A Disregarded Entity is a term that means the business entity is separate from the owner for liability reasons, but not when it comes to federal income tax purposes. The Internal Revenue Service (IRS) disregards the entity when it comes to tax filing, while they regard the owner for tax purposes. The owner reports the separate entity’s income and deductions as part of their own individual federal tax return.
The IRS considers Single-Member LLC a disregarded entity unless otherwise requested. It’s a separate legal entity and taxed through the owner's personal tax return when they calculate their business income on Schedule C and enter it onto their personal income tax return Form 1040.
What are the pros and cons of a disregarded entity?
From protecting personal assets to reducing business taxes, there are benefits to consider when it comes to a disregarded entity.
Avoid double taxation with pass-through (flow-through) taxation. The business does not pay corporate taxes at the entity level as they are passed to the owner of the business. The business owner will account for taxes as part of their personal income tax. This means that a disregarded entity skips double taxation. They do not pay corporate taxes in addition to taxes the owner would pay on any dividends earned, if it had a different business classification.
Simplified Tax Filing. For companies that are disregarded entities, the IRS will look to the owner of a company for tax filings. The entity itself does not have to file. A business structure that is not set up this way must file taxes along with further documentation and supporting paperwork. As a Single-Member LLC Disregarded Entity, the owner is able to claim business income and expenses as part of their own personal tax return.
Limited Liability. This type of business has the benefit of liability protection despite not being regarded for tax purposes. It’s still considered separate and offers protection to the business owner. A business that is set up otherwise, perhaps as a sole proprietorship of an unincorporated business would not have the same protection. In the case of any legal issues, the courts can pursue the owner's personal assets to cover debts. Incorporating a business or structuring a business as a limited liability corporation or a CCorporation protects a business owner's personal assets, but these structures are regarded as entities when it comes to tax purposes. A disregarded entity LLC has the benefit of liability protection as well as simplified tax filings.
In addition to some of the positive aspects of a disregarded entity, there are a couple of reasons a business owner may not choose this for their type of business.
Additional Taxes. Tax filings are made simple as a disregarded entity, but there are other taxes for a business owner to consider. A company may need to file self-employment, employment taxes, and/or excise taxes. These additional taxes have a number of variables. Self-employment taxes are still applicable to the owner of the disregarded entity, and it can be considered that to a certain point, they are deductible (up to 50%). However, self-employment taxes are on top of personal income taxes. Employment taxes would play a role if the company had employees in addition to the owner. Excise taxes are imposed on the sale of specific goods and services or on certain uses. State Law varies in regard to rates, deductions, and excise taxes and is an important consideration.
Employment Requirements. A business that will have employees needs to obtain an Employer Identification Number (EIN). A Disregarded Entity owner’s Social Security Number (SSN) may become the EIN. As an employer, there are additional costs such as payroll taxes and medicare. This is even a consideration for businesses that only have one employee. Employers must provide employees with a W-2 Wage and Taxation Form annually, along with the W-3 Form to the Social Security Administration.
What types of business can be a disregarded entity?
The most common type of business that is structured as a Disregarded Entity is a Single Member Limited Liability Company (SMLLC). An individual or a corporation may be a single owner. An SMLLC is an LLC with just one voting member. This is different from a typical LLC that would have multiple members who vote on decisions for the company. The IRS automatically considers an SMLLC a disregarded entity at the time it’s created unless otherwise requested.
A qualified REIT (Real Estate Investment Trust) subsidy and a qualified subchapter S subsidiary are two other types of business that are classified as disregarded entities.
A disregarded entity is a simple approach for new small business owners and entrepreneurs. As a business grows, the owner can request changes to become a sole proprietor, S-Corp, or C-Corporation.