Disregarded Entity

What Is a Disregarded Entity?

A disregarded entity is a business entity that has a single owner and has not elected to be taxed as a separate entity by the Internal Revenue Service (IRS). This means taxes owed by this type of business are paid as part of the owner’s personal income tax return.

The term gets its name from the fact that the IRS disregards the company, or does not treat it as a separate taxable entity from its owner.

What Types of Businesses Can Be a Disregarded Entity?

In order to be a disregarded entity, a business must have one single owner. This means that single-member limited liability corporations can be disregarded entities (and are automatically regarded as such unless the owner elects otherwise), but partnerships or LLCs with multiple members cannot.

A disregarded entity must have an actual business structure. Unlike LLCs, sole proprietorships don’t operate with a formal legal entity. As a result, a sole proprietorship cannot be classified as a disregarded entity.

Additionally, because most corporations are distinct legal entities that file their own tax returns, they do not qualify as disregarded entities, despite the fact that some allow for pass-through taxation. Still, it’s important to note that there are exceptions to this rule, as is the case with qualified subchapter S subsidiaries and REIT subsidiaries.

Disregarded Entity Examples

There are a few disregarded entity examples that can help you understand which specific businesses qualify for this designation:

• Single-member LLC: A business with one owner in which that owner pays taxes on their personal income tax returns
• Qualified joint venture: A business co-owned by a married couple operating in a community property state
• Qualified subchapter S subsidiary: An S-corp that is owned by another S-corp, which means it has a single owner and is not taxed as a separate legal entity
• Qualified REIT subsidiary: A business structure in which the REIT owns all stock, meaning the subsidiary has a single owner and is not taxed separately

These businesses are usually automatically taxed as disregarded entities. In some cases (such as single-member LLCs), they can elect to be taxed differently by the IRS.

Does a Disregarded Entity Have to File Tax Returns?

Since the owner pays the disregarded entity’s federal taxes on their personal return, the disregarded entity is not required to file a federal income tax return. Some state laws vary, though, so consult your state tax office to learn what’s required in your area.

A disregarded entity is also responsible for paying employment taxes and certain excise taxes if they are due.

What Would Disqualify a Single-Member LLC From Being a Disregarded Entity?

In most cases, a single-member LLC is considered a disregarded entity by the IRS by default. However, there are two situations in which this type of business entity can become disqualified for that designation.

Corporate Taxation

Single-member LLCs qualify for disregarded entity status in part because of the owner’s decision to not be taxed as a separate entity and instead report business income on their personal taxes. However, that all changes when a business owner files Form 8832 with the IRS and elects to be taxed as a corporation.

When corporate taxation is elected, the business will then be regarded as a separate entity from the owner. As such, the business must file and pay its own corporate taxes, which means it can no longer be ignored or disregarded by the IRS.

Additional Members

To qualify as a disregarded entity, a company is allowed to have only one owner. The minute a single-member LLC acquires even one additional owner, it’s no longer classified the same way.

Adding an owner to the LLC now makes it a business partnership in the eyes of the IRS. Unless the new owner is the other half of a married couple and that couple decides to start a qualified joint venture in a community property state, the business will lose its disregarded entity status.

What Are the Advantages of a Disregarded Entity?

Many business owners choose to structure their business as a disregarded entity because of the significant benefits it brings. Not only are there financial advantages, but disregarded entities also help business owners protect their assets and save time and possible frustration in the long run.

Tax Advantages

A disregarded entity enjoys substantial tax advantages. Unlike regular corporations, a disregarded entity is not subject to double taxation, where a corporation pays taxes on its profits, and then the profits are taxed again when the corporation’s owners receive dividends.

Instead, owners of disregarded entities enjoy the benefits of pass-through taxation. As an LLC owner, you are not considered an employee of the business and, therefore, you won’t have to pay employment taxes on your income. Rather than paying taxes twice, you’ll only pay them once on your personal income tax return.

Simple Administration

It’s also simpler for a disregarded entity to handle income taxes since it doesn’t have to file its own separate return. This saves business owners (especially those without a dedicated accounting department) a great deal of time and removes worries about tax compliance-related fines and penalties.

It also removes the financial and administrative burden of having to hire someone to outsource tax preparation. In turn, this allows you to allocate resources for other important business activities.

Legal Protection

The status of “disregarded entity” is only relevant at the federal level. At the state level, the business is still considered a separate entity even though it isn’t taxed as such by the IRS.

Consequently, a disregarded entity provides some legal protection for both the owner and the SMLLC, so legal action against one is less likely to affect the other. By law, the owner’s personal assets are separated from the disregarded entity’s business assets.

Disadvantages of a Disregarded Entity

There are certainly many administrative and monetary benefits to running a business that qualifies as a disregarded entity. However, just like everything else in business, there are also a few drawbacks. Here is an explanation of some of the tradeoffs business owners make when they operate a disregarded entity.

Legal Complexities in Running the Business

The laws surrounding disregarded entities are both highly specific and very complex. If you’re not well versed in tax laws, you will likely need help from an accountant, tax advisor, or financial expert to understand them. This advice will be key in ensuring that you are running the business properly and staying in compliance with the law.

Unfortunately, this can be an added expense or administrative burden for your business. Though you can outsource the tax filing responsibilities to another party, you can’t get away from ultimately having to make tax decisions for the business.

Limits on the Type of Business You Can Start

Because of the complicated laws governing disregarded entities, choosing this type of business structure means having limits on the type of business you can start. For example, you’ll be limited to a single-member LLC or qualified joint venture (and that’s only if you live in a community property state).

If you want to enjoy the advantages of running a C-corp or S-corp, you’ll have to give up some of the advantages of operating a disregarded entity — including those attractive tax benefits. Though a disregarded entity is simpler to run, these limits can impact your goals, financial outlook, and future decisions.

Limits on the Changes You Can Make to Your Business

In addition to limiting the type of business you can start, having disregarded entity status also limits the changes you can make to your business (and sometimes to your personal life). For example, if you’re running a qualified joint venture and opt to move out of state, you could lose your business status depending on the community property laws in that jurisdiction.

If you’re a single-member LLC and wish to add another owner to the business or elect to be taxed as a corporation, you will likely have to make the tradeoff of losing your disregarded entity status. As your business grows and shifts, you will have to make tough decisions about what’s best on both a financial and administrative level.

Requirements for Employment and Excise Taxes

Disregarded entities enjoy income tax benefits. However, when it comes to dealing with the IRS, disregarded entity status does not exempt business owners from having to pay other taxes.

If your disregarded entity has employees, the IRS still expects the business to pay employment and payroll taxes multiple times per year. These are separate from income taxes and consist of obligations like Medicare and Social Security taxes.

Additionally, if you operate your business in certain industries (such as crude oil, tobacco, or alcohol), you will still owe excise taxes to the IRS. Like employment taxes, these taxes must be paid multiple times throughout the year, which is an added administrative burden for businesses.

Requirements for Self-Employment Taxes

If you are maintaining a disregarded entity for tax purposes, it’s important to realize that it doesn’t exempt you from personal taxation.

As the single owner of the business, you are considered by the government to be self-employed rather than being an employee. This means you become responsible for paying self-employment taxes, which are imposed to cover Medicare and Social Security taxes.

Furthermore, these taxes are in addition to — not in lieu of — your employment and excise taxes. One of the ways to avoid these taxes includes electing to be taxed as an S-corp and paying yourself a salary as an employee. However, doing so can ultimately jeopardize your disregarded entity status.

Possible Hesitancy From Investors

If you want to maintain your business’s status as a disregarded entity, you may have to deal with the fact that some investors and financial institutions will see your business as less credible than a corporation. Not only do corporations tend to be larger and viewed as more stable, but they can also offer shares for purchase. Having shareholders can add to a business’s sense of stability.

If you are running a startup and need additional funding to grow, you may want to reconsider maintaining disregarded entity status. Although raising money as an LLC is not impossible, the level of difficulty involved can outweigh the perceived advantages for many business owners.