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A disregarded entity is a limited liability company, or LLC, with one owner. It is not treated as a separate entity for income tax purposes.
An LLC is a business structure formed at the state level. One or more people can own an LLC, though the IRS refers to owners as members. A single-member LLC is considered a disregarded entity because business profits are passed through to the owner’s personal tax return.
What is a disregarded entity?
The disregarded entity designation is reserved for single-member LLCs. LLC members can choose how the IRS treats the business.
Members can elect to be taxed as a:
- Traditional Corporation
- Disregarded entity
For disregarded entities and partnerships, company profits are passed through to the business owner’s personal income. Taxes are paid as part of their personal income tax return. LLCs that choose to be treated as a traditional corporation would owe corporate taxes. S corporations, on the other hand, are pass-through entities and don’t owe corporate taxes, though LLCs cannot elect to be treated as S-corps.
In general, the LLC structure protects business owners from personal liability. Creditors and other parties would not be able to come after the owners’ personal assets because they would be separate from the business assets.
However, single-member LLCs don’t always receive the same protection. Whether your personal assets are unconditionally protected from creditors would depend on your state laws regarding LLCs. New York, for instance, does not provide LLC owners with as much protection from creditors as other states. If not fully protected, you could find yourself personally on the hook for business debts.
Other entities that can be considered disregarded include:
Real estate investment trusts: These trusts are a separate legal entity providing protections for the owner, but they’re also treated as a disregarded entity because the profits of the trust are passed to the owner’s personal income taxes.
Foreign disregarded entities: A foreign branch of a disregarded entity that’s based in the U.S. would receive the same designation.
Qualified subchapter S subsidiary: A QSub is an S-corp owned by another S-corp. Only the parent company would be responsible for taxes, and the QSub would be considered disregarded.
Community property: Some state laws may consider a husband-and-wife-owned LLC as community property. The IRS considers this property a partnership or a disregarded entity for federal tax purposes.
How to elect to be a disregarded entity
If you are the only owner of an LLC, the IRS automatically classifies your business as a disregarded entity.
To form an LLC, you need to meet the following requirements:
- File documents with your state’s secretary of state office, including Articles of Organization or Certificate of Organization.
- Register the business name, depending on your state’s requirements.
- Pay a one-time filing fee, which typically costs a few hundred dollars. An LLC is often a less expensive option for business owners looking for liability protection. It could cost thousands to form a corporation.
Single-member LLCs are only treated as disregarded entities for income tax purposes. For employment tax and certain excise tax purposes, LLCs with one owner are separate. The business would need to pay self-employment taxes consisting of Medicare and Social Security payments, as well as certain excise taxes that pertain to your specific business.
If you don’t want to be taxed as a disregarded entity, you’d need to file Form 8832 with the IRS and elect to be treated as a corporation. The change couldn’t take effect for more than 75 days before the form is filed or 12 months after. You could file the form when you start the business or change your classification down the line.
Pros and cons of being a disregarded entity
If you’re wondering whether to stick with the default classification for your single-member LLC, consider these benefits and downsides of being taxed as a disregarded entity.
- You could take advantage of the pass-through deduction. Because business income would be passed to your personal income, the business would be considered a pass-through entity. The Tax Cuts and Jobs Act of 2017 enacted a 20% deduction for pass-through entities, meaning you may be able to deduct up to 20% of qualified business income.
- You could avoid double taxation. Corporate profits are typically taxed twice, unless the business is an S-corp. The business must pay corporate taxes, and shareholders owe personal tax on the dividends they receive. If you’re treated as a disregarded entity rather than a corporation, your LLC could bypass double taxation.
- An LLC could be an affordable business entity to establish. An LLC structure protects your personal assets, such as your car, house and savings account, from being at risk if your business fails. A corporate structure provides the same protection, but an LLC can be formed for a fraction of the cost.
- Liability protection may be limited. Courts in some states could decide single-member LLCs don’t have the same liability protection as multiple-member LLCs. Putting an operating agreement in place and adhering to the guidelines you set could help the business maintain protections as a separate entity.
- The classification only applies to income tax. The IRS would consider the business a separate entity in regard to employment and excise taxes. The business would need to report and pay these taxes to the IRS.
- You won’t benefit from corporate tax cuts. Besides creating the pass-through deduction, the Tax Cuts and Jobs Act capped the top corporate tax rate at 21%. For companies that generate high revenue, the tax rate restriction could be beneficial.
- It may be more difficult to raise money. Investors often prefer C-corps because those businesses can issue different kinds of stock, making it easier to receive payouts in dividends.
What disregarded entities need to know for tax season
Owners of single-member LLCs need to complete a Schedule C form to file and report federal income tax on the business. You would need to attach the form to the personal tax return that you typically file with IRS.
Schedule C, also called Form 1040, is required to report income gains or losses from business activity. The form also seeks your business expenses, including costs incurred while working from a home office.
Disregarded entities owe tax on all profits, regardless of whether you distribute them to yourself. The IRS doesn’t distinguish between money in the business bank account or your personal bank account. This prevents business owners from taking portions of profits to lower their taxes.
The business would owe self-employment tax, as well as employment tax if you have any employees. As mentioned earlier, self-employment tax is comprised of Social Security and Medicare contributions. Employment tax includes the same contributions for your employees, as well as their federal income tax withholding and federal unemployment tax.
Some businesses are also subject to excise tax. This would depend on details such as the kind of products you sell and the type of business you operate. You can find out here if you owe excise tax to the IRS.
Can disregarded entities get an EIN? A disregarded entity needs an employer identification number if the business has employees or excise tax liability. If you don’t employ anyone and the business is not subject to excise tax, the IRS does not require an EIN. However, state law may require single-member LLCs to have an EIN, in which case the LLC itself could obtain one by filing IRS Form SS-4.
How do I know if my LLC is a disregarded entity? A disregarded entity is the default classification for single-member LLCs. Unless you file IRS Form 8832 to classify the business as a corporation, you would be a disregarded entity.
Does a disregarded entity file a tax return? Business income would be passed through to your personal income and reported on your personal tax return. You would need to attach Schedule C, or Form 1040, to your return to indicate income generated from the business.