“Disregarded entity” is a term used to describe how a business is classified for tax purposes. A disregarded entity is one that is disregarded (or ignored) as an entity separate from its owner.
While the business may need to file an informational tax return, the income from the business is reported on the owner’s personal tax return.
Here’s what you need to know about disregarded entities as a small business owner.
An Overview of Disregarded Entities
While the term “disregarded entity” sounds technical, it’s really not that complicated. It is a term that is used to describe how a business is classified for income tax purposes.
Many business owners choose to run their business through a formal business entity, such as an LLC, S Corp or C Corp.
A disregarded entity (DE) is one that is separate or distinct from the business owner, but for tax purposes, that entity is disregarded as a separate entity from the business owner by the Internal Revenue Service and/or state taxing authority. Income from the business will be reported on the business owner’s tax return.
A disregarded entity (DE) is one that is separate or distinct from the business owner, but for federal tax purposes, that entity is disregarded as a separate entity from the business owner by the Internal Revenue Service. The business owner and the business file taxes together.
It’s important to understand that business owners who have formed a business entity because they want to separate their business and personal finances, and to protect their personal assets from the actions of the business, don’t lose those legal protections simply because the business is considered a disregarded entity for tax filing purposes. What’s more, if your business is a disregarded entity it doesn’t negatively impact your ability to qualify for business credit cards or a small business loans.
What Types of Businesses Can Be a Disregarded Entity?
When it comes to classification for tax purposes, certain business entities may choose how they are classified for federal tax purposes.
As long as it is not automatically classified as a corporation, a business entity with at least two members can choose to be classified as a corporation or a partnership for tax purposes, while a business entity with a single member can choose to be classified as either a corporation or disregarded as an entity separate from its owner.
The business makes this election using IRS Form 8832, Entity Classification Election.
The type of business structure under which your business operates, the number of owners, and the chosen tax election, will determine whether it is considered a disregarded entity. And, as mentioned, there are times when you can choose how the business is classified for tax purposes.
Let’s look at the main types of business structures and whether they are or can be disregarded entity;
As a sole prop, the business operates without any formal legal entity. The business owner may register a business name or get a business license, but the business is not legally separate from the business owner.
Even though the business owner files information about business income and expenses with their personal income tax return (on Schedule C) the business is not a disregarded entity because there is no separate business entity to begin with.
Limited Liability Company (LLC)
Limited liability companies (LLCs) have members, who may be individuals or other businesses.
A single member limited liability company (an LLC with one member; or SMLLC) owned by an individual is considered a disregarded entity unless it elects to be taxed as a corporation by filing IRS Form 8832.
An individual owner of a single member LLC that has not elected to be classified as a corporation uses Schedule C to report business income and losses, just as a sole proprietor does. This is the most common disregarded entity.
If the sole owner of the LLC is a corporation or partnership, the LLC will be included on the owner’s federal income tax return as a division of the corporation or partnership.
A multi-member LLC (an LLC with more than one member) is not a disregarded entity. It can elect to be classified as a partnership or a corporation.
There are special guidelines for LLCs owned solely by spouses as community property in community property states. Review the IRS Information: Election for Married Couples Unincorporated Businesses.
Partnerships are typically not disregarded entities, however, there are times when partners may be a DE. In those cases, the IRS has specific reporting requirements.
Corporations are not disregarded entities. That’s true whether the corporation is taxed as a C Corporation or an S Corporation.
There are a few other disregarded entities, including a qualified subchapter S subsidiary, a qualified Real Estate Investment Trust (REIT) subsidiary, or an LLC owned solely by a husband and wife in a community property state that chooses to be classified as a DE, but we won’t cover those here.
What’s the Difference Between a Sole Proprietor and a Disregarded Entity?
A sole proprietorship is not a legal business entity. It is not a disregarded entity, as there is nothing to distinguish between the business and the individual owner. Sole proprietors file Schedule C with their personal tax return to report business income and losses.
Does a Disregarded Entity Need an EIN?
For federal income tax purposes, the IRS says that a single-member LLC classified as a disregarded entity generally must use the owner’s social security number (SSN) or employer identification number (EIN) for information returns and reporting related to income tax.
Let’s say, for example, you are the sole member of an LLC that is a disregarded entity. If a client requires you to provide a Form W-9, Request for Taxpayer Identification Number (TIN) and Certification, the W-9 should list the owner’s SSN or EIN, not the LLC’s EIN.
However, if your LLC has employees, or if you are required to file certain excise tax forms, you’ll need to get an EIN. In addition, there are times when single-member LLCs need an EIN to open a business bank account or because state law requires that. In those cases, the single-member LLC can apply for and obtain an EIN.
Taxation for Single Owner Businesses
The tax return a single owner business must file, and the taxes it will pay, will depend on the type of entity, and how it has elected to be taxed.
The owner of a single-member LLC that is a disregarded entity claims business income on his or her personal income tax return for both state and federal tax purposes. This is referred to as pass-through taxation, where the business’ income and taxes pass through to the business owner on his tax return.
Note that, like a corporation, a single-member LLC may be required to pay franchise taxes in the state it does business in.
So what do you need to do each tax year if you own a disregarded entity? Nothing special. Simply file your Schedule C IRS form for your single-member LLC with your 1040 personal tax return.
Does a Disregarded Entity Pay Payroll Taxes?
Payroll taxes is a term that refers to the taxes employers withhold from employee pay to cover Social Security and Medicare. If a disregarded entity has employees, it is responsible for employment tax and would file W-2s or 1099s with its tax return, based on whether its workers are employees or contractors.
Even without employees, though, the owner of a disregarded entity may be required to pay self-employment taxes on income. When there is no employer, self-employment taxes cover what is normally the employer and employee share of these taxes,
Some LLC owners choose to be taxed as an S Corporation in order to to reduce the owner’s tax liability for payroll taxes.
Pros of a Disregarded Entity
- Simplified tax returns
- Maintain legal protection
- May pay more in employment taxes
- Can be harder to grow
Many entrepreneurs prefer the reduced paperwork and pass-through tax treatment that comes with the disregarded entity. Rather than having to pay a tax professional to prepare a corporate tax return (which is often more expensive), or navigate it themselves using tax preparation software, the business owner prefers to keep it simple.
Also, because a single-member LLC has, as its name says, limited liability protection, the owner’s personal assets usually are safe, because the business is a separate entity from the owner (outside of income tax purposes), and creditors generally can’t go after the owner’s personal assets to pay debts of the business.
Cons of a Disregarded Entity
If you ever want to bring on investors, you may struggle to do so as a disregarded entity LLC. Why? The LLC would be taxed as a partnership (with the investors being additional members), and they would have to pay taxes on the limited liability company’s income even if no cash was distributed to them. So being a single-member LLC, you won’t be able to attract investors the way you could as a corporation.
Another drawback would be that if you don’t have employees, you’ll likely use your social security number as your Employee Identification Number (EIN), as you would with a sole proprietorship. Many people are uncomfortable using their social security number in a way that puts it at risk of being compromised.
As mentioned earlier, you may also have to pay more taxes than you would if your business elects to be taxed as an S Corporation, which may help the owner-employee save money on self-employment taxes.
4 Examples of Disregarded Entities in Real Life
Disregarded entities are legal structures that are treated as separate from their owners for liability and tax purposes. Here are four real-life examples explaining when and when they can’t be considered disregarded entities:
Single Member LLC
A single-member LLC is a common example of a disregarded entity. In this structure, a business owner operates as a sole proprietorship but gains the liability protection and flexibility of an LLC. The IRS doesn’t recognize the LLC as a separate entity for tax purposes and the owner reports business income and expenses on their personal tax return.
A sole proprietorship is the simplest form of business structure, where an individual owns and operates the business. Similar to a single-member LLC, the business is not considered a separate legal entity from the owner. The owner is personally liable for business debts and business income is reported on the owner’s personal tax return.
An S corp is a type of corporation that elects to be treated as a disregarded entity for tax purposes. Shareholders report their share of the corporation’s income, deductions, and credits on their individual tax returns. This structure allows shareholders to avoid double taxation since the S corp itself doesn’t pay federal income tax.
In estate planning, a grantor trust is a trust in which the grantor (the person who establishes the trust) retains control over the assets and income generated by the trust. The IRS treats the trust as a disregarded entity and the grantor reports the trust’s income and expenses on their personal tax return. This structure provides flexibility and control over assets while allowing for tax planning.
It’s important to note that the availability and specific regulations surrounding disregarded entities may vary by location. Consulting with a legal or tax professional can give you guidance on the best structure for your business.
FIRPTA for Disregarded Entity
The Foreign Investment in Real Property Tax Act of 1980, also known as FIRPTA. This tax law imposes U.S. income tax on foreign persons selling U.S. real estate. Under FIRPTA, if you buy U.S. real estate from a foreign person, you may be required to withhold 10% of the amount realized from the sale. A foreign person is anyone other than a US Person and the definition of a US Person may include a disregarded entity, if the owner qualifies as a disregarded entity.
What Are the Possible Repercussions of a Disregarded Entity?
The biggest repercussion of a disregarded entity is that the business owner may pay more in payroll taxes by not choosing to be taxed as an S corporation. S corporation owners may save money on employment taxes by paying themselves a salary plus owner draws.
In addition, a single member LLC will likely find it difficult to grow by bringing on equity investors or partners and may instead need to rely on small business loans and financing for capital.
Nav’s Final Word: Disregarded Entity
If you operate as a single-member LLC, being considered a disregarded entity can simplify your federal tax return, state tax return (if applicable) while offering protection for your personal assets.
There’s nothing special you need to do if you’ve already filled out the paperwork to be an LLC and there are no other members. However, you may save money by electing to be taxed as an S corporation instead.
If you are operating as a sole proprietorship, you have no asset protection benefits and you may find it more difficult to get small business loans and financing to grow your business. Take some time to look into the benefits of business formation.
Regardless of whether you decide to be taxed as a disregarded entity or not, you’ll want to have a good accounting system in place. It’s also important to separate your business and personal finances by using a business bank account and a business credit card, rather than personal checking and personal credit cards. Doing so will make it a lot easier to file your business taxes, and will help ensure you maintain the asset protection benefits of your business structure.
This article was originally written on June 4, 2020 and updated on November 14, 2023.