If you research small business taxes, you’ll come across the term “disregarded entity.” You may have scratched your head, wondering what it means, and what it means for your small business.
Here’s what you need to know about disregarded entities as a small business owner.
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 federal 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 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 a business credit card or a small business loan, or build business credit.
What Types of Businesses Can Be a Disregarded Entity?
When it comes to classification for tax purposes, certain business entities automatically are classified as corporations. Other 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.
They make this election using IRS Form 8832, Entity Classification Election.
The type of business structure under which your business operates, then, will in part 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 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 Is 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-member 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 reduce tax liability for payroll taxes.
Pros of a Disregarded Entity
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 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 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.
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.
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.