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What is a disregarded entity LLC?

A disregarded entity LLC may be helpful to small business owners because it combines the features of a limited liability company with those of a sole proprietorship.

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Entrepreneurs are often drawn to limited liability companies (LLCs) because of the inherent liability protection and flexibility in tax filing. Limited liability means that a creditor isn't allowed to go after the business owner’s personal assets in case the business fails to pay its debts and obligations.

At the same time, the Internal Revenue Service (IRS) allows LLC owners to choose the tax status they prefer. Options include sole proprietorship, partnership, S corporation (S corp), and C corporation (C corp). By having this flexibility, small business owners can choose a status that guarantees the lowest possible federal tax returns.

It’s impossible to ignore the advantages of a sole proprietorship, particularly its simplicity in management. As a sole proprietor, you have complete control over the business. Plus, there’s less paperwork involved when you are setting up this type of entity. That’s why sole proprietorships are the most popular business structure in the U.S., accounting for over 23 million small businesses1.

Sole proprietorships do not have the legal protections of LLCs. You can get the best of both business structures by forming a disregarded entity LLC. This is an LLC that provides the simple management structure of a sole proprietorship. Read on to find out everything you need to know about a disregarded entity LLC, including its pros, cons, and income tax requirements.

Key takeaways

  • A disregarded entity LLC is not considered a taxpayer by the IRS. Instead, it passes its income to the owner, who then files personal income returns.
  • While real estate investment trusts (REITs) and qualified subchapter S subsidiaries are also disregarded entities, the most common type of disregarded entity is the single-member LLC.
  • Being a disregarded entity may simplify your tax filing and help you avoid double taxation.

What is a disregarded entity LLC?

A disregarded entity LLC is a single-member limited liability company (SMLLC) that’s treated as a sole proprietorship for tax purposes. This means the business itself does not pay taxes. Instead, it passes its income through to the owner, who then files personal income tax returns using Schedule C. The term “disregarded entity” means the IRS doesn’t recognize the business as being separate from its owner. In other words, there’s no difference between you and your LLC in the eyes of the IRS.

Despite the IRS ignoring LLCs for federal income tax purposes, a disregarded entity is a valid business structure in all 50 states. State laws allow entrepreneurs to form single-member LLCs. They come with all the legal protections of an LLC, including liability protection. A disregarded LLC is no different from a multi-member LLC, which is protected like a corporation but taxed like a partnership.

Example of a disregarded entity

While there are several types of business structures that the IRS recognizes as disregarded entities, the most common example is the single-member limited liability company (SMLLC). Owners of SMLLCs report business profits on their income tax returns, even though the business absorbs liabilities.

Say that you want to start a laundromat business as a single owner. You have the option to set it up as a sole proprietorship. This type of business structure doesn’t have liability protection. If you want these legal protections, you would need to form a limited liability company. Since you are the sole owner, the company would be a single-member limited liability company.

Your business would provide the limited liability of a typical LLC, but have disregarded entity status by the IRS. Your business wouldn’t pay any taxes. Instead, it would pass its income – along with losses, deductions, and credits – to you, who would then file personal tax returns using Schedule C. 

How do I know if I am a disregarded entity?

Your business is a disregarded entity if it’s:

  • A real estate investment trust (REIT)4
  • A qualified subchapter S subsidiary (QSub subsidiary)3, or
  • A single-member limited liability company (SMLLC)2

If your company falls in any of the above categories, then it may be disregarded, assuming you haven’t previously selected a different entity classification. Of the three, SMLLCs are the most common. 

By default, the IRS will not treat your SMLLC, REIT, or qualified Chapter S subsidiary as a separate entity from you. For federal income tax purposes, your company essentially doesn’t exist and isn’t subject to any business taxes. You assume all its earnings and file taxes on your tax return. This applies to LLCs that have a single owner, whether that owner is an individual or S corporation.

Any LLC with more than one owner is automatically taxed as a partnership and isn’t a disregarded entity. In states that have community property laws, the IRS may allow LLCs that are owned by two spouses to be treated as disregarded entities. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Consider checking your state law to see its provisions and requirements regarding spouse-owned LLCs.

How do you apply for a disregarded entity LLC?

As long as you are the sole owner, you don’t need to submit any application documents for the IRS to treat your LLC as a disregarded entity. Simply file your SMLLC taxes using Schedule C of Form 1040. This is where you report your company’s net income or loss, and it will automatically put you in the disregarded entity classification. 

Can you lose your disregarded entity status?

Yes, an SMLLC can lose its disregarded entity classification. This may happen:

  • If you file IRS Form 8832 (Entity Classification Election) which taxes you as a corporation,
  • If you add one or more members to your LLC, losing your single-member status,
  • If your business fails to comply with SMLLC state law and is stripped of this status.

Does a disregarded entity LLC have to file business taxes?

A disregarded LLC doesn’t have to file federal income tax returns. Instead, the business owner pays taxes on their personal tax returns – as is the case with sole proprietorships. This is known as pass-through taxation. Some states may have exceptions, so make sure to consult a professional accountant if need be.

Depending on the industry and state of incorporation, you may also need to pay sales and excise taxes that apply to your business. Keep a keen eye on excise taxes because different types of these taxes are treated differently. According to IRS regulations – specifically Regs. Secs. 301.7701-2(c)(2)(iv) and (v) – a business entity with a single owner may only be treated as a disregarded entity for excise taxes specified in Code chapters 31 through 36 and 38. The business may be treated as a corporation for other excise taxes. 

Self-employment tax 

As the owner of an SMLLC, the IRS doesn’t consider you an employee of the business. Instead of receiving a salary, you may draw profits from your capital accounts. The money isn’t taxed at a business level when you are drawing it. Instead, it’s passed to you, after which you pay income and self-employment taxes every quarter. 

Self-employment taxes are paid by business owners (as well as freelancers and independent contractors) who have no employers to withhold their employment taxes. The current rate of self-employment tax is 15.3%, which covers both Social Security and Medicare.

Employment taxes

While the IRS disregards SMLLCs when they are filing income taxes, it considers these entities separate from their owners when they are paying employment taxes. If your SMLLC has staff, you will have to withhold and pay employee taxes separately from your personal taxes. This means using the business’s Employer Identification Number (EIN) to file employment taxes.

Pros of being a disregarded entity

  • Simpler tax filing. Disregarded entities have an easier time during taxes because the business itself is not a taxpayer – it doesn’t have to file separate returns. Instead, most of the tax filing can be handled by the business owner, which helps save time and money.
  • Pass-through taxation. Disregarded entities are not taxed at business level. All income is passed through to the business owner, who then pays federal taxes on their personal tax returns. This avoids double taxation, which corporations often experience. Double taxation is basically where a corporation is taxed on business earnings and dividends.
  • Liability protection. The disregarded entity status of an SMLLC doesn’t take away its liability protection. While the IRS may disregard your business for federal tax purposes, you still enjoy the limited liability that comes with an LLC. As far as legal protection of the owner's assets, a disregarded LLC is similar to a multi-member LLC.
  • Flexibility in taxation. By default, an SMLLC is treated as a disregarded entity. However, you can elect to have it taxed as an S corp or C corp. Each tax classification comes with different requirements and liabilities, so make sure to do some groundwork before choosing a status. 

Cons of being a disregarded entity 

  • Excise and employment taxes. An SMLLC is only disregarded for federal income taxes and some excise and employment taxes. If the business has employees and is subject to excise taxes, it may need to file some of them as a business entity using its Employer Identification Number (EIN). If you’re not sure which excise and employment taxes should be filed by your SMLLC, consult a professional accountant.
  • Thinner corporate veil. Disregarded entities enjoy liability protection but creditors often seek the owner’s personal assets in case the business defaults. 

Disregarded entity vs. a partnership

While disregarded entities are ignored by the IRS for tax purposes, partnerships are not. All kinds of partnerships – including limited liability partnerships, limited partnerships, and general partnerships – can’t be treated as disregarded entities so their taxes can’t be figured on Schedule C.

Partners can pass through their business income to each other. They are just not disregarded because the IRS doesn’t ignore them as it does SMLLCs. A partnership can turn into a disregarded entity if its ownership reduces to a single person, which essentially turns it into a sole proprietorship. 

A special case exists when a business is owned by two spouses. Through the community property provision (which creates Qualified Joint Ventures), the IRS may treat such a business as a disregarded entity despite having more than one owner. This is only applicable in a community property state, and if the two spouses are the only owners of the business. They also must not have elected to be taxed as a corporation. 

References 

The Startups Team. “Sole Proprietorships: What You Need to Know.” Startups.com, 9 Jul. 2018, https://www.startups.com/library/expert-advice/sole-proprietorship

IRS. “Single Member Limited Liability Companies.” 15 Jun. 2022, https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-companies

IRS. “About Form 8869, Qualified Subchapter S Subsidiary Election.” 15 Jun. 2022, https://www.irs.gov/forms-pubs/about-form-8869

IRS. “Instructions for Form 1120-REIT (2021).” 15 Jun. 2022, https://www.irs.gov/instructions/i1120rei

Alistair M. Nevius. “Excise and Employment Tax Treatment of Disregarded Entities Clarified.” Association of International Certified Professional Accountants, 1 Jan. 2012, https://www.thetaxadviser.com/issues/2012/jan/newsnotes-jan2011-story-04.html

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