Fact checked for accuracy by Janet Berry-Johnson, CPA.
Deciding on the type of business entity to set up is not an easy task.
You’ve probably come across the term “disregarded entity” in your research on LLCs. So, what does that mean exactly?
This article guides you on everything you need to know about disregarded entities as they relate to LLCs. Let’s get started.
What is a Disregarded Entity?
A disregarded entity is a business entity that’s separate from its owner. However, the Internal Revenue Service (IRS) does not recognize this separation for tax purposes.
A single-member LLC is a disregarded entity. It may be challenging to understand this, but to put it simply, the IRS regards the owner and the LLC as the same person. This is purely to allow the owner to pay taxes from their income. Otherwise, the two are legally separate, with a LLC protecting the personal assets of the business owner.
Related column: What is an LLC?
To make this easier for you, the IRS does the following:
- Ignores the LLC
- Doesn’t recognize the existence of the LLC
- Considers the owner and the LLC as the same person
- Doesn’t recognize the LLC as a separate business entity
The only circumstances under which the above doesn’t apply is when a single-member LLC elects the IRS to tax them as a corporation. In such instances, the business is no longer a disregarded entity in the eyes of the IRS.
Remember that a sole proprietorship is not a disregarded entity and will always pay taxes as a sole proprietorship.
Which Types of Businesses are Considered Disregarded Entities?
The only business that can be a disregarded entity is a single-member LLC. What about LLCs with multiple owners? Can they become disregarded entities?
The answer is simply no. By default, this is a partnership unless the company has elected to receive a corporation tax treatment.
Since corporations and partnerships file their tax returns separate from their owners, they can never assume disregarded entity’s status. Further, a single-member LLC shelves a disregarded entity status once it files Form 8832, electing taxation as a C corporation, or files Form 2553, electing taxation as an S corporation.
It’s worth noting, however, that in some states, there are exceptions. For example, where a couple owns an LLC in a community property state, the husband and wife can elect a single-member treatment, becoming a disregarded entity.
Special Cases for Spousal Joint Ownership Businesses
A special case, as mentioned above, applies to spouses who own an LLC. Note that this is a multi-member LLC because its owners are two legally married people. In this case, the couple can either elect to:
- Have their business treated as a partnership for tax purposes, or
- Make an election to the IRS for disregarded entity status.
In the eyes of the IRS, such a business (treated as a disregarded entity) is a qualified joint venture. The couple can therefore file two schedules Cs, dividing the income from the company equally amongst themselves.
However, for the election to be successful, the married couple needs to comply with the following:
- The two must be the only owners of the business.
- The business must be in a community property state, meaning the couple jointly and equally owns the LLC.
- For tax purposes, you’ll steer clear of categorizing the business as a corporation.
How to Pay Taxes as a Disregarded Entity
A single-member LLC is a disregarded entity that pays its taxes as a sole proprietorship.
Therefore, the owner reports the business expenses and income on the personal tax returns. They can do this using Form 1040, Schedule C for profit or loss from business.
In some circumstances, they may also use Form 1040, Schedule E for supplemental income and loss, and Form 1040, Schedule F for profit or loss from farming.
Employment Tax
A single-member LLC disregarded entity status does not apply to employment taxes. Therefore, the LLC must use the business’ name and federal tax ID number (EIN) to report employment taxes if it has employees.
You should never use your personal Social Security Number or taxpayer identification number (TIN) whatsoever. Instead, when registering for excise tax activities, remember to use the business EIN.
Self-Employment Tax
Since the laws don’t allow the owner to be an employee of a disregarded entity, they have to file Self-Employment Tax using Form 1040, Schedule SE.
The tax is usually 15.3 % of the total net income of the LLC.
For more, read our column on how LLC taxes work.
Estimated Tax
A disregarded entity member must make estimated tax payments using Form 1040-ES for estimated tax. Those estimated payments are due on April 15, June 15, September 15, and January 15 of the following year.
Advantages of a Disregarded Entity
A single-member disregarded entity LLC has a fair share of benefits. These include the following.
Pass-Through Taxation
A disregarded entity is a sole proprietorship in the eyes of the IRS. Therefore, for tax purposes, all its income, expenses, losses, and credits pass through the company to the business owner.
The owner reports them on an individual tax return. This makes tax filing more straightforward and also eliminates the double taxation challenge some corporations face.
Flexibility
The flexibility that comes with an SMLLC (single-member LLC) is another attractive feature of disregarded entities.
The entity’s natural setting is a disregarded entity with pass-through taxation. However, owners are free to elect to S or C corporation treatment for taxation reasons.
It’s up to the owner to choose the tax structure that best benefits their business financially. But remember, once you file Form 8832 or Form 2553, your business no longer holds the disregarded entity status.
Liability Protection
The disregarded entity status only applies at the federal level for purposes of tax.
At the state level, an LLC remains a separate entity, enjoying all the benefits of an LLC, just like multi-member LLCs and corporations.
That means if anyone takes legal action against the company, the limited liability will protect the business owner’s personal assets from legal action.
Disadvantages of a Disregarded Entity
The advantages of a disregarded entity are clear for all to see. Still, it cannot be the best fit for everyone as it has some downsides, which include the following.
It Involves a Lot of Paperwork and Formalities
For sole proprietorships wanting to switch to SMLLC, you must be ready for more costs and paperwork.
A single-member disregarded entity LLC requires you to maintain a clear separation of personal assets from your business. That means you have to draft an agreement outlining how your company operates.
In addition, there’s annual reporting and filing tax returns, among other paperwork, which also adds to the workload.
Easier to Pierce Corporate Veil
Theoretically, there’s no difference in limited liability protection between an SMLLC and a multi-member LLC. Nevertheless, things are different in practice.
The personal assets of an SMLLC business owner are more vulnerable in case legal action is taken against the business. The reason being that separating the owners from their businesses and maintaining that gap is difficult. Thus, the risk of a creditor attempting to pierce the veil is higher here than it is with a multi-member LLC.
The Last Word
A disregarded entity means that the IRS views your LLC as a single person, purely for tax reasons. As you file individual tax returns, you’ll also include your business taxes. In fact, a disregarded entity is simply a single-member LLC that’s not elected corporation treatment. Hence, your business gets taxed as a sole proprietorship.
With this understanding of a disregarded entity and what it means as an LLC, hopefully you can make a decision on whether or not this status could be of great benefit to your business.
Filed under: Advice Columns
