What Is a Disregarded Entity?
A disregarded entity is a business entity that is separate from its owner but disregards this distinction for tax purposes. The IRS will allow the owner of a disregarded entity to report the business’s income, losses, credits, and deductions on their personal tax return. A single-member limited liability company (LLC) is the most common example of a disregarded entity.
When starting a business, one of the most important decisions you’ll make is your company’s business entity structure. This impacts the extent of legal protections for your business and the size of your tax bill when it comes time to file your small business taxes.
A disregarded entity is a type of business entity that offers unique advantages for slashing the amount of business taxes you’ll owe the IRS. The owners of disregarded entities only pay taxes on business income at the personal level and don’t have to worry about corporate taxes. In addition, a disregarded entity reduces a business owner’s legal risks.
Learn more about how disregarded entities work, the pros and cons of disregarded entities, and how to set up this structure for your company.
How Disregarded Entities Work
There are several types of disregarded entities, but the main one that small business owners should know about is the single-member LLC. This is an entity choice that’s available to businesses with one owner. In order to launch a single-member LLC, as with any other registered business entity, you start by filing business formation paperwork with your state.
After filing formation papers, you’ll need to decide how you want your LLC to be taxed. If your LLC has multiple owners, then by default the IRS will tax your company as a partnership unless you elect to have the business taxed as a corporation (which you can do by filing IRS Form 8832). If your LLC has one owner only, then by default the IRS will tax your company as a disregarded entity unless you elect to have the business taxed as a corporation.
U.S.-based companies, as well as foreign companies, can choose to structure as disregarded entities. A foreign disregarded entity is treated as a foreign branch of a U.S. corporation for tax purposes. And as with a domestic disregarded entity, all of the business’s income would flow through to the owner’s personal income tax return. The foreign company does not need to separately report the company’s income, which makes tax filing simpler for international businesses.
Pros and Cons of Disregarded Entities
Opting for disregarded entity status serves a “best of both worlds” approach for favorable tax and liability treatment. But there are also disadvantages that you’ll want to take into consideration for your business.
Pros of a Disregarded Entity
- Easy tax filing
- No double taxation
- Limited liability protection
The biggest advantage of organizing your LLC as a disregarded entity is the ease with which you can file taxes. If you have a disregarded entity, all of your LLC’s income and expenses will get reported on your personal tax return on Schedule C—no different from how a sole proprietor would report business income and expenses. You’ll pay taxes on the business’s income at your personal income tax rate. Starting in the 2019 tax season, as a result of the Trump tax plan taking effect, disregarded entities will be able to claim a 20% deduction on business income before filing their return.
A single-member LLC that opts to be taxed as a disregarded entity can save money by avoiding double taxation. C-corporations often get hit with double taxation. Owners of C-corporations pay taxes once under the corporate income tax rate—which is a flat 21% as of 2019. On top of that, shareholders must pay personal taxes on dividends. With a disregarded entity, you only pay taxes once at the personal level, potentially saving your company thousands of dollars.
One final advantage of a disregarded entity is the limited liability protection. If your LLC gets sued, the claimant is limited to collecting from your LLC’s assets. They cannot come after your personal assets, such as your house or personal bank accounts. In contrast, owners of sole proprietorships and partnerships face the risk of losing their personal assets over a business dispute.
An important caveat deserves mention here. Courts have “pierced the veil” of single-member disregarded entity LLCs, which means they’ve held the owner to be personally liable for acts of the business. The best way to avoid this is to follow all of the formalities that your state requires for LLCs. Also, you should make sure you have an LLC operating agreement and a separate business bank account to use only for business transactions. This shows the legal system that even if your entity is “disregarded” for tax purposes, your business is, in fact, separate from the owner.
Cons of a Disregarded Entity
- Harder to raise money
- Responsible for other types of taxes
In many ways, a disregarded entity provides the perfect “sweet spot” for a small business owner—you can save money on your taxes and protect your personal assets from litigation. That said, there are some downsides to structuring your business as a single-member LLC disregarded entity.
The biggest disadvantage is that it’s harder to raise money from investors as a disregarded entity. Most investors prefer only to invest money in C-corporations. C-corporations are able to issue different classes of stock, which investors can easily buy to claim ownership in the company or sell to divest their ownership.
The other downside to a disregarded entity, as we’ll explain in more detail below, is that your LLC still has to pay self-employment taxes, payroll taxes, and excise taxes (if applicable to your type of business). These are in addition to your income taxes and can significantly raise your tax bill. Owners of a C-corporation, by contrast, don’t have to pay self-employment taxes. And they have the option to avoid payroll taxes by structuring compensation as a dividend (though that will be subject to the dividend tax rate).
Disregarded Entity Facts to Know If You Have One
Forming a disregarded entity entails some important tax considerations. Here are the tax considerations you should know about if you’re considering forming a disregarded entity:
You will be taxed as a sole proprietor with flow-through taxation benefits.
This is perhaps the biggest benefit of 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. Two other types of disregarded entities—QSubs and real estate investment trusts (REITs)—are also not subject to an entity-level tax, as profit flows to the corporation or investment company respectively.
You need to use your social security number or parent company’s EIN number on W-9 forms.
If you’re a freelancer, chances are you’ve been asked to submit at least one Form W-9 for clients. And you needed to supply your social security number—even if your business already has an EIN number. For disregarded entities, you’ll need to provide the owner’s social security number or EIN, not the EIN of the LLC.
The LLC itself is responsible for payroll and excise taxes.
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, disregarded entities are responsible for:
- Withholding, reporting, and depositing FICA and FUTA taxes
- Obtaining unique EIN numbers
- Registering for tax excise activities
- Paying and reporting excise taxes
- Claiming refunds, credits, and payments if they’re considered employers under federal tax laws
The business owner is still responsible for self-employment taxes.
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% to 57% cap.
If you live in a community property state, you could choose how the IRS can tax your business.
For residents of the nine states that treat assets earned during marriage as community property—this includes California, Arizona, and Louisiana, among others—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:
- The business is jointly owned by the spouses as community property at state law
- No other owners are involved in the company other than the husband, wife, or both
- The spouses did not elect to have their business taxed as a corporation
You could lose your limited liability protections.
While it’s simple to form disregarded entities, it can be just as easy to lose the limited liability protections that they offer. 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 or signing agreements as yourself personally and not on the entity’s behalf.
Use a separate business bank account for business transactions only, and follow any business formalities that your state requires for LLCs.
You can also automatically 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.
How to Set up a Disregarded Entity
If you determine that a disregarded entity is the right business entity choice for you, it’s time to set up your business. Setting up a disregarded entity is usually pretty straightforward. It starts with filing business formation paperwork with your state’s business filing agency. You can do this on your own, through a business lawyer, or a legal help site like Incfile.
After that, it’s beneficial to create an LLC operating agreement. Your agreement will outline how your business is run on a day-to-day basis. Even though you’re the only owner of the business, it’s important to create this agreement to maintain limited liability protections. This is one of the business formalities your company should observe to conserve limited liability protection.
Different states have different rules for how to maintain your LLC. Some states require LLCs to hold regular meetings, document business decisions, and file an annual report. There might also be an LLC tax or franchise tax for the privilege of doing business in your state.
The Bottom Line
Given the tax consequences of a disregarded entity, the first person we recommend you consult is an experienced tax professional. They can tell you whether a disregarded entity is a good option for your business and how your tax burden will change if you opt for another type of business entity. For entrepreneurs, S-corporations, and real estate investors looking for favorable tax and liability treatment, a disregarded business entity is a business decision worth considering.