What is a Disregarded Entity? Business 101

Many small business owners eventually elect to form limited liability companies . This confers upon them several tax-related advantages, as well as protects owners and executives from liability in the event that the company in question eventually goes under. However, some smaller businesses may elect to be considered “disregarded entities”. Like LLC status, the status of disregarded entity can make a big difference in terms of taxable income for a given business. It can heavily influence how much you have to pay or are owed at the end of every tax year. Let’s break down disregarded entities in more detail so you know whether you should count your business as one or if you should stick with a traditional LLC status.

What Exactly is a Disregarded Entity?

To understand what a disregarded entity is, you first have to understand why companies are treated as separate entities legally. In a nutshell, businesses can elect to become limited liability companies , corporations, and other types of companies in order to separate the activities and liability of their business from their owners. For example, a limited liability company prevents its owners or executives from necessarily going bankrupt if the LLC in question runs out of money or is found guilty of certain irresponsible practices. Owners and executives often transform their companies into different business structures for tax benefits, to protect themselves in the event of expenses or legal accusations, and more. However, company executives may sometimes wish to form limited liability companies or other business types without separating their business from their taxes. Therefore, a disregarded entity is any business entity with a single owner that isn’t recognized as a separate taxable entity from that owner. Because of the inherent limitation in the definition (there can only be a single owner or chief executive), most disregarded entities are so-called single-member LLCs, although there are a few exceptions. The net profits and other taxable information for a disregarded entity must be reported alongside the tax information of its owner. Put in other words, a disregarded entity simply doesn’t exist when it comes to tax information.

Single-Member LLCs and Other Disregarded Entities

As mentioned, the most common disregarded entity is the single-member LLC or SMLLC . A single-member LLC is exactly what it sounds like: it's a limited liability company with a single member instead of a group of executives. Many small businesses are also single-member LLCs since they gain special benefits from transitioning without their owners necessarily having to separate their income from those of their businesses. As a result, any SMLLC won't have to file a separate tax return. Instead, both the income and loss for that business is filed by the single SMLLC member/owner. Such taxes must be reported on Form 1040. Note that, by default, the IRS only recognizes two types of LLCs for tax purposes: partnerships if there is more than one member and sole proprietorships if there’s just a single member. If the owner of the SMLLC in question is a corporation, any income or loss will be reported on Form 1120: the standard form on which corporations file their tax return info. In addition to SMLLCs, there are two types of corporations that can also qualify as disregarded entities: qualified subchapter S subsidiaries and qualified REIT (real estate investment trust) subsidiaries.

How To Become a Disregarded Entity

If you want to make sure that your business is considered to be a disregarded entity and is not totally separated from your own income come tax time, you need to elect for your business to be regarded as one. To do this, just file any single-member LLC taxes using a Schedule C form. Then, be sure to include the net income or loss for your single-member LLC on your personal income tax return. This will ensure that the IRS defaults to considering your SMLLC as a disregarded entity. You should also:

• Use your Social Security number for any income tax purposes. This should be easy since any single-member LLC won't have any other Social Security numbers to worry about. Furthermore, any SMLLC that doesn't have employees also doesn't need an employer identification number or EIN
• Use your own tax ID number for any federal tax purposes
• Remember that you don't need to apply any employment taxes. This is, theoretically, because you don't have any employees

Furthermore, be sure to check any state-specific requirements regarding income tax. Some states may require that you use a specific form if you want to file as a disregarded entity SMLLC.

Two-Spouse Businesses

There is a special case in all of this that only crops up when two spouses collectively own the same business. In this case, both spouses can treat the entity as disregarded when it comes to tax purposes. This only qualifies because married couples can file jointly already or as the same taxable entity. In IRS parlance, this is called a "Qualified Joint Venture". In such a case, both spouses will file two Schedule C tax returns. This splits the net income of the business equally between them. Note that such cases are only eligible for any couples that:

• Live in a community property state
• Own the business together with no one else
• Own a business that is not taxed as a corporation

Therefore, you should investigate all of these aspects before filing your taxes like your business is a disregarded entity. If you make a mistake, you could be in trouble come tax time.

Advantages of Being a Disregarded Entity

With all this said, why would anyone bother filing to be a disregarded entity when so many companies become LLCs specifically for their tax benefits? In reality, there are lots of advantages to your business being considered a disregarded entity by the IRS.

Potentially Bigger Returns

For starters, if your company isn’t particularly big and doesn’t make a huge amount of profit, you can potentially benefit from a bigger tax return or fewer taxes owed if all of your business’s income and expenses are reported on your tax forms. Remember, with a disregarded SMLLC, any income from the business is effectively the same thing as your income. The IRS makes no distinction.

Easier Tax Filing

There's definitely something to be said for the easier time that disregarded SMLLC owners have when filing their taxes. In these scenarios, business owners alone are taxed rather than both the business owner and the business. This saves you time since you only have to file a single tax return rather than two, going over extensive records all the while.

You Still Get Liability Benefits

Even though SMLLCs are considered to be disregarded entities by default, such companies still limit the liability that their owners might face for bankruptcy or other issues. At the state level, any SMLLC is still considered to be a separate legal entity from the owner. Thus, any liability advantages conferred by the LLC structure are retained. For instance, any assets owned by the SMLLC in question will still be protected by any creditor claims that might be placed on the company owner and vice versa.

Disadvantages of Being a Disregarded Entity

Note that there are also some disadvantages to electing to be considered a disregarded entity.

• Such LLCs are often still liable for both employment and excise taxes. Still, this only applies if you have more employees beyond yourself. If you run your business as a solo operation, you don’t need to worry about this potential downside.
• Self-employment taxes can be quite high and are still applied. Even as a disregarded entity, SMLLC owners must still pay self-employment taxes. These are on top of any normal income taxes. However, there is some good news – the amount you pay for self-employment taxes is deductible up to a certain maximum limit.

Because there are both positives and negatives to the disregarded entity path, business owners should consider carefully which one they want to choose. Of course, you can eventually switch later down the road. But it takes time, and often money, to make the switch.

Summary

Overall, disregarded entities are best understood as single-member LLCs that are taxed as the same entity as their owners. SMLLCs are disregarded entities by default, although a few other rare types of business organizations can also qualify. Disregarded entities do not count as separate taxable entities at the federal level. This allows SMLLC and other business owners to file a single tax return at the end of the year, as well as potentially gain some additional advantages. At the same time, disregarded entities retain the other benefits of their business structures, such as limited liability for limited liability companies. At Seek Capital you can learn more about SMLLCs and other business tips by browsing our extensive business guides . Don’t hesitate to contact us for assistance with business loans or other advice! Sources https://www.nolo.com/legal-encyclopedia/what-is-a-limited-liability-company.html https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-companies https://www.legalzoom.com/articles/pros-and-cons-of-being-a-disregarded-entity