When starting a business, one of the most important decisions is deciding what type of business entity it will be. Depending on your choice, you can face either significant legal liability, high tax burdens, or both.
Sole proprietors, for example, can be personally liable on their contracts and debt obligations, while dividends for C corporation shareholders are subject to double taxation.
There is, however, a workaround for owners and businesses seeking lower tax burdens and enhanced legal protections.
To do this, business owners, S corporations, and real estate investors can choose to adopt any one of the three forms of “disregarded entities” recognized under federal tax laws—the most popular form being the single-member limited liability company, or SMLLC. These types of entities offer unique advantages for slashing the amount of business taxes you owe the IRS.
Disregarded entities serve a best-of-both-worlds approach for ensuring favorable tax and liability treatment. From the IRS’s perspective, the disregarded entity does not exist, and you include your LLC activities on your Form 1040 Schedules C, E, and F.
But for businesses that get sued, business creditors and adverse parties are in most instances limited to recovering from the LLC’s assets only. All you need to do in order to form one is file articles of organization with the secretary of state’s office in the state you want to conduct business in—and, if necessary, appoint an agent to receive process on your behalf in the state you’re organizing in—and draft an operating agreement for managing the internal affairs of your LLC.
The two other types of disregarded entities are QSub subsidiaries—which can be formed by S corporations only—and REITs, a type of disregarded entity used as a vehicle for real estate and real estate debt investing. Both corporations and individual entrepreneurs can become owners of single-member LLCs.
Legal benefits aside, forming a disregarded entity does entail some important tax considerations. Here are a few you should know about if you’re considering forming a disregarded entity:
This is perhaps the biggest benefit to organizing as a disregarded entity. Under the single-member LLC structure, business owners can take advantage of flow-through taxation treatment on income received through the LLC.
This means that owners’ LLC incomes are not taxed twice at the business entity level and individual level as it would in a C corporation. QSubs and REITs are also not subject to an entity-level tax, as profit flows to the corporation or investment company respectively.
If your LLC hires employees, the LLC is responsible for reporting and paying employment taxes. These rules changed in 2009 to prevent owners of disregarded entities from withholding and paying employment taxes at the owner level.
So, SMLLCs are responsible for:
If you’re a freelancer, chances are you’ve been asked to submit at least one W9 form to clients. And you needed to supply your social security number—even if your business already has an EIN number. But for businesses that own the disregarded entity, it should provide its EIN number on the W9 instead.
As with other partnership, sole proprietor, and LLC entities, single-member LLC owners are required to pay self-employment taxes.
Unlike employees, owners need to pay roughly 15% in taxes toward social security and Medicare combined if they earn over $400 and roughly 92.35% of their net earnings are self-earned.
Despite this, you can apply your self-employment taxes as a deduction toward your personal reported income, though at a 50%-57% cap.
For residents of the nine states that treat assets earned during marriage as community property—this includes California, Arizona, and Louisiana—the IRS lets you choose whether to have your LLC taxed as a disregarded entity or as a partnership.
This is because in these states, any property created during marriage is equally owned by each spouse—which can prove problematic for tax purposes as there’s more than one owner. The IRS allows this as long as:
While it’s simple to form disregarded entities, it can be just as easy to lose their protections. Most cases where this occurs is when the owner doesn’t follow the formalities of the LLC. Some behaviors that could compromise your status include commingling your personal funds with business funds and personally guaranteeing loans, or signing agreements as yourself personally and not on the entity’s behalf.
You can also lose your sole proprietor tax treatment rights by adding members to your LLC—causing it to be taxed as a partnership—or electing to have it taxed as an S corporation or C corporation.
Regardless of how you decide to organize your business, you should consult with experienced attorneys and accountants to get a better sense of whether your business should be organized as a disregarded entity.
For entrepreneurs, S corporations, and real estate investors looking for favorable tax and liability treatment, it’s a business decision worth considering.