Disregarded Entity

A disregarded entity is a structure in which a business is not considered separate from its owner for tax purposes. This means that the business's income, losses, and tax obligations are reported directly on the owner's personal tax return without the company filing a separate tax return.

A disregarded entity is a structure that simplifies tax reporting by allowing the business's income, losses, and tax obligations to flow directly to the owner. While it offers tax simplicity and can offer legal protections in the case of an LLC, it also requires the owner to take responsibility for reporting all business financials on their individual tax return and making any applicable payments. This structure is particularly beneficial for small businesses and self-employed individuals seeking a blend of liability protection and tax efficiency.

• Tax Simplicity: A disregarded entity is treated as part of its owner for tax purposes, so the business doesn't file its own tax return. Instead, the owner reports the business's income and expenses on their tax return.
• Common Example: Single-member Limited Liability Companies (LLCs) are the most common type of disregarded entity and are automatically designated as such.
• Legal Separation: Although disregarded entities are not separate from their owners for tax purposes, they can still be legally separate, offering liability protection in the case of an LLC, for example. That's one of the reasons this business structure is so popular.

In the world of business and taxes, a disregarded entity is a classification for certain types of companies that are essentially ignored for federal tax purposes. This means that while the business might exist as a separate legal entity, it is not treated as a separate entity for tax reporting. Instead, all of the business's financial activities are reported on the owner's personal tax return.

The term disregarded entity comes from the fact that, in the eyes of the Internal Revenue Service (IRS), the entity is "disregarded" for tax purposes, and all income, expenses, and deductions are treated as if they belong directly to the owner. Because of this, single-member LLC disregarded entities do not necessarily need an independent employer identification number (EIN), although they can acquire one if desired. However, they must apply for their own EIN if they have employees or excise tax liability.

Common Examples of Disregarded Entities

A single-member LLC is the most common type of disregarded entity (especially popular among small business owners, freelancers, and entrepreneurs). When someone forms an LLC with only one owner (member), the IRS automatically classifies it as a disregarded entity for federal tax purposes unless the owner elects to tax the business as a corporation. This allows the owner to enjoy the limited liability protections of an LLC without the need to file a separate tax return for the company.

Another example of a disregarded entity is a qualified subchapter S subsidiary. In this case, a parent S corporation owns a subsidiary, which is disregarded for tax purposes, meaning its financials are included in the parent S corporation's tax return.

It's important to note that while disregarded entities are treated as part of their owner for federal tax purposes, they may still be required to file separate tax returns for state or local taxes, depending on the jurisdiction. State laws vary; some states may treat disregarded entities differently than the IRS does.

Common Examples of what is NOT a Disregard Entity

C corporations, even single-member C-corps, are not disregarded entities. This means that the IRS counts the member and the corporation as two separate entities, and both will need to pay taxes on the money made from the business. This is often called double taxation because the same income stream is taxed at two levels.

**Sole proprietorships and S corporations** might be confused with disregarded entities because they are pass-through entities, meaning they do not engage in double taxation. But technically, these are not disregarded entities (sole proprietorship also does not offer limited liability protection). **Partnerships and LLCs with more than one member** are also not disregarded entities.

Benefits of Being a Disregarded Entity

• Simplified Tax Reporting: Since the disregarded entity does not file a separate tax return, the owner reports all of the business's income and expenses on their tax return. For a single-member LLC, this means filing a Schedule C (Profit or Loss from Business) along with Form 1040. This simplicity saves time and reduces administrative burdens.
• Limited Liability Protection: A single-member LLC is disregarded for tax purposes but still exists as a separate legal entity. This means the owner can enjoy the personal liability protection that LLCs offer. If the business faces a lawsuit or accrues debt, the owner's personal assets are generally protected from these liabilities.
• Flexibility: Disregarded entities offer flexibility in how they are treated for tax purposes. For example, a single-member LLC can choose to be treated as a corporation for tax purposes if that is more beneficial. However, by default, it will be classified as a disregarded entity.

Challenges of Being a Disregarded Entity

• Self-Employment Taxes: Owners of disregarded entities, especially single-member LLCs, are typically responsible for paying self-employment taxes on their business income. This means that in addition to regular income taxes, the owner may be liable for Social Security and Medicare taxes, which can add up to 15.3% of their business income.
• Lack of Separation for Tax Liability: Although disregarded entities offer legal separation between the owner and the business, this separation does not apply to taxes. The owner is fully responsible for reporting and paying taxes on all business income, which could lead to higher personal tax liabilities. They're also responsible for payroll taxes, if applicable.
• Potential for Confusion: The term "disregarded entity" can be confusing because it implies that the business does not exist. However, the business still exists as a legal entity. The disregard only applies to federal tax filing status. This can create misunderstandings, particularly for new business owners.
• Investor Limitations: If a business is looking to grow and raise capital in exchange for ownership, it would no longer be considered a disregarded entity because it has more than one owner. This could limit potential growth if owners aren't willing to change their tax structure.