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.

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.

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.

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.

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