entities as far as federal taxes are concerned. The owners report the business activity on their personal income tax returns.

An LLC can choose to be taxed as a corporation. If your SMLLC chooses this option, it is no longer considered a disregarded entity as far as incomes taxes go. Form 8832, Entity Classification Election, is used to notify the IRS of the decision. According to the IRS, an SMLLC that doesn't make this election will be treated as a disregarded entity.

An LLC can own property, enter into contracts, take legal action, and be subject to lawsuits independently. The owners of an LLC don't normally have personal liability for the company's obligations.

LLCs and the S Corp Election

An LLC can elect S Corp taxation by filing Form 2553 with the IRS. This election changes how the business is taxed but does not alter its legal structure. The primary reason for making this election is to reduce self-employment taxes.

  • Self-Employment Taxes: Disregarded entities (default LLCs) pay self-employment taxes (Social Security and Medicare) on all net earnings. S Corps, in contrast, only require these taxes on the "reasonable salary" paid to owners.
  • Owner Distributions: After the salary, remaining profits can be distributed as dividends, which are not subject to self-employment tax.
  • Payroll Compliance: S Corp owners must set up payroll, file employment tax returns, and withhold appropriate taxes.

For business owners earning substantial profits, an S Corp election can result in significant tax savings. However, the IRS requires that owner-employees receive a reasonable salary, preventing them from avoiding self-employment tax altogether.

Sole Proprietorships

A sole proprietorship is not a disregarded entity because it has no legal identity apart from the owner. The business may operate under a trade name, but unless it has a legal existence under state law, the business and the owner are legally one and the same.

S Corporations

An S corporation is not subject to income taxes in and of itself. The company's management team sets the tax attributes, including income, credits, and deductions, and then allocates them to the owners in proportion to their share of ownership. An S corporation must file an annual tax return that is informational in nature. By comparison, a disregarded entity has no tax attributes and doesn't file an annual informational tax return.

Each owner of an S corp, even if there is only one, gets a Schedule K-1 from the business. The information from the K-1 goes onto Schedule E of the personal tax return.

S Corp Shareholder Eligibility and Restrictions

To elect S Corp status, a business must meet specific IRS requirements:

  • Must be a domestic business entity
  • Can have no more than 100 shareholders
  • All shareholders must be U.S. citizens or residents
  • Must issue only one class of stock

Additionally, certain entities cannot be S Corp shareholders, including:

  • Corporations
  • Partnerships
  • Certain trusts

Ownership Through an LLC:A disregarded LLC can own shares in an S Corp if it is a single-member LLC owned by a U.S. citizen or resident. However, a multi-member LLC cannot own S Corp shares unless it elects to be treated as an S Corp itself.

Entities That Are Not Disregarded

Corporations are usually not disregarded unless they are S corporations or real estate investment trusts (REITs). These companies pay taxes on profits before the shareholders take any distributions.

Disregarded Entity vs. S Corp – Which is Better?

The choice between a disregarded entity and an S Corp depends on:

  • Tax Savings Potential: Businesses with high profits may benefit from an S Corp's ability to reduce self-employment taxes.
  • Simplicity vs. Compliance: A disregarded entity requires less administrative work, while an S Corp has stricter filing and payroll obligations.
  • Liability Protection: Both structures offer limited liability, protecting personal assets from business debts.
  • Future Growth: S Corps may be better for businesses planning to add shareholders or investors.

General Recommendation:

  • Small businesses or solo entrepreneurs with modest earnings may find a disregarded entity easier to manage.
  • Businesses earning over $75,000+ in net profit may benefit from S Corp taxation for self-employment tax savings.

If you're unsure, consulting a business attorney on UpCounsel can help you determine the best structure for your financial and legal goals.

Frequently Asked Questions (FAQ):

1. What are the main tax benefits of an S Corp over a disregarded entity? An S Corp allows owners to split income between salary (subject to payroll taxes) and dividends (not subject to self-employment tax), potentially reducing tax burdens.

2. Can a disregarded entity elect S Corp taxation? Yes, a single-member LLC can elect to be taxed as an S Corp by filing Form 2553 with the IRS. This election allows the LLC to change its tax structure without altering its legal status.

3. Do S Corps have more administrative requirements than disregarded entities? Yes, S Corps must file an annual tax return, maintain corporate records, run payroll, and ensure compliance with IRS reasonable compensation rules. Disregarded entities report income through their owner’s tax return without separate filings.

4. Can a disregarded entity hire employees? Yes, disregarded entities can hire employees, but they must register for payroll tax accounts and file required employment tax returns.

5. How do I choose between an S Corp and a disregarded entity? Consider factors such as tax savings, administrative complexity, payroll requirements, and long-term business growth. If you expect high profits and want tax flexibility, an S Corp may be better; for simplicity, a disregarded entity is preferable.

If you need help thinking through an LLC disregarded entity vs S corp situation, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.