You may have heard the term “disregarded entity” floating around the business world, and scratched your head, wondering what it was and whether your business was one.
Disregarded entities have a special tax classification and apply to one primary type of business structure, so it’s important to understand what they are and whether you need to do anything special when filing your taxes.
What is a Disregarded Entity?
A disregarded entity is a business that is not seen as a separate entity from the business owner for tax purposes. Rather than the IRS taxing the business, the income of the business is passed through to the owner’s income tax return. In this way, the business and the owner are considered one entity.
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How Do I Know if I Have a Disregarded Entity?
The type of business structure you set your business up to operate as will determine whether it’s a disregarded entity or not. Single-member LLCs are considered disregarded entities, whereas sole proprietorships, partnerships, corporations, and LLCs with more than one owner are not.
As a sole proprietor, you are treated as one and the same as your business for income tax purposes, and you will pay taxes on the business’ income on your personal tax return. However, unlike with an LLC or corporation business structure, your personal assets are not protected under a sole proprietorship, and could be seized should your business be sued or have debts it is unable to pay out of its own assets.
A partnership, too, is considered an extension of its owners, and its profits are passed through to each partner’s income tax return.
If you operate as a corporation or LLC with multiple members, the business is a separate entity from the owners, but it is not considered a disregarded entity. As a separate entity, a corporation offers protection of the owner’s assets, as does an LLC. A corporation is taxed, as are owners on income they receive from the business. With an LLC, the income is passed through to the owner, like with a sole proprietorship or partnership, though an LLC can be taxed as a partnership or an S corp.
The most common disregarded entity, LLCs with single members (aka owners), in the eyes of the IRS, doesn’t exist. Instead, its assets and liabilities are considered that of the owner, and the owner is taxed accordingly.
There are a few other disregarded entities, including a qualified subchapter S subsidiary and a qualified REIT subsidiary, but we won’t cover those here.
Does a Disregarded Entity Pay Taxes?
The business itself, the limited liability company, doesn’t pay taxes on income. However, the owner of the disregarded entity LLC does claim all business income on his personal income tax return for both state and federal tax. This is referred to as pass-through taxation, where the business’ income and taxes pass through to the business owner on his tax return.
This is exactly how a sole proprietorship or partnership is taxed.
Note that, like a corporation, a single-member LLC may be required to pay franchise taxes in the state it does business in. And if the 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.
So what do you need to do each tax year if you’re a disregarded entity? Nothing special. Simply file your Schedule C IRS form for your single-member LLC and then claim the business income on your 1040 personal tax return.
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Pros of a Disregarded Entity
Many entrepreneurs prefer the reduced paperwork and pass-through tax treatment that comes with the disregarded entity. Rather than have to deal with a complicated tax return for a corporation and then having to file your personal income taxes on top of that, being able to ignore, so to speak, your business for income tax purposes makes it simpler.
Also, because a single-member LLC has, as its name says, limited liability protection, the owner’s personal assets can’t be touched, because the business is a separate entity from the owner (outside of income tax purposes), and the owner’s personal assets cannot be used to cover debts for the limited liability company.
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 will 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. You can still apply for an EIN on IRS form SS-4.
You may also have to pay more taxes than you would if your business structure was an S corporation, since there are tax savings built into that entity.
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Nav’s Final Word: Disregarded Entity
If you run a single-member LLC, being considered a disregarded entity can simplify taxes and offer liability 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, if you’re operating as a sole proprietorship and want to become a disregarded entity, you’ll need to form an LLC (and have no other partners in the business). Check your state’s Secretary of State website to find instructions for doing so.
Keep good records on your company’s income and what you take out in draws as the business owner. This will be helpful for income tax purposes when you’re filing your personal tax return. Any money you take out of your business account for personal use is considered a reportable transaction and must be reported as income.